- 05 Nov 2009
- Working Paper
Medium Term Business Cycles in Developing Countries
Executive Summary — At the end of 2007, the U.S. economy entered a recession that, by the first quarter of 2009, had reduced U.S. GDP by 2.2 percent. The Mexican economy was showing no sign of distress until the U.S. recession began. Despite that, Mexican GDP declined by 7.8 percent during the same period. This and similar episodes from other developing countries motivate several questions: Why do shocks to developed economies affect developing countries to such an extent? Does the response of developing economies to shocks that originate in their developed neighbors account for the larger volatility of developing economies? More broadly, what ingredients do macroeconomic models need to incorporate in order to account for the unique features of economic fluctuations in developing economies? To investigate these questions, the researchers developed a two-country asymmetric model to study the business cycle in developing countries. The mechanisms introduced in the model should provide an accurate account of business cycles in other developing countries. Key concepts include:
- First, U.S. shocks have a larger effect on GDP in Mexico than in the United States. This result is driven by the larger amplitude of fluctuations in Mexican productivity and by the subsequent effects on investment. This finding has important implications for the sources of Mexican volatility.
- Second, the slow diffusion of technologies to Mexico results in U.S. shocks having more persistent effects on Mexico than in the United States. This result explains the observed lead of U.S. GDP over the medium-term component of Mexican output and the relative price of capital.
- Third, consumption is no less volatile than output in Mexico. The researchers' model accounts for this stylized fact because a Mexican recession slows down the diffusion of technologies to Mexico, generating a gradual increase in the price of installed capital. As a result, Mexican interest rates increase despite the lower marginal product of capital, and consumption drops precipitously.
We build a two country asymmetric DSGE model with two features: (i) a product cycle structure determines the range of intermediate goods used to produce new capital in each country and (ii) there are investment flow adjustment costs in the developing economy. We calibrate the model to match the Mexico-US trade and FDI flows. The model is able to explain (i) why US shocks have a larger effect on Mexico than in the US and hence why the Mexican economy is more volatile than the US; (ii) why US business cycles lead over medium term fluctuations in Mexico and (iii) why Mexican consumption is not less volatile than output. Keywords: Business Cycles in Developing Countries, Co-movement between Developed and Developing economies, Volatility, Extensive Margin of Trade, Product Life Cycle, FDI. 58 pages.