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M. R. Jahan-Parvar, X. Liu, and P. A. Rothman, 2013, Equity Returns and Business Cycles in Small Open Economies, Journal of Money, Credit, and Banking, 45(6), 1117-1146. [Link]
M. R. Jahan-Parvar, X. Liu, and P. A. Rothman, 2013, Equity Returns and Business Cycles in Small Open Economies, Journal of Money, Credit, and Banking, 45(6), 1117-1146. [Link]
Background
Background
To explain the observed equity premium in the data with economic theory is a classical question.
Jermann (1998) and Boldrin et al. (2001) are two important papers about the equity premium data in the US economy.
Both use models of a closed economy with production.
Their models generate the equity premium and key business cycles observed in the US economy.
Observation
Observation
Both models are subject to the volatility of risk free rates puzzle, a trade-off between equity premium and the volatility of risk free rates. Specifically, if their models generate the observed equity premium, the model-generated standard deviation of risky free rates will be too high (compared to the data), as shown in Case 1; or if their models generate the observed standard deviation of risk free rates, the model-generated equity premium will be almost zero, as shown in Case 2.
The reason is that the standard Euler equation with respect to bond generates a direct link between risk-free rates and marginal rates of substitution (MRS) across states. If risk-free rates are not volatile enough, MRS across states will be flat and the model generated equity premium will be almost zero.
However, for a small open economy (emerging economies are typically regarded as small open economies), it has to take the volatility of risky free rates as given. In other words, a simple extension of the models in Jermann (1998) and Boldrin et al. (2001) will fail to generate the observed equity premium in emerging economies, as implied by Case 2.
In this paper
In this paper
To generate observed equity premium with the given volatility of risk-free rates, it is necessary to break up the direct link between MRS and risk free rates.
We introduce financial frictions into the Mendoza (1991) model, a classical RBC model about a small open economy. With financial frictions, the direct link between MRS and risk free rates is broke up.
The model can generate the observed business cycle moments and equity returns in emerging economies.
In addition, the model can explain some puzzles (that are hard to explain with typical RBC models).
Main references
Main references
M. Boldrin, L. J. Christiano, and J. D.M. Fisher. (2001) Habit Persistence, Asset Returns, and the Business Cycle. American Economic Review, 91, 149–166.
J. Garcia-Cicco, R. Pancrazi, and M. Uribe, 2010. "Real Business Cycles in Emerging Countries?," American Economic Review, 100(5), 2510-2531.
S. Schmitt Grohé and M. Uribe, 2004. Solving Dynamic General Equilibrium Models Using a Second - Order Approximation to the Policy Function. Journal of Economic Dynamics and Control 28, 755–775.
U. Jermann, (1998) Asset Pricing in Production Economies. Journal of Monetary Economics, 41, 257–275.
E. Mendoza, (1991), Real Business Cycles in a Small Open Economy. American Economic Review, 81, 797–818.
M. Uribe and V.Z. Yue, 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, 69(1), 6-36,
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