Equity Returns and Business Cycles in Small Open Economies

Jahan-Parvar, Mohammad R. and Liu, Xuan and Rothman, Philip (2009): Equity Returns and Business Cycles in Small Open Economies.

Abstract

This is the first paper in the literature to match key business cycle moments and long-run equity returns in a small open economy with production. These results are achieved by introducing three modications to a standard real business cycle model: (1) borrowing and lending costs are imposed to increase the volatility of the intertemporal marginal rate of substitution; (2) investment adjustment costs are assumed to make equity returns more volatile; and (3) GHH preferences are employed to smooth consumption. We also decompose the contributions of productivity, the world interest rate, and government expenditure shocks to the equity premium. Our results are based on data from Argentina, Brazil, and Chile.

• Item Type: MPRA Paper
• Language: English
• Keywords: Asset Pricing; Equity Returns; Dynamic Stochastic General Equilibrium Model; Real Business Cycle; Small Open Economy.
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Aguiar, M. A., Gopinath, G., 2007. Emerging Market Business Cycles: The Cycle is the Trend. Journal of Political Economy 115 (1), 69-102.

Atkeson, A., Phelan, C., 1994. S. Fischer and J. J. Rotemberg (ed.), NBER Macroeconomics Annual 1994. MIT Press, Cambridge, Ch. Reconsidering the Costs of Business Cycles with Incomplete Markets.

Bansal, R., 2008. Rajnish Mehra (ed.), Handbook of the Equity Risk Premium. Elsevier, Amsterdam, Ch. Long-Run Risks and Risk Compensation in Equity Markets.

Bansal, R., Yaron, A., 2004. Risks For the Long Run: A Potential Resolution of Asset Pricing Puzzles. Journal of Finance 59, 1481-1509.

Barro, R. J., 2009. Rare Disasters, Asset Prices, and Welfare Costs. American Economic Review 99 (1), 243-264.

Bekaert, G., Harvey, C. R., 2003. Emerging Markets Finance. Journal of Empirical Finance 10, 3-55.

Boldrin, M., Christiano, L. J., Fisher, J. D. M., 2001. Habit Persistence, Asset Returns, and the Business Cycle. American Economic Review 91 (1), 149{166. Burnside, A. C., Eichenbaum, M., Fisher, J., 2004. Fiscal Shocks and Their Consequences. Journal of Economic Theory 115 (1), 89-117.

Campbell, J. Y., Cochrane, J. H., 1999. By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior. Journal of Political Economy 107 (2), 205-251.

Campbell, J. Y., Mankiw, G. N., 1989. Olivier Jean Blanchard and Stanley Fischer (ed.), NBER Macroeconomics Annual: 1989. MIT Press, Boston, MA, Ch. Consumption, Income, and Interest Rates: Reinterpreting Time Series Evidence, pp. 185-216.

Cecchetti, S. G., Lam, P.-S., Mark, N. C., 1993. The Equity Premium and the Risk- Free Rate: Matching the Moments. Journal of Monetary Economics 31 (1), 21-45.

Chari, V. V., Kehoe, P. J., McGratten, E. R., 2005. Sudden Stops and Output Drops. American Economic Review 95 (2), 381-387.

Cochrane, J. H., 2006. Financial Markets and the Real Economy. Working Paper, Graduate School of Business, University of Chicago, 1-94.

Constantinides, G. M., Duffie, D., 1996. Asset Pricing with Heterogeneous Consumers. Journal of Political Economy 104 (2), 219-240.

Epstein, L. G., 1983. Stationary Cardinal Utility and Optimal Growth Under Uncertainty. Journal of Economic Theory 31 (2), 133-152.

Epstein, L. G., Zin, S. E., 1991. Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis. Journal of Political Economy 99 (2), 263-286.

Gallant, A. R., McCulloch, R. E., 2009. On the Determination of General Scientic Models with Application to Asset Pricing. Journal of the American Statistical Association 104 (485), 117-131.

Greenwood, J., Hercowitz, Z., Huffman, G. W., 1988. Investment, Capacity Utilization, and the Real Business Cycles. American Economic Review 78, 402-417.

Hodrick, R. J., Prescott, E. C., 1997. Postwar U.S. Business Cycles: An Empirical Investigation. Journal of Money, Credit and Banking 29 (1), 1-16.

Jermann, U. J., 1998. Asset Pricing in Production Economies. Journal of Monetary Economics 41, 257-275.

Kydland, F. E., Prescott, E. C., 1982. Time to Build and Aggregate Fluctuations. Econometrica 50 (6), 1345-70.

Lubik, T., Schorfheide, F., 2006. Mark Gertler and Kenneth Rogoff (ed.), NBER Macroeconomics Annual 2005. MIT Press, Cambridge, MA, Ch. A Bayesian Look at New Open Economy Macroeconomics.

Mehra, R., Prescott, E. C., 1985. The Equity Premium: A Puzzle. Journal of Monetary Economics 15, 145-161.

Mendoza, E. G., 1991. Real Business Cycles in a Samll Open Economy. American Economic Review 81 (4), 797-818.

Mendoza, E. G., Smith, K. A., 2006. Quantitative Implications of a Debt-Deflation Theory of Sudden Stops and Asset Prices. Journal of International Economics 70, 82-114.

Michalopoulos, C., 1969. Productivity Growth in Latin America: Comment. American Economic Review 59 (3), 435-439.

Neumeyer, P. A., Perri, F., 2005. Business Cycles in Emerging Economies: the Role of Interest Rates. Journal of Monetary Economics 52, 345-380.

Ravn, M., Schmitt Grohe, S., Uribe, M., 2008. The Macroeconomics of Subsistence Points. Macroeconomic Dynamics 12, 136-147.

Ravn, M., Schmitt-Grohe, S., Uribe, M., 2009. Incomplete Cost Pass-Through Under Deep Habits. Review of Economic Dynamics, forthcoming.

Schmitt-Grohe, S., Uribe, M., 2003. Closing Small Open Economy Models. Journal of International Economics 61, 163-185.

Schmitt Grohe, S., Uribe, M., 2004. Solving Dynamic General Equilibrium Models Using a Second - Order Approximation to the Policy Function. Journal of Economic Dynamics and Control 28, 755-775.

Tallarini Jr., T. D., 2000. Risk-Sensitive Real Business Cycles. Journal of Monetary Economics 45, 507-532.

Uribe, M., Yue, V. Z., 2006. Country Spreads and Emerging Countries: Who Drives Whom? Journal of International Economics 69, 6-36.