Business cycles in emerging markets: The role of liability dollarization and valuation effects

Understanding differences in business cycle phenomena between Emerging Market Economies (EMEs) and industrialized countries has been at the center of recent research on macroeconomic fluctuations. We investigate whether these are linked to credit market imperfections. To this end, we develop a small open economy Dynamic Stochastic General Equilibrium (DSGE) framework featuring both permanent and transitory productivity shocks, endogenous exchange rate movements, and liability dollarization and valuation affects, thereby accounting for the fact that emerging markets are facing difficulties in borrowing in domestic currency on international capital markets. We estimate our model using Bayesian techniques for several EMEs, thereby controlling for potential heterogeneity across countries. Our main findings regarding EMEs' business cycles are (i) despite financial frictions, trend shocks are the main determinant of macroeconomic fluctuations, (ii) accounting for liability dollarization ameliorates the model fit, and (iii) valuation effects on average stabilize changes in the net foreign asset position.