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This paper shows how changes in the volatility of the real interest rate at which small open emerging economies borrow have a quantitatively important effect on real variables like output, consumption, investment, and hours worked. To motivate our investigation, we document the strong evidence of time-varying volatility in the real interest rates faced by a sample of four emerging small open economies: Argentina, Ecuador, Venezuela, and Brazil. We postulate a stochastic volatility process for real interest rates using T-bill rates and country spreads and estimate it with the help of the Particle filter and Bayesian methods. Then, we feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model. We calibrate eight versions of our model to match basic aggregate observations, two versions for each of the four countries in our sample. We find that an increase in real interest rate volatility triggers a fall in output, consumption, investment, and hours worked, and a notable change in the current account of the economy. Download Paper
The existing literature on the stabilizing properties of interest-rate feedback rules has stressed the perils of linking interest rates to forecasts of future inflation. Such rules have been found to give rise to aggregate fluctuations due to self-fulfilling expectations. In response to this concern, a growing literature has focused on the stabilizing properties of interest-rate rules whereby the central bank responds to a measure of past inflation. The consensus view that has emerged is that backward-looking rules contribute to protecting the economy from embarkingon expectations-driven fluctuations. A common characteristic of the existing studies that arrive at this conclusion is their focus on local analysis. The contribution of this paper is to conducta more global analysis. We find that backward-looking interest-rate feedback rules do not guarantee uniqueness of equilibrium. We present examples in which for plausible parameterizations attracting equilibrium cycles exist. The paper also contributes to the quest for policy rules that guarantee macroeconomic stability globally. Our analysis indicates that policy rules whereby the interest rate is set as a function of the past interest rate and current inflation are likely to ensure global stability provided that the coefficient on lagged interest rates is greater than unity. Download Paper