DP7264 Risk Matters: The Real Effects of Volatility Shocks

Author(s): Jesús Fernández-Villaverde , Pablo A. Guerron-Quintana , Juan Francisco Rubio-Ramirez , Martín Uribe

Publication Date: April 2009

Keyword(s): DSGE Models , Small Open Economy , Stochastic Volatility

JEL(s): C32 , C63 , F32 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7264.asp.asp

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.