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International Monetary Fund
This paper examines how durable goods and financial frictions shape the business cycle of a small open economy subject to shocks to trend and transitory shocks. In the data, nondurable consumption is not as volatile as income for both developed and emerging market economies. The simulation of the model implies that shocks to trend play a less important role than previously documented. Financial frictions improve the ability of the model to match some key business cycle properties of emerging economies. A countercyclical borrowing premium interacts with the nature of durable goods delivering highly volatile consumption and very countercyclical net exports.
International Monetary Fund

borrowing requirement ( Neumeyer and Perri, 2005 ). In this case, a countercyclical borrowing premium amplifies the variability of consumption because it makes the demand for labor more sensitive to the interest rate. Furthermore, shocks to the volatility of the borrowing premium also play a significant role in explaining the volatility of consumption in emerging market economies ( Fernández-Villaverde, Guerrón-Quintana, Rubio-Ramírez, and Uribe, 2009) . 1 None of these papers, however, consider durable goods. Other papers in the literature study the importance of

Stephen J. Turnovsky, Serpil Tekin, and Ms. Valerie Cerra

. Welfare Analysis Figures 1. Capital and Debt 2. Financial Variables 3. Sectoral Activity and Output 4. Consumption and Welfare 5. Sensitivity to Borrowing Premium: Untied Transfer 6. Sensitivity to Borrowing Premium: Productive Transfer to Traded Sector 7. Sensitivity to Borrowing Premium: Productive Transfer to Nontraded Sector

International Monetary Fund

estimates for Mexico 6. Simulated moments and parameter estimates for an alternative specifications of the borrowing premium

Stephen J. Turnovsky, Serpil Tekin, and Ms. Valerie Cerra
A dynamic dependent-economy model is developed to investigate the role of the real exchange rate in determining the effects of foreign aid. If capital is perfectly mobile between sectors, untied aid has no longrun impact on the real exchange rate. A decline in the traded sector occurs because aid, being denominated in traded output, substitutes for exports in financing imports. While untied aid causes short-run real exchange appreciation, this response is very temporary and negligibly small. Tied aid, by influencing sectoral productivity, does generate permanent relative price effects. The analysis, which employs extensive numerical simulations, emphasizes the tradeoffs between real exchange adjustments, long-run capital accumulation, and economic welfare, associated with alternative forms of foreign aid.
Stephen J. Turnovsky, Serpil Tekin, and Ms. Valerie Cerra

) where r * is the world interest rate and ω(N/ ( pK) ) is the borrowing premium that increases with the country’s stock of debt, N , relative to the value of its capital stock, pK . In making his individual decisions, the representative agent takes the interest rate as given. This is because the interest rate facing the debtor nation is an increasing function of the economy’s aggregate debt, which the individual, being atomistic, rationally assumes he is unable to influence. 10 Given this access to the world goods and financial markets, the domestic agent

Ding Ding

(1) household financial inclusion, that is, improving household access to financial markets in emerging Asia; (2) lowering the sensitivity of the external finance premium to corporate leverage (or net worth); and (3) reducing emerging Asia’s external borrowing premium, possibly through financial integration. Household financial inclusion scenario —This scenario assumes that the share of liquidity-constrained households in emerging Asia declines from 50 percent in the baseline scenario to 25 percent, the level that is applicable in advanced Asia. If more

Ding Ding, Mr. Waikei R Lam, and Mr. Shanaka J Peiris

savings in the region and potentially lower infrastructure financing cost. In particular, we illustrate the benefits of financial development in three scenarios representing the three important agents in the economy—households, corporate, and the sovereign. The three scenarios are: (i) household financial inclusion, i.e., improving household access to financial markets in emerging Asia; (ii) lowering the sensitivity of the external finance premium to corporate leverage (or net worth); and (iii) reducing emerging Asia’s external borrowing premium possibly through

Ding Ding, Mr. Waikei R Lam, and Mr. Shanaka J Peiris
There is a role for Asia’s financial sector to play to address the challenges associated with the region’s changing demographics and infrastructure investment needs. Enhancing financial innovation and integration in the region could facilitate intra-regional financial flows and mobilize resources from the aging savers in industrialized Asia to finance infrastructure investment in emerging Asia. Strengthening the financial ties within the region as well as with the global financial markets alongside appropriate prudential frameworks could also help diversify sources of financing and reduce the cost of funding in emerging Asia. Finally, financial deepening could help ease the potential overheating from scaling up infrastructure investment and hence achieve a more balanced growth in the region.
Mr. Subir Lall, Mr. Selim A Elekdag, and Mr. Harun Alp
Korea was one of the Asian economies hardest hit by the global financial crisis. Anticipating the downturn that would follow the episode of extreme financial stress, the Bank of Korea (BOK) let the exchange rate depreciate as capital flowed out, and preemptively cut the policy rate by 325 basis points. But did it work? This paper seeks a quantitative answer to the following question: Were it not for an inflation targeting framework underpinned by a flexible exchange rate regime, how much deeper would the recession have been? Taking the most intense year of the crisis as our baseline (2008:Q4?2009:Q3), counterfactual simulations indicate that rather the actual outcome of a -2.1 percent contraction, the outturn would have been -2.9 percent if the BOK had not implemented countercyclical and discretionary interest rate cuts. Furthermore, had a fixed exchange rate regime been in place, simulations indicate that output would have contracted by -7.5 percent over the same four-quarter period. In other words, exchange rate flexibility and the interest rate cuts implemented by the BOK helped substantially soften the impact of the global financial crisis on the Korean economy. These counterfactual experiments are based on an estimated structural model, which, along with standard nominal and real rigidities, includes a financial accelerator mechanism in an open-economy framework.