Open Economy Business Cycle

Journal of International Economics 56 (2002) 299–327 www.elsevier.com / locate / econbase

Explaining business cycles in small open economies ‘How much do world prices matter?’
M. Ayhan Kose*
Graduate School of International Economics and Finance, MS-021, Brandeis University, Waltham, MA 02454, USA Received 27 May 1998; received in revised form 20 October 2000; accepted 7 April 2001

Abstract This paper analyzes the role of world price shocks – fluctuations in the prices of capital, intermediate, and primary goods, and in the world real interest rate – in the generation and propagation of business cycles in small open developing countries. I construct a stochastic dynamic multi-sector small open economy model. The model is a variant of the specificfactors model and reflects the major structural characteristics of developing economies. I utilize variance decomposition methods to quantitatively evaluate the impact of world price shocks. The results indicate that world price shocks account for a significant fraction of business cycle variability in developing countries. © 2002 Elsevier Science B.V. All rights reserved.
Keywords: Business cycles; Relative prices JEL classification: F41; E31; E32; D58

1. Introduction Small open developing countries differ from developed economies along several dimensions. They rely heavily on a narrow range of primary commodities for their export earnings. These earnings are highly unstable due to recurrent and sharp fluctuations in the relative prices of primary commodities. Moreover, a significant
*Tel.: [phone]; fax: [phone]. E-mail address: [e-mail] (M.A. Kose). 0022-1996 / 02 / $ – see front matter © 2002 Elsevier Science B.V. All rights reserved. PII: S0022-1996( 01 )00120-9

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fraction of their export revenues is used to pay back their large foreign debt. Developing countries also depend heavily on imported capital goods

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