An estimated small open economy model of the financial accelerator

This paper develops a small open economy model in which entrepreneurs partially finance investment using foreign currency–denominated debt subject to an external finance premium. We use Bayesian estimation techniques to evaluate the impor-tance of balance sheet–related credit market frictions for emerging market coun-tries by incorporating the financial accelerator mechanism. We obtain a sizable value for the external finance premium, which is tightly estimated away from zero. Our results support the inclusion of the financial accelerator in an otherwise stan-dard model that—acting through balance sheets—magnifies the impact of shocks, thereby increasing real and financial volatility. [JEL C11, F41] Episodes of severe financial crises in recent years have renewed interest in thedebate on the most appropriate exchange rate regime for emerging market countries (EMCs). For a small open economy, the common policy prescription— dating back to Friedman (1953)—has advocated exchange rate flexibility. As emphasized by the textbook Mundell-Fleming model, a freely floating nominal exchange rate can act as a shock absorber, insulating the economy against poten-tially destabilizing external disturbances. However, EMCs face two fundamental issues that complicate the conduct of monetary policy. First, these countries can typically borrow only in foreign *Selim Elekdag and Ivan Tchakarov are Economists at the IMF in the Research and the Asia and Pacific Departments, respectively. Alejandro Justiniano is currently an Economist at the Board of Governors of the Federal Reserve although much of this paper was completed while he was at the IMF. We are grate