Adjustment of a small open economy to external shocks

Perhaps, one of the main contributions of the Real Business Cycle (RBC) theory has been to narrow the gap between dynamic general equilibrium theory and empirical macroeconomics. While this literature focuses on explaining some important facts of developed countries business cycle, this dissertation examines some important policy issues particularly relevant for developing countries. As in the RBC literature, the framework used is a stochastic dynamic general equilibrium model. However, the model developed herein differs sharply from the standard RBC model because it tries to capture some important characteristics of LDC economies: The theoretical economy has accumulated a large foreign debt, it relies on imports of investment goods for its capital formation and it faces an upward sloped supply of foreign loans. The policy issues analyzed within this framework are: The Harberger-Laursen-Mezler effect or the impact of transitory movements in terms of trade on the cyclical behavior of the current account, the sources of debt accumulation, the relation between saving and investment and the potential crowding out effect of investment by foreign debt. While productivity shocks play a crucial role in the RBC literature, terms of trade and world interest rate fluctuations constitute the major shocks affecting LDC economies