Business Cycles in Small Developed Economies

Empirical evidence for small developed economies finds that consumption is procyclical and as volatile as output, and real net exports are coutercyclical. Earlier studies have not been able to reproduce these regularities in a DSGE small open economy model when productivity shocks drive the business cycles and households have a normal intertemporal elasticity of substitution. Instead, these studies have reduced this elasticity to make consumption more procyclical and volatile and real net exports countercyclical. This paper shows that a standard model can reproduce these regularities, without lowering the intertemporal substitution, if the terms of trade and foreign interest rate are added as source of business cycle fluctuations. These shocks, compared to productivity shocks, make consumption and investment more volatile and procyclical relative to output, and make real net exports countercyclical.Terms of trade;Productivity;External shocks;Economic models;net exports, open economy, export sector, elasticity of substitution, aggregate consumption, trade shocks, terms of trade shocks, trade shock, tradable goods, nontradable goods, current account balance, political economy, domestic demand, open economies, aggregate demand, exportable sector, economic indicators, trade effects, terms of trade effects, fixed investment, importable goods, domestic production, domestic goods, domestic firms, export good, foreign trade, prices of exports