Equity Returns and Business Cycles in Small Open Economies

This is the first paper in the DSGE literature to match key business cycle moments and long-run equity returns in a small open economy with production. These results are achieved by introducing four modifications to a standard real business cycle model: (1) borrowing and lending costs are imposed to increase the volatility of the marginal rate of substitution over time; (2) capital adjustment costs are assumed to make equity returns more volatile; (3) GHH preferences are employed to smooth consumption and (4) a working capital constraint to generate countercyclical trade balances. Our results are based on data from Argentina, Brazil, and Chile