Trend Shocks and Financial Frictions in Small Open Economies Modeling

This paper studies the relative importance of including trend shocks and financial frictions whwn characterizing economic flutuations in a set of 12 emerging developed small open economies. We find that trend shocks, captured by permanet technology innovations, are relatively more important than transtory shocks in emerging market economies expanding the two-country (Canada and Mexico) evidence in Aguiar and Gopinath (2007). We also find that adding financial frictions improves the fit of the model in all the studied emerging market economies, but only in 5 developed small open economies, expanding the two-country (Argentina-Mexico) evidence in García-Cicco et al. (2010). In the process of comparing models, we provide a set parameter estimates for a large set of countries that could serve as a guide for future studies.