World Interest Rate, Business Cycles, and FinancialIntermediation in Small Open Economies

The consensus about the ability of the standard open-economy neoclassical growthmodel to account for interest-rate driven business cycles has changed over time:whereas early research concluded that business cycles are neutral to interest-rateshocks, more recent investigations suggest that these shocks can explain a large ex-tent of the business cycles of a small open economy when firms borrow to pay fortheir labor cost before cashing their sales. The first goal of this paper is to showthat the recently found effectiveness of interest-rate shocks to cause business cyclesrests more on the statistical properties of the shocks than on the working-capital con-straint; in particular, recent results are only valid when the level and volatility of theinterest rate are high and when the interest rate is negatively correlated with totalfactor productivity. The paper also shows that interest-rate shocks cannot be thesole driving force of business cycles even when the canonical model is augmented toinclude a working-capital constraint. The second goal of the paper is to quantitativelyexplore the dynamic properties of the neoclassical growth model extended to includefinancial intermediation. It is shown that the extended model with external effectsin financial intermediation can match the negative correlation between GDP and adomestic borrowing-lending spread in emerging countries if the economy is subjectto productivity shocks but not when the model is subject to both productivity andinterest-rate shocks.[...]