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Interest Rate Shocks, Labor Market Search and Emerging Market Business Cycles

There exists numerous recent studies on emerging economies which emphasize the relationship between the changes in the real interest rates countries face in the international fi nancial markets and the business cycle fluctuations those countries experience. However there is less number of studies that take into account the labor market dynamics in explaining emerging market business cycles. Recent crisis originated in financial sector but then transmitted to the real sector through the cost of working capital of firms and caused a rise in unemployment in both developed and emerging economies.

This fact pointed out the need to incorporate labor market dynamics into an emerging market business cycle model that can account for the e ffect of real interest rates on fi rms operating costs. The studies that incorporated labor market dynamics into a, otherwise, standard SOE-RBC model are insufficient in that dimension since they do not have the mechanism to let changes in real interest rates affect the firm's operating costs. This paper aims to fill this gap in the literature by constructing a SOE-RBC model augmented with search and matching frictions in labor market and working capital requirement on firm's wage bill.

In the literature empirical regularities of emerging economies are documented with their diff erences from those of developed economies. The data Neumeyer and Perri (2005) analyzed show that in emerging markets real interest rates are counter cyclical and lead the business cycle in contrast to real interest rates developed economies face which are a cyclical and lag the cycle. Moreover the volatility of consumption relative to output and volatility of output in emerging economies are higher than those in developed economies and net exports appear more strongly counter cyclical in emerging economies than in developed economies.

In addition to these, Boz, Durdu and Li (2009) documents some regularities in emerging market labor markets such as real wages are almost twice as variable as output and positively correlated with output in contrast to developed economies in which real wages are less variable than output and a cyclical.

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Interest Rate Shocks, Labor Market Search and Emerging Market Business Cycles