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Risk Matters: The Real Effects of Volatility Shocks

This paper shows how changes in the volatility of the real interest rate at which emerging economies borrow have a substantial effect on real variables like output, consumption, investment, and hours worked. These effects appear even when the level of the real interest rate itself remains constant. We argue that, consequently, the time-varying volatility of real interest rates is an important force behind the distinctive size and pattern of business cycle fluctuations of emerging economies.

To prove our case this paper makes two points. First, we document the strong evidence of time-varying volatility in the real interest rates faced by a sample of four emerging small open economies: Argentina, Ecuador, Venezuela, and Brazil. We postulate a stochastic volatility process for real interest rates and estimate it using T-bill rates and country spreads with the help of the Particle ?lter and Bayesian methods. We uncover large movements in the volatility of real interest rates and a systematic relation of those movements with output, consumption, and investment.

Second, we feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model as in Mendoza (1991) calibrated to match data from our set of countries. We ?nd that an increase in real interest rate volatility triggers a fall in output, consumption, investment, and hours worked, and a notable change in the current account. The effects are more salient for Argentina and Ecuador and milder for Venezuela and Brazil.

We think of our exercise as capturing the following sequence of events. Prior to period t, households live in an environment characterized by the average standard deviation of real interest rates. At time t, the standard deviation of the innovation associated with the country's spread increases by one standard deviation, while the level of the real interest rate itself remains constant. Then, agents optimally adjust their consumption, labor, investment, and savings decisions to face the new level of risk of real interest rates.

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Risk Matters: The Real Effects of Volatility Shocks