PIER Working Paper 09-013: Risk Matters: The Real Effects of Volatility Shocks

Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, Juan F. Rubio-Ramírez, and Martín Uribe (2009) - Risk Matters: The Real Effects of Volatility Shocks, PIER Working Paper 09-013

This paper shows how changes in the volatility of the real interest rate at which small open emerging economies borrow have a quantitatively important e¤ect on real variables like output, consumption, investment, and hours worked. To motivate our investigation, 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 using T-bill rates and country spreads and estimate it with the help of the Particle …lter and Bayesian methods. Then, we feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model. We calibrate eight versions of our model to match basic aggregate observations, two versions for each of the four countries in our sample. 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 of the economy.