Regime Switching Interest Rates and Fluctuations in Emerging Markets

We estimate regime switching models for emerging market interest rates and embed the obtained nonlinear dynamics in a small open economy model with a financial friction. We show that the presence of an infrequent regime characterized by high level/high volatility of interest rates and the tightening of financial constraints is key to account for the empirical regularities specific to emerging markets, including the high volatility of consumption relative to output and a strongly countercyclical trade balance-to-output ratio. The model accounts for the dynamics of sudden stops and matches the autocorrelation function of the trade balance-to-output ratio as well as the cross-correlations between the main macroeconomic aggregates and interest rates. Our findings suggest that interest rate shocks and financial frictions are essential for explaining emerging market fluctuations, but mostly because of their effects in crisis episodes.