Equity Returns and Business Cycles in Small Open Economies

Abstract

This is the first paper in the literature to match key business cycle moments and long-run equity returns in a small open economy with production. These results are achieved by introducing three modications to a standard real business cycle model: (1) borrowing and lending costs are imposed to increase the volatility of the intertemporal marginal rate of substitution; (2) investment adjustment costs are assumed to make equity returns more volatile; and (3) GHH preferences are employed to smooth consumption. We also decompose the contributions of productivity, the world interest rate, and government expenditure shocks to the equity premium. Our results are based on data from Argentina, Brazil, and Chile.