An Estimated Small Open Economy Model of the Financial Accelerator

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Abstract: This paper develops a small open economy model in which entrepreneurs partially finance investment using foreign currency–denominated debt subject to an external finance premium. We use Bayesian estimation techniques to evaluate the importance of balance sheet–related credit market frictions for emerging market countries by incorporating the financial accelerator mechanism. We obtain a sizable value for the external finance premium, which is tightly estimated away from zero. Our results support the inclusion of the financial accelerator in an otherwise standard model that—acting through balance sheets—magnifies the impact of shocks, thereby increasing real and financial volatility. [JEL C11, F41]