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This paper shows how changes in the volatility of the real interest rate at which small open emerging economies borrow have a quantitatively important effect on real variables like output, consumption, investment, and hours worked. To motivate the investigation, the authors 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. They 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 filter and Bayesian methods. Then, they feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model.
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