Washington - Macroeconomic indicators like GDP, employment, investment, and net exports are highly volatile in emerging countries. To better understand this phenomenon, Constantino Hevia studied data from Mexico and Canada using a model in which households and firms choose how much to work, invest, and save. Introducing several distortions in labor markets, financial markets, and overall productivity to replicate the observed data, Hevia then compared the distortions required to match the data in Mexico with those required to match the data in Canada. The comparison, described in a new paper, suggests that the macroeconomic behavior of emerging countries, unlike that of developed countries, is driven by fluctuations in overall productivity, labor market distortions, and, most importantly, country risk premiums. These results suggest that eliminating fluctuations in country risk premiums—which explain the large volatility in consumption and savings and abrupt changes in capital flows—would greatly enhance welfare in developing countries.

Policy Research Working Paper 4897