Regime Switching Interest Rates and Fluctuations in Emerging Markets∗

Many emerging economies have experienced current account reversals followed by large declines in economic activity. These sudden stops are reflected in their real interest rates, which alternate between tranquil times, when the level is relatively low and stable, and crises, during which interest rates are higher and more volatile. We embed an estimated regime switching process of interest rates into a small open economy model with financial frictions. Our model nests infrequent dramatic crises within regular business cycles, successfully matches the key second and higher order moments of the macroeconomic aggregates and produces plausible endogenous dynamics during crises. We find that the occurrence of sudden stops can account for the empirical regularities of emerging market business cycles. Financial frictions are essential for explaining emerging market fluctuations, but almost exclusively because of their effects in crises. JEL classification: E32, F32, F41