A Neoclassical Analysis of the Asian Crisis:
Business Cycle Accounting for a Small Open Economy
Keisuke Otsu
Bank of Japan, Institute for Monetary and Economic Studies
November 9, 2007

Abstract
This paper applies the business cycle accounting method to a standard neoclassicalsmall open economy model and assesses the recent crises in Hong Kong, Korea, Singapore and Thailand. Quantitative results show that (a) distortions in production (TFP)
are important in all countries in explaining the sudden output collapses, (b) unlike theclosed economy literature, distortions in the labor market do not have contractionarye¤ects, and (c) distortions in the foreign debt market are not important in explaining
the recessions.

Keywords: Business Cycle Accounting, Small Open Economy, Asian Crisis
JEL Classi…cation: E13, E32

1Introduction

In late 1997, several East Asian countries experienced massive economic downturns. The key
common feature of the crises in East Asian countries is the sudden economic contractions interms of output, consumption, labor input and investment in 1998. This paper quantitatively
analyzes the recession patterns in Hong Kong, Korea, Singapore and Thailand using a small
E-mail: keisuke.ootsu@boj.or.jp

1

open economy version of the business cycle accounting method developed by Chari, Kehoeand McGrattan (CKM (2007)).
Broad literature covering the Asian crisis focuses on the causes and the procedures forresolution of the …nancial and currency crises in which the currencies pegged to US dollars
were attacked by speculative investors1 . In contrast, there are fewer studies with quantitative
analyses on the recession patterns in these countries. Therefore, there are open questions
such as, “what are the key forces that caused the economic downturns?”and “what are thechannels through which they operated?” In this paper I address these issues by applying
the business cycle accounting method to the East Asian economies within the small open
economy framework.
The model’s foundation is the standard small open economy optimal neoclassical growthmodel à la Mendoza (1991) and Correia, Neves and Rebelo (1995) which consists of the …rm,household, government and foreign sectors. The …rm produces a …nal good from capitaland labor using constant returns to scale production technology which ‡uctuates according
to exogenous changes in total factor productivity (TFP), which can be considered as thedegree of distortions in the production market. There is an in…nitely-lived representative
household who gains utility from consumption and disutility from labor. The household owns
the physical capital stock and can also borrow from abroad with a non-state-contingent
one-period discount bond at a given real interest rate. The government sector imposes
distortionary labor income and investment taxes on the household. There are also distortionsin the foreign debt market, in the form of shocks to the return on international debt, which is
not present in the existing literature. The distortions in the foreign debt, labor, investment
and production markets are computed as “wedges”in equilibrium conditions and are taken
as exogenous.
The model includes utility function parameters, production function parameters andparameters governing the stochastic shock process. I choose values for these parameters
based on data over the 1960-2003 period for each country following the CKM (2007) method.
1

Burnside, Eichenbaum and Rebelo (2000) and Corsetti, Pesenti and Roubini (1999) claim that implicit
government guarantees to companies and banks led to the crisis by increasing the future government cost.
Chang and Velasco (2000) claims that …nancial liberalization in emerging markets attracted large shortterm loans, which led to liquidity mismatch as in typical bank-run models. Krugman (1999) argues that
capital out‡ow forced the foreign debt relying corporate sector to reduce investment while real exchange rate
depreciation increased the value of existing debt, forced …rms to further reduce investment and led to a debt
crisis.

2

I take the parameterized model, solve the model for linear decision rules, compute the wedges
from the decision rules using data and simulate the model by feeding in the time paths ofthese wedges one by one. I then visually compare output, consumption, labor and investment
from the model to data over the 1990-2003 period focusing on the sharp recessions in 1998.
There are several closely related quantitative studies that analyze the Asian crisis using dynamic general equilibrium models. Meza and Quintin (2007) shows that TFP andfactor hoarding are important in explaining recent episodes of economic downturns during…nancial crises in emerging economies. Otsu (2006) shows that exogenous TFP alone can
explain the sudden drop and rapid recovery of Korean output while real interest rate shocks
are important in explaining the consumption drop. Cook and Devereux (2006) shows thatthe exogenous rise in nominal interest rate premiums in Korea, Malaysia and Indonesia canaccount for the output drop in these countries mainly through a contraction in the nontradable sector within a sticky price setting. Gertler, Gilchrist and Natalucci (2006) also uses a
sticky price model and shows that the …nancial accelerator was important in amplifying thedepressing e¤ect of real interest rate shocks under the …xed exchange rate regime on aggregate demand in Korea. While these studies deduce the impact of certain primary shocks on
the economy, the main focus of this paper is to …nd “where”the important shocks are rather
than “what”they are.
The key …ndings are (a) distortions in production (TFP) are important in explaining
the sudden output collapses in all countries, (b) unlike the closed economy literature, laborwedges do not have contractionary e¤ects, and (c) foreign debt wedges are not important in
explaining the recessions.
The remaining sections are organized as follows. Section 2 discusses the facts of the East
Asian crisis. Section 3 describes the business cycle accounting model. Section 4 presents
quantitative results. Section 5 concludes the paper.

2

Asian Crisis

In this section, I document the similarities and di¤erences of the recession patterns in Hong
Kong, Korea, Singapore and Thailand from both the production and demand sides using
data over the 1990-2003 period. The key similarities are that in all countries output suddenly
dropped in 1998 and consumption dropped as much as output did. The main di¤erences are3the magnitudes of the economic downturns and their durations in each country.

2.1

Production Side

Figure 1 shows the ‡uctuation of GDP and production factors per member of adult population in each country from 1990 to 2002. Each series are linearly detrended. GDP and adult
population data are from the World Bank World Development Indicators (WDI) database.
I computed the capital stock series using the perpetual inventory method and data from
Nehru and Dhareshwar (1993)2 . Labor (total hours worked) is calculated from the numberof employed workers and average weekly hours worked per workers. Labor data is from theInternational Labor Organization LABORSTA database.
GDP per adult fell 6:7%, 8:3%, 4:1% and 12:6% respectively. The ‡uctuation in capitallags the business cycle, which is typical since in general it takes time to replace or install
capital stock. On the other hand, labor reacts instantaneously to exogenous shocks. Thus,in general, the ‡uctuation in labor is important in explaining the business cycle. This is truein Korea during the crisis where the labor series spikes down in 1998. However, labor does
not drop much compared to output in the other countries, which implies an extraordinarily
large drop in TFP in these countries3 .
All four countries experienced GDP collapses in 1998 whereas the magnitudes of economic
downturns are quite di¤erent ranging from 4:1% to 12:6%. Also, the recovery patterns arequite di¤erent. In Hong Kong, output remained over 5% below trend until 1999 and thenrapidly recovered to trend level. In Korea, output immediately recovered from the drop in
1998 and returned to trend level in 2000. In Singapore, output recovered immediately andexperienced a boom in 2000 but fell below trend level again in 2001. In Thailand, it took
until 2002 to return to its trend level.
2First, I compute the average depreciation rate from the Nehru and Dhareshwar (1993) data for total
capital stock and …xed investment over the 1960-1990 period. Next, with the computed depreciation rate,
investment data from WDI and capital stock in 1960 adjusted for prices, I extrapolate the capital stock
series until 2003.
3
This fact is explained in Meza and Quintin (2007). They claim that in Thailand and Indonesia the large‡uctuation in TFP would predict too much ‡uctuation in output compared to data.

4

2.2

Demand Side

Figure 2 shows the ‡uctuation of GDP and its components. The data are from WDI.
Consumption includes private and government consumption4 . Investment includes private
and government …xed investment. For simplicity, inventory investment is included in the
trade balance. The trade balance is divided by GDP in order to stationarize the series. The
unit of each series is log deviations from the trend except for the trade balance to GDP ratio.
Both consumption and investment are procyclical whereas the trade balance is countercyclical during the crisis in all countries. The interesting fact is that in all countries
consumption fell as much as output. The annual consumption drops in Hong Kong, Korea and Singapore from 1997 to 1998 were 7:2%, 12:0%, and 5:1%, which are greater thanthe output drops in each country. Thailand, which experienced the largest GDP drop, also
experienced a large drop in consumption by 11:4%.

3

Business Cycle Accounting Model

The economy is a small open economy in which the representative household can borrowfrom abroad by issuing a 1-period international discount bond to foreigners at a given rateof return. The household owns labor and physical capital stock, and owes debt to foreigners.
Given labor and capital income net of debt payment, the household chooses how much towork, invest, consume, and borrow. The …rm produces a …nal good from capital and laborusing a Cobb-Douglas production function which ‡uctuates according to changes in TFP. The
government collects distortionary taxes on labor income and investment from the household,and fully rebates the revenue through lump-sum transfers. There are also distortions in theforeign debt market which is exogenously determined by foreign creditors. Following thebusiness cycle accounting method in CKM (2007), the distortions are treated as exogenous.
4

Ideally we would like to focus on household non-durable consumption. However, since this data is notavailable for most countries, I use total …nal consumption expenditure instead.

5

3.1

Household

The lifetime utility for the representative agent depends on utility from consumption anddisutility from labor;
1
Xtmax U = E0u(ct ; lt )(1)
t=0

where (0 << 1) is the subjective discount rate, ct is consumption, and lt is labor
supply which is the fraction of total hours available allocated to work5 . For the periodical
preference function, u( ), I assume GHH preferences which are commonly used in the small
open economy real business cycle literature such as Mendoza (1991) and Correia, Neves andRebelo (1995). The functional form isu(ct ; lt ) = log (ct

lt )

(2)

where parameters (> 0) and (> 1) represent the level and curvature of the utility costof labor respectively. GHH preferences are named after from Greenwood, Hercowitz andHu¤man (GHH (1988)) which introduced this preference function to the general equilibrium
model. The main feature of it is that there are no income e¤ects on labor supply6 .
The representative agent maximizes the lifetime utility (1) subject to the budget constraint:
dt+1
wt
l + rt kt + t += ct + xt xt + dt + (dt+1 ) + ( kt )
(3)
l t
d
R t
t
and the capital law of motion:
kt+1 = xt + (1
5

)kt

(4)

In speci…c, labor was computed as
lt =

ht
14 7

et
Nt

where ht is the average weekly hours worked per worker, et is the number of employed workers and Nt isadult population. lt is restricted to be between zero and one given that the average weekly hours worked
never exceeds 14 7 hours.
6
One well known fact in the small open economy real business cycle literature is that with Cobb-Douglas
preferences over consumption and leisure, the model will predict too much consumption smoothing. Correia,
Neves and Rebelo (1995) show that GHH preferences solve this issue due to the lack of income e¤ects onlabor. Result for with Cobb-Douglas preferences are available in the appendix.

6

where kt is capital stock, xt is investment, dt is foreign debt, wt are real wages and rt arereal capital rental rates respectively. The lower-case letters ct ; kt ; xt ; and dt are all detrended
per adult variables. I explain the detrending procedure in the appendix. For simplicity, I
assume that the population growth rate is constant and de…ne = (1 + )(1 + n) where is
the growth rate of labor augmenting technical progress and n is the population growth rate.
dlx
t , t and t represent wedges in foreign debt, labor and investment markets.
2
I assume the functional form of the debt adjustment cost function, (dt+1 ), as (dt+12 d)where d is the steady state foreign debt. The debt adjustment cost is one of several ways toremove the random walk component in the Euler equation for international asset holdingsthat are introduced by Schmitt-Grohe and Uribe (2003). They also introduce models withan endogenous discount factor, debt elastic interest rates and complete asset markets, andconclude that all models deliver virtually identical quantitative results. I set arbitrarily
small so that this portfolio adjustment cost will not a¤ect the short run dynamics of themodel.
It is common to include capital adjustment cost, ( kt ), in small open economy models since otherwise the model will predict excessive volatility in investment. I assume the2functional form of the capital adjustment cost function as (kt+12 kt ) .

3.2

Firm

The …rm produces a single storable good with a Cobb-Douglas production function,yt = zt kt lt1(5)where yt is the detrended per adult output, and zt is TFP. The …rm’s pro…t maximization
problem is,
max t = yt wt lt rt kt :
(6)

7

3.3

Government

The government collects distortionary taxes and fully rebates them to the household using
lump-sum transfer t . Thus, the government budget constraint
t =

1

1
l
t

wt lt + ( xt

(7)

1) xt

holds for all periods. For simplicity, I do not consider government expenditure shocks since
they do not a¤ect the main results. Instead, I include government purchases into consumption and government …xed investment into total investment.

3.4

Foreign Sector

One key di¤erence from CKM (2007) is that I explicitly introduce the foreign sector. Sinceinternational debt is issued to the foreign sector, the small open economy must repay whatever it borrowed from abroad. The trade balance is de…ned by
tbt = dt

(dt+1
dt+1
+
d
2
R t

d)2

(8)

:

That is, I assume that all costs including foreign debt wedges and adjustment costs are paid
to the foreign sector7 .

3.5

Competitive Equilibrium

The competitive equilibrium is, ct ; lt ; kt+1 ; dt+1 ; yt ; xt ; tbt ; wt ; rt ;1. Households optimize given wt ; rt ;

d
t;

l
t;

d
t;

l
t;

1
x
t ; zt t=0 such that;x 1
t t=0 and d0 , k0 :2. Firm optimizes given fwt ; rt ; zt g1
t=0 :3. Markets clear and the government budget constraint (7) holds.
7

It is not important whether the foreign sector receives these or not. What matters is that these resources
exit the small open economy.

8

4. The resource constraint holds:
yt = ct + xt + tbt :(9)st = P0(4 1) + P(4 4) st 1 + "t ; "t s N (0(4 1) ; Q(4 4) )(10)

5. Shocks follow the process

where st = ln

3.6dt ; lnlt ; ln0xand "t = ("dt ; "lt ; "xt ; "zt )0 .
t ; ln zt

WedgesThe business cycle accounting method interprets wedges as distortions in each relevant market. In this section I de…ne the wedges and discuss potential sources of them. Nonetheless,the main focus of this paper is to assess the quantitative impact of these wedges and not toreveal the identity of them8 .
3.6.1

Foreign Debt Wedges

Foreign debt wedges d appear in the foreign debt Euler equation. They are de…ned as thedi¤erence between the intertemporal marginal rate of substitution and the rate of return on
foreign debt9 :1(dt+1 d) = Et [Uct+1 ] :
(11)
Uct
R dt
CKM (2006, 2007) claim that exogenous shocks to the trade balance are equivalent togovernment expenditure shocks. In CKM (2006) the sudden improvements in the tradebalance during the …nancial crises represent sudden stops of capital in‡ows. Instead, in
this paper, I follow the small open economy literature and consider the trade balance as an
endogenous variable. I assume exogenous distortions in the foreign debt market as shocks tothe e¤ective real interest rates. In addition, for simplicity, I assume that foreign debt wedges
are fully paid to foreigners so that wedges directly a¤ect the trade balance as in (8).
8Thoughout this paper I deal with the wedges st and not the innovations "t . One of the criticism ofbusiness cycle accounting made by Christiano and Davis (2006) is that the correlation of innovations shouldbe important in explaining dynamics.
9
Since is set very small, the foreign debt adjustment cost is negligible.

9Foreign debt wedges capture shocks to the country speci…c real interest rate premium.
Neumeyer and Perri (2005) and Uribe and Yue (2005) claim that the ‡uctuation in realinterest rates is a powerful source of business cycles in developing countries. In their setting,the real interest rate premium is determined by foreign investors either independent fromdomestic situations or as a reaction to changes in domestic circumstances.
Foreign debt wedges may also capture domestic monetary and foreign exchange policy
shocks. That is, real interest rates which the domestic household faces may not be equal
to the rate of return on foreign debt. If the household does not have direct access to debt
but can borrow only from a …nancial intermediary, the monetary authority can a¤ect thedomestic interest rate faced by the household through monetary policy. Although, in thiscase the name might be inappropriate.
3.6.2

Labor Wedges

In equilibrium, labor wedges l appear as the di¤erence between the consumption-leisuremarginal rate of substitution and the marginal product of labor:
(1

)

yt 1
=
lt lt

lt

1

:

(12)

CKM (2007) shows that a monetary model with sticky wages à la Cole and Ohanian(2002) can be mapped into a prototype real business cycle model with labor wedges. Coleand Ohanian (2002) assumes that nominal wages are set in the beginning of the period bylabor unions and do not react to monetary shocks which occur subsequently. This creates
distortion in the labor market.
Cooley and Hansen (1989) generates labor wedges with a cash-in-advance constraint on
consumption goods in a monetary model. This model subdivides a period into two. In
the …rst sub-period the goods market opens and in the second sub-period the asset market
opens. The household needs cash in order to consume goods in the goods market whereas it
uses income to accumulate money and …nancial assets for the next period. In‡ation creates
distortions in the consumption-leisure choice by de‡ating the value of labor income relative
to consumption.
In Christiano and Eichenbaum (1992), labor wedges emerge from a working capital assumption on labor input. Since …rms must borrow credit in the …nancial market in order to10pay wages, labor cost includes the borrowing cost in addition to wage payment. Therefore,
exogenous shocks to borrowing rates create distortions in the labor market. Neumeyer andPerri (2005) applies this framework to a small open economy setting.
In Rotemberg and Woodford (1995), the markup of monopolistically competitive …rms
shows up as labor wedges. The key feature of New Keynesian models is that the central
bank can neutralize the e¤ects of short-run markup shocks with monetary policy under theassumption of sticky prices.
3.6.3

Investment Wedges

Investment wedgesx

Uct ( xt + (kt+1

appear in the capital Euler equation:kt )) = Et Uct+1

yt+1
+ (1
kt+1

) xt+1 + (kt+2

kt+1 ):(13)

It is straight forward to compute deterministic investment wedges since all of the arguments in a deterministic Euler equation are observable. However, investment wedges will
erroneously include all expectational errors in this case. In a stochastic model, the estimationof the expected variables and the computation of the wedges must be done simultaneously,
taking into account the fact that future variables are not correctly predicted. The procedure
is described in the following section.
In GHH (1988), investment wedges arise from shocks to investment e¢ ciency. In their
setting, high investment e¢ ciency enables the household to accumulate more capital stock
for a given investment level. This can be interpreted as low investment wedges in the businesscycle accounting model.
CKM (2007) shows that models with …nancial frictions such as Bernanke, Gertler andGilchrist (1999) and Carlstrom and Fuerst (1997) can be mapped into a prototype businesscycle accounting model with investment wedges. They also show that the model with capitalwedges à la Christiano and Davis (2006)10 produces similar simulation results as those of themodel with investment wedges.
Obviously, the value of capital adjustment costs a¤ects the value of investment wedges.
I discuss how the capital adjustment cost is de…ned in the following section.
10

Capital wedges are interpreted as tax on capital income that shows up in the Euler equation.

11

3.6.4

TFP

By de…nition, TFP is a wedge in the production process since it is computed as the residualfrom the production function equation (5). CKM (2007) shows that a multisector modelwith input-…nancing frictions can be mapped into a prototype model with TFP shocks.
Under their setting, intermediate-goods producers are facing …nancial borrowing constraints
that create di¤erences in borrowing rates across producers who have di¤erent productivity
levels. Since intermediate-goods are not perfect substitutes, shocks to these …rm speci…cborrowing rates cause shifts in the input mix of …nal-good production which appear as
shocks to aggregate TFP.
Ohanian (2001) conjectures that the huge drop in TFP during the US Great Depression
was caused by the loss of organizational capital, i.e. “the knowledge and know-how …rms use
to organize production”. When there are failures of intermediate goods suppliers, managers
must shift time away from production to searching for new suppliers. Since the organizational
capital is not used for production, this will appear as a drop in TFP.
Mismeasurement of inputs will also appear as changes in TFP. In GHH (1988), endogenous capital utilization causes ‡uctuation in aggregate TFP. Burnside, Eichenbaum andRebelo (1993) introduces labor hoarding as mismeasurement in labor supply which leads toan overstatement of TFP. Meza and Quintin (2007) shows that factor hoarding explains why
in several emerging market …nancial crisis episodes output did not fall as much as a canonicalreal business cycle model predicts.
Obviously, there is no guarantee that a model with exogenous TFP would yield thesame quantitative results as these endogenous TFP models. In context of business cycle
accounting, this implies that endogenous TFP models might accompany wedges in otherequilibrium conditions.

4

Quantitative Analysis

4.1

Parameter Values

In order to simulate the model, the parameter values must be pinned down. The structuralparameters were chosen by calibration and estimation to match the model to data over the
1960-2003 period. The parameter values are listed in tables 1 and 2.

12

The capital income share parameter is set at 1/3 for all countries. Gollin (2002)shows that after adjusting for self-employment income the mean capital share over 41 sample
countries is approximately 1/3. I use this as the common capital income share for the Asian
countries.
Other parameters were obtained from the 1960-2003 data. I set the long-run averages ofn, l, ky , and tby as their steady state values. Steady state values of wedges are assumed to be
one11 . The trend growth rate is estimated by a regression of the log of Solow residuals:
ln SRt = ln Yt

ln Kt

(1

) ln Lton a linear trend and a constant, where Yt , Kt , and Lt are nondetrended per capita output,
capital and labor respectively. The depreciation rate is the average of t calculated fromthe capital accumulation equation
Nt+1 Kt+1 = Nt Xt + (1t )Nt Kt ;using Nehru and Dhareshwar (1993) data, where Nt is the adult population and Xt is nondetrended per capita investment12 . The discount factor is calibrated from the steady state
capital Euler equation:y):= ( +1k
The labor disutility curvature parameter is computed by equating the elasticity of labor
supply computed from the model 1 1 to the Frisch labor supply elasticity computed fromthe model with Cobb-Douglas preferences following Correia, Neves and Rebelo (1995). The
labor disutility level parameter
was calibrated from the steady state labor …rst ordercondition:(1)y = l :Since investment and foreign debt wedges are de…ned by expectational Euler equations
which include unobservable state variables, the parameters in the shock process (10) are11

The results are not sensitive to variations of these steady state values.
Given that the data is on annual basis, the depreciation rates seem lower than convention. One possible
reason might be because we do not include durable goods consumption in investment. Nonetheless, we do
not adjust for this fact since the results are not sensitive to this parameter.
12

13

estimated following CKM (2007)13 . The parameters to be estimated are the 16 persistence
parameters in the 4 4 matrix P and the 4 standard deviations and 6 pairwise correlationcoe¢ cients of the errors in the variance-covariance matrix Q. I do not estimate the valuesof P0 since they are determined by steady state equations. I use linearly detrended data on
output, consumption, investment and labor for the estimation since there are 4 shocks to be
estimated.
Since there is no real world counterpart for capital adjustment costs, I set the parametersuch that the volatility of investment simulated from the model with only TFP shocks will
match the data. This is a standard treatment in the small open economy real business cycle
literature14 .

4.2

Simulation Method

Given all parameters values, the model can be solved quantitatively. I use a linear solution
method à la Uhlig (1999) to solve for the linear decision rules. Having obtained the decisionrules, I compute the unobserved exogenous variables xt and dt . Assuming that fyt ; ct ; lt ; xt g
are observable, the values of dt ; lt ; xt ; zt can be computed using the linear decision rules(yt ; ct ; lt ; xt ; kt+1 ; dt+1 )0 = DR(6 6) kt ; dt ;

d
t;

l
t;

0
x
t ; ztwhere DR is a matrix containing the corresponding linear decision rule coe¢ cients. In
speci…c, the procedure goes as follows:
1. Assume k1990 = d1990 = 0:
2. Given fk; dg1990 , elicit
3. Given

d

; l;

x

d

; l;

x

; z 1990 from (y; c; l; x)01990 = DR(4 6) k; d;0; z 1990 , obtain fk; dg1991 from (k; d)01991 = DR(26) k; d;4. Given fk; dg1991 , elicit
and so on.

d

; l;

x

d

; z 1991 from (y; c; l; x)01991 = DR(4 6) k; d;

13

d

; l;

; l;
d

x

; l;

x

0

; z 19900; z 1990x

Instead of using MLE as in CKM (2007), I use Bayesian estimation with the Dynare package. Unfortunately, the labor data for Hong Kong, Korea, Singapore and Thailand start at 1985, 1970, 1982 and 1983
respectively. Thus, the estimation periods are short.
14
Note that the value of a¤ects not only the dynamics, but also the estimation of P . Also, in my model
TFP shocks have feed back e¤ects through expectations which depend on the P matrix.

140; z 1991

Next, in order to evaluate the e¤ects of the wedges, I plug each type of wedges into
the model one by one and compute the ‡uctuation of endogenous variables using the linear
decision rules. The method is identical to CKM (2007) except that I assume foreign debt
wedges rather than government wedges. When plugging each type of wedges into the model,
I do not change the estimated stochastic process. That is, the o¤-diagonal terms in thepersistence matrix are kept non-zero. Obviously, plugging in all of the wedges will produce
a simulated series that perfectly matches the data.

4.3

Quantitative Results

4.3.1

Wedge Analysis

Figure 3 presents the values of wedges in each country over the 1990-2003 period. Since
matrix P relates current wedges to future expected wedges, the e¤ects of these wedges arecomplex. That is, a change in wedges today will a¤ect the expectation of future wedges andthe reactions of agents depend on these expectations. In the following, I limit my discussion
to the direct e¤ects of each wedge in order to build some intuition.
An interesting fact is that foreign debt wedges jumped up in Korea in 1998. The factthat this wedge in Korea increased implies that the disturbances in the foreign debt market
suddenly increased during the crisis. An increase in foreign debt wedges a¤ects the marginal
rate of intertemporal substitution in (11), which tends to reduce current consumption15 .
This also reduces investment since the expected return on capital must be equated to thereturn on foreign debt according to (11) and (13). Thailand also experienced an increasein the foreign debt wedge, but to a much smaller extent. This is surprising since the Asian…nancial crisis originated in Thailand. On the other hand, foreign debt wedges in Hong Kongand Singapore increased in 1999.
Labor wedges fell sharply in all countries except for Korea. Labor wedges primarily a¤ectlabor supply and consumption by changing the e¤ective real wage as in (12). A decline inlabor wedges will cause consumption to increase through both income and intratemporal
substitution e¤ects. Since there are no income e¤ects on labor with GHH preferences, labor15
The intertemporal substitution e¤ect of a rise in foreign debt wedge on current consumption is negative
while the sign of the income e¤ect depends on whether the country is a net borrower or lender. If the country
is a borrower, the income e¤ect is also negative.

15

will increase through the substitution e¤ect. Thus, the drops in labor wedges during thecrises have expansionary e¤ects in each country.
Investment wedges fell in 1998 in all countries. A drop in investment wedges stimulates
investment since they represent the prices of investment relative to consumption. This tends
to decrease current consumption through substitution e¤ects, but has little e¤ect on current
labor supply or output due to the lack of income e¤ects on labor. Instead, it a¤ects future
output and labor through increasing future capital stock.
TFP fell sharply in all countries. A drop in TFP leads to a drop in output while it also
reduces the marginal product of labor. This leads to a drop in real wage which reduces labor
supply through the intratemporal substitution e¤ect of leisure on consumption. Consumption
also tends to fall from both income and substitution e¤ects.
4.3.2

Individual Simulation Results

Figure 4 presents the results of each country with each type of wedges16 . In Hong Kong, TFP
wedges have contractionary e¤ects whereas labor wedges have expansionary e¤ects during
the crisis. An important result is that TFP alone predicts output and labor to fall too
much. This is consistent with the …nding of Meza and Quintin (2007) that labor hoarding
is important in explaining why labor and output did not fall as much as the theory would
predict. In context of business cycle accounting, labor hoarding overstates the drop in TFP
and will appear as an expansionary labor wedge. As discussed above, investment wedges do
not have strong e¤ects on current labor or output. The increase in foreign debt wedges in1999 is important to explain the drop in investment. TFP alone cannot explain the drop ininvestment after 1998.
In Korea, almost all of the drops in output, consumption, labor and investment can be
explained by the drop in TFP17 . The increase in foreign debt wedges and the decrease in
the investment wedges help explaining the drop in consumption. Investment wedges tend toincrease investment while foreign debt wedges tend to reduce investment during the crisis,
while these two e¤ects roughly cancel out each other.
In Singapore, TFP has contractionary e¤ects while labor wedges have expansionary effects during the crisis, which …ts the labor hoarding explanation as in Hong Kong. Also,
16
17

Results of simulations with a combination of shocks are available upon request.
This is consistent with the …nding in Otsu (2006).

16

Singapore is the only country in which investment wedges have large contractionary e¤ects
on consumption.
In Thailand, as in Hong Kong and Singapore, the labor hoarding explanation seems to…t. In fact, labor supply did not fall at all during the crisis regardless of the huge dropin TFP. Investment and foreign debt wedges have little e¤ect on output, consumption andlabor. The two have impacts on investment which cancel out each other as in Korea.

5Conclusion

In this paper, I conduct a stochastic business cycle accounting simulation using the standard
neoclassical small open economy model calibrated to data of Hong Kong, Korea, Singapore
and Thailand. I compute wedges from equilibrium conditions and investigate how theya¤ected the East Asian economies over the 1990-2003 period focusing on the year of thecrisis, 1998.
The main …nding is that TFP is important in explaining the economic downturns in
all countries. In Hong Kong, Singapore and Thailand, reduction in labor wedges counterthe excessive contractionary e¤ects of TFP whereas Korea is the only country in which themodel with TFP alone predicts an output contraction close to data. Investment wedges aswell as foreign debt wedges have little impact on output in all countries due to the lack ofincome e¤ects on labor given GHH preferences.
The message of this paper is that sophisticated models of the Asian crisis should accountfor the sudden drop in TFP. If …nancial imperfections or speculative attacks are believed
to be the sources of the output collapses in East Asia, these should cause drops in TFP. In
this sense, understanding the characteristics of the variance and covariance matrix in thesecountries is the …rst step to further progress.

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17[2] Chang, R. and A Velasco (2000) “Banks Debt Maturity and Financial Crises” Journalof International Economics, 51 (1)[3] Chari, V.V., P. Kehoe, and E. McGrattan (2007) “Business Cycle Accounting”Econometrica, 75 (3)[4] Chari, V.V., P. Kehoe, and E. McGrattan (2006) “Sudden Stops and Output Drops”
NBER Working Paper 11133.
[5] Christiano, L. and J. Davis (2006) “Two Flaws in Business Cycle Accounting” NBER
Working Paper 12647.
[6] Christiano, L. and M. Eichenbaum (1992) “Liquidity E¤ects and the Monetary Transmission Mechanism”American Economic Review, 82 (2), 346-353.
[7] Cole, H. and L. Ohanian (1999) “The Great Depression in the United States From A
Neoclassical Perspective” Federal Reserve Bank of Minneapolis, Quarterly Review, 23(1), 2-24.
[8] Cole, H. and L. Ohanian (2002) “The Great U.K. Depression: A Puzzle and Possible
Resolution”Review of Economic Dynamics, 5 (1), 19-44.
[9] Cook, D. and M. Devereux (2006) “Accounting for the East Asian Crisis: A Quantitative
Model of Capital Out‡ows in Small Open Economies” Journal of Money, Credit andBanking, 38 (3), 721-749.
[10] Correia, I., J. Neves and S. Rebelo (1995) “Business Cycles in a Small Open Economy”
European Economic Review, 39 (6), 1089-1113.
[11] Corsetti, J., P. Pesenti and A. Roubini (1999) “What Caused the Asian Currency and
Financial Crisis?”Japan and the World Economy 11 (3), 305-373.
[12] Gertler, M., S. Gilchrist and F. Natalucci (2003) “External Constraints on Monetary
Policy and the Financial Accelerator”forthcoming, Journal of Money, Credit and Banking.
[13] Gollin, D. (2002) “Getting Income Shares Right”Journal of Political Economy 110 (2),458-474.

18

[14] Greenwood, J., Z. Hercowitz and G. Hu¤man (1988) “Investment, Capacity Utilization,and the Real Business Cycle”American Economic Review 78 (3), 402-417.
[15] Greenwood, J., R. Rogerson and R. Wright (1995) “Household Production in RealBusiness Cycle Theory”Frontiers in Business Cycle Research, T. Cooley ed., Princeton,
NJ: Princeton University Press, 157-174.
[16] Krugman, P. (1999) “Balance Sheets, the Transfer Problem, and Financial Crises” in
P. Isard, A. Razin and A. K. Rose, eds. International Finance and Financial Crises:
Essays in Honor of Robert P. Flood, Kluwel Academic publishers.
[17] Mendoza, E. (1991) “Real Business Cycles in a Small Open Economy” American Economic Review, 81 (4), 797-818.
[18] Meza, F. and E. Quintin (2007) “Financial Crisis and Total Factor Productivity”Mimeo.
[19] Nehru, V. and Ashok Dhareshwar (1993) “A New Database on Physical Capital Stock:
Sources, Methodology and Results”Rivista de Analysis Economico, 8 (1), 37-59.
[20] Neumeyer, P. and F. Perri (2005) “Business Cycles in Emerging Economies: The Roleof Interest rates”Journal of Monetary Economics, 52 (2), 345-380.
[21] Ohanian, L. (2001) “Why Did Productivity Fall So Much during the Great Depression?”
American Economic Review, 91 (2), 34-38.
[22] Otsu, K. (2006) “A Neoclassical Analysis of the Korean Crisis” Review of Economic
Dynamics, forthcoming.
[23] Rotemberg, J. and M. Woodford “Dynamic General Equilibrium Models with Imperfectly Competitive Product Markets” Frontiers in Business Cycle Research, T. Cooleyed., Princeton, NJ: Princeton University Press, 243-293.
[24] Schmitt-Grohe, S. and M. Uribe (2003) “Closing Small Open Economy Models”Journalof International Economics 61 (1), 163-185.
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in R. Marimon and A. Scott eds. Computational Methods for the Study of Dynamic
Economies, Oxford University Press.

19

A

Detrending

The business cycle accounting model is detrended with a deterministic growth trend. Consider a non-detrended per adult production function:
Yt = zt Kt (Xt lt )1(14)

where zt is detrended TFP and Xt is the labor-augmenting technical progress. I assume thatthe growth rate of Xt is constant:
Xt = (1 + )Xt 1 :According to neoclassical growth theory, per adult variables Yt , Kt , and Xt lt should be
growing at the same rate as Xt along the balanced growth path. Thus, we obtain (5) from
Yt
= zt
Xt

Kt
Xt

Xt lt
Xt

1

t
kt .
where XYtt yt and K
Xt
A notable assumption is made for the preference function. The detrended preferencefunction (2) is derived from a non-detrended preference functionu(Ct ; lt ) = log(CtXt lt ):

(15)

The growth of labor disutility can be justi…ed as follows. Greenwood, Rogerson and Wright(1995) shows that GHH preferences are equivalent to a reduced form of a preference function
with consumption, leisure, and home production. If we assume that home production uses
the same technology as market-goods production, disutility from the loss of home-goods
should have the same growth trend as market-goods.

B

Cobb-Douglas Preference

In this paper, I assume GHH preferences since this is the standard assumption in the small
open economy literature. In this section, I assume Cobb-Douglas preferences as in CKM

20

(2007). The functional form isu(ct ; lt ) =log ct + (1) log(1lt ):This preference function is widely used in closed economy macroeconomic literature. The key
di¤erence between the Cobb-Douglas and GHH preferences is that Cobb-Douglas preferences
have income e¤ects on labor. The procedure is the same as the GHH preference case. In
order to save space, I will only present the simulation results for Korea simply to point out
that business cycle accounting results depend on the assumption on preferences18 .
Figure A1 shows the computed wedges. Compared to the GHH preference case, the maindi¤erences is that labor wedges jump up during the crisis in the Cobb-Douglas case. In addition, foreign debt wedges decrease during the crisis. Figure A2 shows the simulation resultsfor Korea. Labor wedges have strong contractionary e¤ects on the economy in contrary to
the GHH preference case. The increase in labor wedges causes a positive intratemporal substitution e¤ects on leisure which reduces labor and consumption. Obviously, labor wedges
are much more important in explaining the business cycle with Cobb-Douglas preferences.
Clearly, the results do depend on the assumption on preferences. The business cycle
accounting method is silent in terms of the plausibility of the preference function assumption.

C

Tables and Figures
Table 1. Steady State Parameter Values
Hong Kong Korea Singapore Thailand

n
18

0:942
0:023
0:333
1:134
1:515
1:064
0:038
0:024

0:889
0:018
0:333
1:008
1:429
1:051
0:029
0:021

Figures for other countries are available upon request.

21

0:911
0:018
0:333
1:089
1:409
1:052
0:023
0:028

0:940
0:026
0:333
1:052
1:802
1:058
0:030
0:027

Table 2. Estimated Shock Process Parameters
2

0:720
6
6 0:031
PHK = 6
6 0:149
4
0:278

0:032
0:944
0:028
0:010

0:081
0:065
0:885
0:048

0:725
6
6 0:055
PKR = 6
6 0:047
4
0:328

0:017
0:881
0:083
0:048

0:052
0:017
0:904
0:093

0:731
6
6 0:095
PSP = 6
6 0:054
4
0:250

0:046
0:864
0:009
0:044

0:010
0:014
0:899
0:098

0:648
6
6 0:007
PT L = 6
6 0:120
4
0:117

0:067
0:026
0:914
0:070
0:024 0:9953
0:049 0:018

2

2

2

3
2
0:064
0:00067
6
6
0:077 7
7 ; QHK = 6 0:0000
7
6 0:0000
0:070 54
0:884
0:00003
2
0:140
0:00057
6
6
0:025 7
7 ; QKR = 6 0:0000
6 0:0001
0:021 75
4
0:888
0:00002
3
0:111
0:00076
7
6
0:0027
7 ; QSP = 6 0:0000
6 0:0001
0:05074
5
0:909
0:00002
3
0:030
0:0004
6
7
6
0:076 7
7 ; QT L = 6 0:0000
6 0:0000
7
0:06054
0:892
0:000022

0:00000:00190:0001
0:00030:0000
0:00010:00130:0000

0:0000
0:00080:0000
0:0001

0:0001
0:00000:00150:0000

0:0000
0:00090:0001
0:0001

0:0001
0:0001
0:0030
0:0000

0:00000:0051
0:0001
0:00070:0000
0:00010:0010
0:00003
0:00007
0:000377
0:0000750:001230:00007
0:0001 7
7
0:0000 7
5
0:00073
0:0001
7
0:0001770:0000750:00103
0:00007
0:000777
0:000075
0:0022

Figure 1. Production Factors
Hong Kong

Korea

0.06

0.08
0.06

0.04

0.04
0.02

0.02

0

0
-0.02

-0.02

-0.04
-0.04

-0.06

-0.06

-0.08
1990

1992

1994
Output

1996

1998

Labor

2000

2002

1990

1992

Capital

1994

1996

OutputSingapore

1998

Labor

2000

2002

CapitalThailand

0.1
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
-0.1

0.15
0.1
0.05
0
-0.05
-0.1
-0.15
1990

1992

1994
Output

1996

1998

Labor

2000

2002

1990

Capital

1992

1994
Output

23

1996

1998

Labor

2000 2002
CapitalFigure 2. GDP Components
Hong Kong

Korea

0.3

0.2

0.2

0.1

0.1
0
0
-0.1

-0.1
-0.2

-0.2
1990

1992

1994

1996

OutputInvestment

1998

2000

2002

1990

1992

Consumption
TB/GDP

1994

1996

OutputInvestment

Singapore

1998

2000

2002

Consumption
TB/GDP

Thailand

0.3

0.5

0.2
0.25
0.1
0

0

-0.1
-0.25
-0.2
-0.3

-0.5
1990

1992

1994

1996

OutputInvestment

1998

2000

2002

1990

Consumption
TB/GDP

1992

1994

1996

OutputInvestment

24

1998

2000 2002

Consumption
TB/GDPFigure 3. Wedges
Hong Kong

Korea

0.1

0.05
0.04
0.03
0.02
0.01
0
-0.01
-0.02
-0.03
-0.04
-0.05

0.05
0
-0.05
-0.1
-0.15
1990

1992

Foreign Debt

1994

1996

Labor

1998

2000

Investment

2002

1990

TFP

1992

Foreign Debt

Singapore

1994

1996

Labor

1998

2000

Investment

2002
TFP

Thailand

0.15

0.15

0.1

0.1

0.05

0.05

0
0
-0.05
-0.05

-0.1

-0.1

-0.15
-0.2

-0.15
1990

1992

Foreign Debt

1994

1996

Labor

1998

2000

Investment

2002

1990

TFP

1992

Foreign Debt

25

1994

1996

Labor

1998

2000

Investment

2002
TFP

Figure 4a. Results: Hong Kong
OutputConsumption

0.15

0.15

0.1

0.1

0.05

0.05

0

0

-0.05

-0.05

-0.1

-0.1

-0.15

-0.15
1990

1992

Foreign Debt
TFP

1994

1996

1998

Labor
Data

2000 2002

1990

Investment

1992

1994

Foreign Debt
TFP

Labor

1996

1998

Labor
Data

2000

2002

Investment

Investment

0.1

0.3
0.2

0.05

0.1
0
0
-0.05

-0.1

-0.1

-0.2
1990

1992

Foreign Debt
TFP

1994

1996

Labor
Data

1998

2000

2002

1990

Investment

1992

Foreign Debt
TFP

26

1994

1996
Labor
Data

1998

2000

2002

Investment

Figure 4b. Results: Korea
OutputConsumption

0.15

0.1
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
-0.1

0.1
0.05
0
-0.05
-0.1
-0.15
1990

1992

Foreign Debt
TFP

1994

1996

1998

Labor
Data

2000

2002

1990

Investment

1992

Foreign Debt
TFP

Labor

1994

1996

1998

Labor
Data

2000 2002
Investment

Investment

0.08

0.25
0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2

0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
1990

1992

Foreign Debt
TFP

1994

1996

Labor
Data

1998

2000

2002

1990

Investment

1992

Foreign Debt
TFP

27

1994

1996

Labor
Data

1998

2000 2002
Investment

Figure 4c. Results: Singapore
OutputConsumption

0.2

0.2

0.15

0.15

0.1

0.1

0.05

0.05

0

0

-0.05

-0.05

-0.1

-0.1

-0.15

-0.15

-0.2

-0.2
1990

1992

Foreign Debt
TFP

1994

1996

1998

Labor
Data

2000

2002

1990

Investment

1992

1994

Foreign Debt
TFP

Labor

1996

1998

Labor
Data

2000 2002
Investment

Investment

0.1

0.3
0.2

0.05
0.1
0

0
-0.1

-0.05
-0.2
-0.1

-0.3
1990

1992

Foreign Debt
TFP

1994

1996

Labor
Data

1998

2000 2002

1990

Investment

1992

Foreign Debt
TFP

28

1994

1996
Labor
Data

1998

2000

2002

Investment

Figure 4d. Results: Thailand
OutputConsumption

0.3

0.2
0.15

0.2

0.1

0.1

0.05

0

0
-0.05

-0.1

-0.1

-0.2

-0.15

1990

1992

Foreign Debt
TFP

1994

1996

1998

Labor
Data

2000

2002

1990

Investment

1992

1994 1996

Foreign Debt
TFP

1998

Labor
Data

2000 2002
Investment

Investment

Labor

0.5
0.4
0.3
0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5

0.15
0.1
0.05
0
-0.05
-0.1
-0.15
1990

1992

Foreign Debt
TFP

1994 1996
Labor
Data

1998

1990

2000 2002

1992

Foreign Debt
TFP

Investment

29

1994

1996
Labor
Data

1998

2000

2002

Investment

Table A1. Estimated Shock Process Parameters (Cobb-Douglas)
2

0:593
6
6 0:224
PKR = 6
6 0:036
4
0:433

0:066
0:841
0:059
0:068

0:036
0:000
0:919
0:060

3
2
0:068
0:00037
6
6
0:0377
7 ; QKR = 6 0:0000
7
6 0:0001
0:067 54
0:872
0:0000

0:00000:0010
0:0001
0:0000Figure A1. Wedges (Cobb-Douglas)
Korea
0.12
0.1
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
1990

1992

Foreign Debt

1994

1996

Labor

30

1998

2000

Investment

2002
TFP

0:0001
0:00010:0010
0:0001

3
0:00007
0:000077
0:0001 7
5
0:0008Figure A2. Results: Korea (Cobb-Douglas)
OutputConsumption

0.08

0.1
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
-0.1

0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
1990

1992

Foreign Debt
TFP

1994

1996

1998

Labor
Data

2000 2002

1990

Investment

1992

1994

Foreign Debt
TFP

Labor

1996

1998

Labor
Data

2000

2002

Investment

Investment

0.03
0.02
0.01
0
-0.01
-0.02
-0.03
-0.04
-0.05
-0.06
-0.07

0.3
0.2
0.1
0
-0.1
-0.2
-0.3
1990

1992

Foreign Debt
TFP

1994

1996

Labor
Data

1998

2000

2002

1990

Investment

1992

Foreign Debt
TFP

31

1994

1996
Labor
Data

1998

2000

2002

Investment