Can world real interest rates explain business cycles in a small open economy?

While the world real interest rate is potentially an important mechanism fo r transmitting international shocks to small open economies, much of the re cent quantitative research that studies this mechanism concludes that it ha s little effect on output, investment, and net exports. We re-examine the i mportance of world real interest rate shacks using an approach that reverse s the standard real business cycle methodology. We begin with a small open economy business cycle model. But, rather than specifying the stochastic pr ocesses for the shocks and then solving and simulating the model to evaluat e how well these shocks explain business cycles, we use the model to back o ut the shocks that are consistent with the model's observable endogenous va riables, Then we use variance decompositions to examine the importance of e ach shock. We apply this methodology to Canada and find that world real int erest rate shocks can play an important role in explaining the cyclical var iation in a small open economy. In particular, they can explain up to one-t hird of the fluctuations in output and more than half of the fluctuations i n net exports and net foreign assets. (C) 2001 Elsevier Science B.V. ALL ri ghts reserved.