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Risk shocks in a small open economy: Business cycle dynamics in Canada

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  • Mendicino, Caterina
  • Zhang, Yahong

Abstract

Recent literature suggests that risk shocks – changes in the volatility of the cross-sectional uncertainty on entrepreneurial asset returns – play an important role in explaining business cycle fluctuations. In this paper, we study the effect of risk shocks in a small open economy with tradable and non-tradable sectors of production. In each sector, firms are subject to uncertainty when converting raw capital into effective capital. Due to financial frictions, when risk is high firms pay higher borrowing costs. This leads to a decline in investment and output. We conduct Bayesian estimation and draw implications on the sources of the Canadian business cycle. Our findings suggest that a significant fraction of the fluctuations in output, investment, risk premium and firms' net worth in the Canadian economy can be accounted for by sectorial level risk shocks. We further construct volatility measures based on firm-level stock returns in Canada and find that our model's out-of-sample performance is reasonably well.

Suggested Citation

  • Mendicino, Caterina & Zhang, Yahong, 2018. "Risk shocks in a small open economy: Business cycle dynamics in Canada," Economic Modelling, Elsevier, vol. 72(C), pages 391-409.
    • Handle: RePEc:eee:ecmode:v:72:y:2018:i:c:p:391-409
    DOI: 10.1016/j.econmod.2018.02.014
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    More about this item

    Keywords

    Risk shocks; Financial frictions; Business cycles;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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