Default Risk Premium and Aggregate Fluctuations in a Small Open Economy
AbstractThis study investigates the implications of risk premium shocks for aggregate fluctuations in a small open economy with financial and informational frictions. A dynamic, stochastic, general equilibrium framework is developed, where the informational asymmetries among the agents in the model and the uncertainty in the production process necessitate financial intermediation in the economy. The Holmstrom-Tirole type of uncertainty in the production process also leads to collateralized borrowing by firms, with the physical capital stock of firms serving as the collateral as well as the factor of production. There is also a government sector in the economy that borrows domestically with a partial default risk. In order to compensate the lenders for the default risk included in the government bonds, the government has to offer them some risk premium in addition to the exogenously given world interest rate offered by the foreign bond issuers. It is shown that, under certain circumstances, it is possible for the government to reduce its debt and increase its spending in response to a positive, temporary risk premium shock.
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Bibliographic InfoPaper provided by Koc University-TUSIAD Economic Research Forum in its series Koç University-TUSIAD Economic Research Forum Working Papers with number 1131.
Length: 25 pages
Date of creation: Nov 2011
Date of revision:
default risk premium; dynamic stochastic general equilibrium; aggregate fluctuations;
Find related papers by JEL classification:
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- H39 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Other
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-11-28 (All new papers)
- NEP-DGE-2011-11-28 (Dynamic General Equilibrium)
- NEP-OPM-2011-11-28 (Open Economy Macroeconomic)
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