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Default Risk Premium and Aggregate Fluctuations in a Small Open Economy

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  • S. Meral Cakici

    ()
    (Institute for International Economics, University of Bonn)

Abstract

This 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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File URL: http://eaf.ku.edu.tr/sites/eaf.ku.edu.tr/files/erf_wp_1131.pdf
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Bibliographic Info

Paper provided by Koc University-TUSIAD Economic Research Forum in its series Koç University-TUSIAD Economic Research Forum Working Papers with number 1131.

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Length: 25 pages
Date of creation: Nov 2011
Date of revision:
Handle: RePEc:koc:wpaper:1131

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Keywords: default risk premium; dynamic stochastic general equilibrium; aggregate fluctuations;

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  1. Cakici, S. Meral, 2011. "Financial integration and business cycles in a small open economy," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1280-1302.
  2. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
  3. Huixin Bi & Eric M. Leeper, 2010. "Sovereign Debt Risk Premia and Fiscal Policy in Sweden," NBER Working Papers 15810, National Bureau of Economic Research, Inc.
  4. Feldstein, Martin & Green, Jerry, 1983. "Why Do Companies Pay Dividends?," American Economic Review, American Economic Association, vol. 73(1), pages 17-30, March.
  5. repec:ubc:bricol:93-25 is not listed on IDEAS
  6. Cakici, S. Meral, 2012. "Technology shocks under varying degrees of financial openness," International Review of Economics & Finance, Elsevier, vol. 21(1), pages 232-245.
  7. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
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