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Financial crises and time- varying risk premia in a small open economy: a Markov-Switching DSGE model for Estonia

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  • Boris Blagov

Abstract

Under a currency board the central bank relinquishes control over its monetary policy and domestic interest rates converge toward the foreign rates. Nevertheless a spread between both usually remains. This spread can be persistently positive due to increased risk in the economy. This paper models that feature by building a DSGE model with a currency board, where the domestic interest rate is derived as a function of the foreign rate, the external debt position and an exogenous risk premium component. Applying Markov-Switching allows for time variation in the volatility of the risk premium component. The model shows that the size of risk premia shocks in an economy with a currency board is small in quiet times but the shocks are much larger during crises, which the standard model would understate. The model is applied with Bayesian methods to Estonian data and is able to match the banking and financial crises

Suggested Citation

  • Boris Blagov, 2013. "Financial crises and time- varying risk premia in a small open economy: a Markov-Switching DSGE model for Estonia," Bank of Estonia Working Papers wp2013-8, Bank of Estonia, revised 09 Dec 2013.
    • Handle: RePEc:eea:boewps:wp2013-8
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    Cited by:

    1. José E. Boscá & Javier Ferri & Margarita Rubio, 2025. "Fiscal and macroprudential policies in a monetary union," Review of Quantitative Finance and Accounting, Springer, vol. 65(1), pages 365-399, July.
    2. Feng, Shu & Fu, Liang & Ho, Chun-Yu & Alex Ho, Wai-Yip, 2023. "Political stability and credibility of currency board," Journal of International Money and Finance, Elsevier, vol. 137(C).
    3. Baranowski, Paweł & Kuchta, Zbigniew, 2015. "Changes in nominal rigidities in Poland – a regime switching DSGE perspective," MPRA Paper 70573, University Library of Munich, Germany, revised Mar 2016.
    4. Istvan Konya & Franklin Maduko, 2018. "Interest premium and external position: a time varying approach," CERS-IE WORKING PAPERS 1829, Institute of Economics, Centre for Economic and Regional Studies.
    5. Konya, Istvan & Maduko, Franklin, 2020. "Interest premium and external position: A state dependent approach," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 66(C).

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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