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Risk Shocks in a Small Open Economy

Author

Listed:
  • Caterina Mendicino

    (European Central Bank - Directorate General Research - Monetary Policy Research)

  • Yahong Zhang

    (Department of Economics, University of Windsor)

Abstract

Recent literature suggests that risk shocks –idiosyncratic uncertainty on asset returns – plays 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. Following Christiano, Motto and Rostagno (2014), we assume that firms are subject to uncertainty when converting raw capital into effective capital. Due to the 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 can be accounted for by risk shocks.

Suggested Citation

  • Caterina Mendicino & Yahong Zhang, 2016. "Risk Shocks in a Small Open Economy," Working Papers 1602, University of Windsor, Department of Economics.
    • Handle: RePEc:wis:wpaper:1602
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Risk; Financial frictions; Business Cycles.;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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