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THE NONLINEAR NATURE OF COUNTRY RISK AND ITS IMPLICATIONS FOR DSGE MODELS

Published online by Cambridge University Press:  03 August 2018

Michał Brzoza-Brzezina  and
Jacek Kotłowski
Michał Brzoza-Brzezina
Affiliation:
Narodowy Bank Polski and SGH Warsaw School of Economics
Jacek Kotłowski*
Affiliation:
Narodowy Bank Polski and SGH Warsaw School of Economics
*
Address correspondence to: Jacek Kotłowski, Narodowy Bank Polski Economic Analysis Department ul. Świętokrzyska 11/21 00-919 Warszawa, Poland; e-mail: [email protected]
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Abstract

Country risk premia can substantially affect macroeconomic dynamics. We concentrate on one of their most important determinants—a country’s net foreign asset (NFA) position and—in contrast to the existing research—investigate its nonlinear link to risk premia. The importance of this particular nonlinearity is two-fold. First, it allows to identify the NFA level above which the elasticity becomes much (possibly dangerously) higher. Second, such a nonlinear relationship is a standard ingredient of dynamic stochastic general equilibrium (DSGE) models, but its proper calibration/estimation is missing. Our estimation shows that indeed the link is highly nonlinear and helps to identify the NFA position where the nonlinearity kicks in at approximately −70% to −75% of GDP. We also provide a proper calibration of the risk premium—NFA relationship which can be used in DSGE models and demonstrate that its slope matters significantly for economic dynamics in such a model.

Keywords

Risk PremiumPSTR ModelOpen Economy DSGE Model
Type
Articles
Information
Macroeconomic Dynamics , Volume 24 , Issue 3 , April 2020 , pp. 601 - 628
Copyright
© Cambridge University Press 2018

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Footnotes

The views expressed herein are ours and not necessarily those of Narodowy Bank Polski or the Warsaw School of Economics. We would like to thank the participants of the Dynare conference in Rome, Computing in Economics and Finance conference in Bordeaux, Ecomod conference in Lisbon, the Conference on Computational and Financial Econometrics in Sevilla and the seminar at the Narodowy Bank Polski for valuable comments. Comments received from Johannes Pfeifer, the associate Editor and an anonymous referee are gratefully acknowledged as well.

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