Risk premium in a real business cycle framework

Abstract

A real business cycle framework with financial and informational frictions is developed for a small open economy in order to analyze the implications of risk premium shocks for aggregate fluctuations. The frictions in the dynamic, stochastic, general equilibrium model necessitate financial intermediation and the uncertainty in the production process requires collateralized borrowing in the economy. Sovereign risk exists in the model due to a government that borrows domestically with a partial default risk. The associated risk premium that the government is subject to is captured both endogenously and exogenously, which constitutes one of the major contributions of this study to the literature. It is shown that a positive, temporary risk premium shock leads to an increase in government borrowing and a decrease in government spending due to the rise in the cost of borrowing for the government. The model also predicts a fall in output, labor supply and loans as well as a rise in the default probability of the government. The results confirm the findings of the literature with respect to the expected effects of a positive risk premium shock on a small open economy in a novel framework, where financial and informational frictions as well as sovereign risk as key features of emerging economies are captured and analyzed.