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

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.