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

Boris Blagov

No wp2013-8, Bank of Estonia Working Papers from Bank of Estonia

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

Keywords: Markov-Switching DSGE Models; currency board; stochastic risk premium (search for similar items in EconPapers)
JEL-codes: C51 C52 E32 F41 (search for similar items in EconPapers)
Date: 2013-12-09, Revised 2013-12-09
New Economics Papers: this item is included in nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Financial crises and time-varying risk premia in a small open economy: a Markov-switching DSGE model for Estonia (2018)
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