THE ROLE OF FOREIGN DEBT AND FINANCIAL FRICTIONS IN A SMALL OPEN ECONOMY DSGE MODEL

Myung-Soo Yie () and Byoung Hark Yoo
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Myung-Soo Yie: Economic Research Institute, Bank of Korea, Seoul 100-794, Korea
Byoung Hark Yoo: #x2020;Department of Economics, Soongsil University, Seoul, South Korea

The Singapore Economic Review (SER), 2016, vol. 61, issue 05, 1-23

Abstract: We examine the role of foreign debt and financial frictions in the Korean business cycle using a small open economy DSGE (dynamic stochastic general equilibrium) model where domestic banks borrow external funds, denominated in foreign currencies, for a risk premium and make loans to domestic producers. We find that the Korean economy is ‘financially vulnerable’, which means that the risk premium increases when the domestic currency depreciates. As a result, depreciation could cause recession, rather than expansion, when there exist substantial amount of foreign debt or financial frictions. A simulation shows that the Korean business cycle would suffer less volatility with a lower steady-state level of foreign debt or no financial frictions.

Keywords: Small open economy DSGE model; foreign debt; risk premium; Korean economy (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (6)

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DOI: 10.1142/S0217590815500770

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