Risk Shocks in a Small Open Economy

Caterina Mendicino and Yahong Zhang

No 1602, Working Papers from University of Windsor, Department of Economics

Abstract: Recent literature suggests that risk shocks –idiosyncratic uncertainty on asset returns – plays an important role in explaining business cycle fluctuations. In this paper, we study the effect of risk shocks in a small open economy with tradable and non-tradable sectors of production. Following Christiano, Motto and Rostagno (2014), we assume that firms are subject to uncertainty when converting raw capital into effective capital. Due to the financial frictions, when risk is high firms pay higher borrowing costs. This leads to a decline in investment and output. We conduct Bayesian estimation and draw implications on the sources of the Canadian business cycle. Our findings suggest that a significant fraction of the fluctuations in output, investment, risk premium and firms’ net worth can be accounted for by risk shocks.

Keywords: Risk; Financial frictions; Business Cycles. (search for similar items in EconPapers)
JEL-codes: E31 E32 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2016-04
New Economics Papers: this item is included in nep-dge and nep-mac
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http://web2.uwindsor.ca/economics/RePEc/wis/pdf/1602.pdf First version, 2016 (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:wis:wpaper:1602

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