The non-linear 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 position and - in contrast to the existing research - investigate its nonlinear link to risk premia. The importance of this particular non-linearity is twofold. First, it allows to identify the NFA level above which the elasticity becomes much (possibly dangerously) higher. Second, such a non-linear relationship is a standard ingredient of 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 non-linearity 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.