Should Developed Economies Manage International Capital Flows? An Empirical and Welfare Analysis
43 Pages Posted: 22 Mar 2022
The literature on the effects of country risk premium shocks has mostly focused on emerging market economies. We show empirically that in developed economies, risk premium shocks explain a non-trivial share of aggregate fluctuations and are key drivers of real activity in particular crises. Both our empirical results and results from a two-country New Keynesian model indicate that an increase in the country risk premium leads to a reduction in aggregate output under monetary union, but not so in countries with flexible exchange rates and independent monetary policy. Model simulations suggest that managing international capital flows enhances welfare in countries under monetary union.
Keywords: country risk premium, capital flow management, Bayesian panel VAR, exchange rate regime, welfare analysis
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