Sovereign risk and macroeconomic fluctuations in an emerging market economy
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Date
2010-12-08
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Abstract
This paper assesses the role of sovereign risk in explaining macroeconomic fluctuations
in Turkey. We estimate two versions of a simple New Keynesian small open
economy model on quarterly data for the period 1994Q3-2008Q2: A basic version and a
version augmented by a default premium on government debt due to a perceived risk
of sovereign debt default. Model comparisons clearly support the augmented version
since it leads to stronger internal propagation and hence smaller shocks are required in
order to reconcile the observed dynamics of nominal and real variables, leading to better
forecasting performance. The estimated default probability is highly debt-elastic, indicating
that default fears are a relevant concern. The results suggest that the augmented
model may lead to a better understanding of macroeconomic fluctuations in emerging
market economies that are subject to sovereign risk. In terms of policy implications,
counterfactual experiments show that both more active monetary policy and stronger
fiscal feedbacks from debt on taxes can lead to less volatile inflation and debt dynamics,
but higher debt feedbacks on taxation additionally reduce expected default rates. JEL classification: E10; E30; E63; H30
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Keywords
Emerging market economy, Macroeconomic fluctuation, Monetary and fiscal policy, Small open economy model, Sovereign default risk monetary and fiscal policy