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I provide a framework for understanding debt deleveraging in a group of _nancially integrated countries. During an episode of international deleveraging world consumption demand is depressed and the world interest rate is low, reecting a high propensity to save. If exchange rates are allowed to oat, deleveraging countries can depreciate their nominal exchange rate to increase production and mitigate the fall in consumption associated with debt reduction. The key insight of the paper is that in a monetary union this channel of adjustment is shut o_, and therefore the falls in consumption demand and in the world interest rate are ampli_ed. Hence, monetary unions are especially prone to hit the zero lower bound on the nominal interest rate and enter a liquidity trap during deleveraging. In a liquidity trap deleveraging gives rise to a union-wide recession, which is particularly severe in high-debt countries. The model suggests several policy interventions that mitigate the negative impact of deleveraging on output in monetary unions.

This thesis consists of an introductory chapter and three essays, all of which aim to study the functioning of a small open economy. The thesis starts with an investigation of export and import price determination and moves to a small open economy DSGE model framework in order to study the role of financial factors in economic fluctuations. In all three essays, theoretical small open economy models are used for quantitative analysis of the small open economy of Finland. The first essay develops a model for aggregate trade price inflation that takes into account two price setting conventions: local currency pricing (LCP) and producer currency pricing (PCP). In our empirical work, we confront our model with Finnish data and estimate the relative shares of LCP and PCP firms in the economy. In the estimation period 1980 1998, the share of local currency pricing was 40 percent in the export sector and 60 percent in the import sector, implying a limited pass-through from exchange rate to destination-country prices in both sectors. The second essay builds a small open economy DSGE model with the BGG financial accelerator and financial market shocks. In our empirical work covering the period 1995 2008, we provide evidence of an operative financial accelerator in Finland. The financial accelerator acts as an amplifying mechanism for many disturbances hitting the Finnish economy. Our main result is that financial market disturbances have contributed significantly to Finnish cyclical fluctuations between 1995 and 2008. Even allowing for several shocks stemming from both domestic sources and the international economy, domestic financial market shocks emerge as key drivers of recent business cycle fluctuations in Finland. The third essay studies the boom-bust period in Finland in the late 1980s and early 1990s, focusing on the role of financial factors and investment behaviour. We construct a small open economy DSGE model with the BGG financial accelerator and an unconventional shock structure that captures the key events of the episode. In this model framework, we study the role of financial market deregulation in the boom, the negative impact of the collapse of Soviet-Finnish trade in 1991, and the effect of the collapse of the fixed exchange rate regime in 1992. We argue that the financial accelerator mechanism is a key amplifying mechanism that helps the model to match, in particular, the large and persistent swings of investment first above and later below its trend. This essay demonstrates that the shocks Finland encountered combined with financial frictions are able to produce a boom and a severe depression, matching key salient features of the actual boom-bust cycle experienced in Finland in the late 1980s and early 1990s. Väitöskirja koostuu johdannosta ja kolmesta tutkimusluvusta, joiden tutkimuskohteena on pienen avoimen talouden toiminta. Väitöskirjassa tutkitaan ensin vienti- ja tuontihintojen määräytymistä, minkä jälkeen tarkastellaan rahoitustekijöiden merkitystä reaalitalouden vaihteluissa. Kaikissa kolmessa tutkimusluvussa teoreettisia pientä avotaloutta kuvaavia malleja käytetään Suomen talouskehityksen kvantitatiiviseen analyysiin. Ensimmäisessä tutkimusluvussa kehitetään kansainvälisesti kaupattavien hyödykkeiden inflaatiokehitystä kuvaava malli, jossa ulkomaankaupan hinnat voivat olla jäykkiä joko ostajan valuutassa (hinnoittelu paikallisen valuutan määräisenä) tai myyjän valuutassa (hinnoittelu tuottajan valuutan määräisenä). Empiirisessä työssä estimoidaan Suomen tilastotietoja käyttäen ostajan ja myyjän valuutassa hinnoittelevien yritysten suhteellinen osuus taloudessa. Estimointiajanjaksona 1980 1998 ostajan valuutassa hinnoittelevien yritysten estimoitu osuus oli 40 % vientisektorilla ja 60 % tuontisektorilla. Näin ollen valuuttakurssin läpimeno kohdemaan tuontihintoihin oli estimointiajanjaksolla epätäydellinen sekä vienti- että tuontisektorilla. Toisessa tutkimusluvussa rakennetaan pienen avotalouden makromalli, jossa rahoitusmarkkinoiden toiminta vaikuttaa reaalitalouteen erityisesti investointien kautta. Ajanjaksoa 1995-2008 koskevien tulosten mukaan Suomen taloudessa toimii ns. rahoitusakseleraattori, jonka takia investointeja varten tarvittavan ulkoisen rahoituksen hinta riippuu lainanottajien taseiden vahvuudesta. Rahoitusakseleraattori voimistaa monien Suomen talouteen kohdistuvien sokkien vaikutuksia. Lisäksi tutkimuksessa osoitetaan, että yllättävät muutokset lainanottajien rahoituskustannuksissa (ns. rahoitusmarkkinasokit) selittävät suuren osan investointien ja sitä kautta kokonaistuotannon suhdannevaihteluista Suomessa vuosina 1995-2008. Kolmannessa tutkimusluvussa tutkitaan Suomen talouden ylikuumenemista 1980-luvun lopulla sekä 1990-luvun alun lamaa keskittymällä erityisesti rahoitustekijöiden ja investointien merkitykseen. Työssä rakennetaan pienen avotalouden makromalli, jossa on rahoitusakseleraattori sekä sokkirakenne, joka formalisoi aikakauden keskeiset tapahtumat. Tässä mallikehikossa arvioidaan rahoitusmarkkinoiden vapauttamisen merkitystä 1980-luvun talouden ylikuumenemisessa, vuoden 1991 Suomen Neuvostoliiton-kaupan romahduksen epäsuotuisia vaikutuksia sekä vuoden 1992 kiinteästä valuuttakurssijärjestelmästä luopumisen vaikutuksia. Keskeinen tutkimustulos on, että rahoitusakseleraattorilla on tärkeä sokkien seurauksia voimistava vaikutus, mikä auttaa mallia toistamaan erityisesti investointien suuret ja pitkäaikaiset vaihtelut trendinsä ylä- ja alapuolelle. Tässä tutkimusluvussa osoitetaan, että Suomeen kohdistuneet sokit yhdistettynä rahoitustekijöihin pystyvät aikaansaamaan talouden ylikuumenemisen ja syvän laman ja toistamaan Suomen 1980-luvun lopun ja 1990-luvun alun toteutuneen talouskehityksen keskeiset piirteet.

In this paper we present an analysis of the impact of the great recession of the years 2008 and 2009 on the Austrian economy. For this purpose, we utilize the new estimated DSGE model of the OeNB for the Austrian economy within the Euro area. This model is a small open-economy version of Smets & Wouters (2003), where the domestic economy is linked to a highly stylized representation of the rest of the Euro area via trade and financial flows. The model identifies foreign demand and confidence shocks as the main transmission channels. Moreover the risk premium shock contributed significantly to the downturn of the Austrian economy. In contrast price shocks (price markup and raw material shocks) were supportive throughout the crisis. The strong resilience of the Austrian labour market during the crisis and the subsequent upswing is reected in a series of negative technology shocks.

Empirical evidence shows that sovereign defaults are associated with significant downturns in economic activity in defaulting countries. However, the existing literature on sovereign debt and default mainly analyzes endowment economies and, therefore, does not address the relationship between default risk and macroeconomic dynamics. This paper develops a general equilibrium small open economy model with financial frictions that allows to simultaneously examine the behavior of output, investment and borrowing dynamics and its interaction with sovereign default. When calibrated to match the business cycles properties of an average emerging market economy, the model is able to reproduce the countercyclicality of net exports and sovereign spreads and the negative correlation between investment and net exports observed in the data. Furthermore, when analyzing its behavior around sovereign default, the model successfully captures the declines in output, consumption and investment that are actually associated with these episodes.

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, Discussion Paper / SFB 823 ; 49/2010

This paper uses the EAGLE, a multi-country dynamic general equilibrium model, to illustrate dynamic adjustments in a small open economy undergoing real convergence. We consider the effects of productivity catch-up and misperceptions about future productivity developments. Our results indicate that even if real convergence takes the form of a gradual process, the dynamic responses of key macrovariables can be far from smooth. We also find that overly optimistic expectations about productivity shifts can generate sizable boom-bust cycles and so be relevant in accounting for cyclical deviations from a sustainable real convergence path. Our comparisons across alternative monetary regimes reveal that a flexible exchange rate helps to smooth real convergence processes and misperceptions associated with tradable sector productivity, while the opposite usually holds true for scenarios based on nontradable sector developments.

The paper holds that the country risk premium is the triggering factor of the business cycle in a small, financially open and highly volatile economy like that of Argentina. A rise of the premium determines a capital outflow, an aggregate demand contraction and a recession; a fall of the premium determines a capital inflow, an aggregate demand expansion and a boom. We build a model where country risk plays a central role in macroeconomic equilibrium. We evaluate the empirical relationship between country risk and GDP, consumption, investment, and the current account balance. We compare our country-risk model with those of various schools of macroeconomic thought. Main conclusions are: a) Country-risk perceptions of foreign and local investors determine the fraction of world income they like to spend in the small country and the country's GDP adjusts passively to that fraction. b) Country risk causes a sort of labor unemployment that resembles involuntary unemployment. c) Openness softens the impact of a rise in country risk. d) Argentine time series for the period 1985-97 show a strong negative correlation between country risk and those aggregate variables, with causality going from the former to the latter.

This paper performs a welfare analysis based on the hypothetical scenario that Denmark gave up its peg and started conducting monetary policy according to a Taylor rule. For this we rely on a dynamic stochastic general equilibrium model for a small open economy that was estimated on Danish data using Bayesian methods. We obtain the result that the gain in welfare is equivalent to a permanent increase of around 0.8 pct in the level of consumption. Examining a range of alternative scenarios does not change this conclusion, unless we assume a degree of policy errors under the Taylor rule that is substantially larger than those estimated by other studies.