Systemic Risk, Aggregate Demand, and Commodity Prices. by Javier Gómez Pineda, Dominique Guillaume, and Kadir Tanyeri

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1 WP/5/5 Sysemic Risk, Aggregae Demand, and Commodiy Prices by Javier Gómez Pineda, Dominique Guillaume, and Kadir Tanyeri IMF Working Papers describe research in progress by he auhor(s) and are published o elici commens and o encourage debae. The views expressed in IMF Working Papers are hose of he auhor(s) and do no necessarily represen he views of he IMF, is Execuive Board, or IMF managemen.

2 5 Inernaional Moneary Fund WP/5/5 IMF Working Paper OMD Sysemic Risk, Aggregae Demand, and Commodiy Prices Prepared by Javier Gómez-Pineda, Dominique Guillaume, and Kadir Tanyeri Auhorized for disribuion by Dominique Guillaume June 5 IMF Working Papers describe research in progress by he auhor(s) and are published o elici commens and o encourage debae. The views expressed in IMF Working Papers are hose of he auhor(s) and do no necessarily represen he views of he IMF, is Execuive Board, or IMF managemen. Absrac The paper presens a global model for analysis and projecions. The model feaures a handful of elemens ha make i suiable for analyzing hree broad ses of opics; firs, sysemic risk and is ransmission o counry risk premiums; second, he ransmission from counry risk premiums o demand-relaed variables such as he oupu gap, he rade balance, and unemploymen; and hird, he ransmission from commodiy prices o counry inflaion. The model incorporaes one sysemic risk channel and wo foreign channels, specifically, a foreign aggregae demand channel and a foreign exchange rae channel. The model is esimaed wih Bayesian mehods. In addiion, he effec of risk on aggregae demand is calibraed wih he aid of a VAR. Among he resuls are ha he episodes of surges in sysemic risk idenified in he paper were ransmied o counry risk premiums and aggregae demand--relaed variables; ha he effec of sysemic risk shocks on world economic aciviy is large, and ha he buss in he world oupu gap correspond wih he major financial evens idenified by he esimaed ime series for he unobserved sysemic risk. In addiion, sysemic risk shocks are imporan drivers of oupu gaps while counry risk premium shocks can have imporan effecs on he rade balance. Surprisingly, commodiy prices, in paricular he price of oil, are shown o be demand driven; hence, demand relaed facors may play a nonrivial role in explaining noncore inflaion. The model performed well a one- and four-quarer horizons compared o a survey of analyss' forecass. In addiion, sysemic risk shocks were imporan a explaining he forecas variance of he world oupu gap, counry oupu gaps, he price of oil, and counry risk premiums. The breah of reach of sysemic risk shocks back he effors for financial surveillance wih a sysemic focus. JEL classificaion: F; F7: F; F; F7; E58 Keywords: Sysemic risk; Financial linkages; Capial flows; Global imbalances Commodiy prices Auhors' addresses: jgomezpi@banrep.gov.co, dguillaume@imf.org, kanyeri@imf.org The auhors work for he Banco de la República, he IMF, and he IMF respecively. The auhors hank Davide Furceri and Juan J. Julio for commens and Carlos A. Guzmán-Belrán and Kamal Krishna for research assisance.

3 Conens Absrac,,,. I. Inroducion,,,. 5 II. The Model III. The Daa,, IV. Resuls V. Conclusions... 5 References 7 Figures. Model Calibraion A Shock o Sysemic Risk (Response of Global Variables).... A Shock o Sysemic Risk (Response of Counry Variables)..... A Shock o he Counry Risk Premium (Response of Global Variables) A Shock o he Counry Risk Premium (Response of Counry Variables) Shocks o Commodiy Prices (Response of Global Variables).. 7. Shocks o Commodiy Prices (Response of Counry Variables). 8. An Ineres Rae Shock (Response of Global Variables) An Ineres Rae Shock (Response of Counry Variables). 5. Smoohing Resuls: Global Variables.... Smoohing Resuls: Counry Variables Smoohing Resuls: Counry Variables Smoohing Resuls: Counry Variables World: Hisorical Decomposiion of Global Variables Counries and Regions: Hisorical Decomposiion of Counry Risk Premiums..... Counries and Regions: Hisorical Decomposiion of Counry Oupu Gaps Hisorical Decomposiion of Trade Balance Gaps....

4 8. Counries and Regions: Hisorical Decomposiion of Counry Unemploymen Gaps.. 9. Counries and Regions: Hisorical Decomposiion of Counry Energy- and Food-Price Gaps 5. World: Forecas Error Variance Decomposiion.... Counries and Regions: Forecas Error Variance Decomposiion. Tables. Daa Sources.. 7. Some calibraed Parameers.. 8. Esimaed Parameers Goodness of i... Appendices. Trade balance equaion. 9. Oupu Gap Equaion Equaion for he curren accoun... 5

5 I. Inroducion There is somehing srikingly Keynesian in he way he economy works. As Akerlof and Schiller (9) have poined ou: You pick he ime. Your pick he counry. And you can be fairly well guaraneed ha you will see a play in he macroeconomy he animal spiris. Animal spiris are he roo cause of bous of euphoria followed by pessimism; rounds of impulsiveness followed by resrain; and periods of confidence followed by recession. Animal spiris gave rise o macroeconomics, alhough hey have no been consisenly a he core of dynamic macroeconomic models. Afer he global financial crisis, animal spiris became he subjec maer of sudy, measuremen, and conrol under he rubric of sysemic risk (see Bisias e al, ). Sysemic risk is a hrea o confidence in he financial sysem and a subsanive hrea o growh and living sandards. Sysemic risk ypically involves various financial markes, insiuions, and counries. I also usually involves considerable leverage and inerconnecedness. Sysemic risk also involves cycles in credi and asse prices, including he price of real esae. Examples of surges in sysemic risk are he global financial crises and he counless crises episodes described in Reinhar and Rogoff (9). For some definiions or descripions of sysemic risk see Blancher e al (p ), IMF (9), (p ), and Bisias e al (), (p ). Among he various measures of sysemic risk currenly being developed in he lieraure, he measure in IMF () is based on principal componens analysis. In his paper, we measure sysemic risk wih facor analysis, a similar mehodology. Paricularly, we embed a common facor model of marke measures ino a global macroeconomic model. Counry risk premiums are assumed o follow he unobserved, common, sysemic-risk facor. The sraegy we follow is o assume ha sysemic risk is exogenous and o analyze is implicaions on a variey of variables such as counry risk premiums, commodiy prices, and aggregae demand relaed variables such as oupu gaps, curren accouns, and unemploymen. The paper is mosly relaed wih Carabenciov e al () as i is a global projecion model wih six regions based on a ypical inflaion argeing model. I is also relaed wih Carabenciov (8c) in ha i includes commodiy prices and is effec on inflaion. However, commodiy prices are deal wih here in real erms so ha a relaionship beween he price of oil and he global oupu gap arises. The paper conribues o his lieraure in proposing a measure of sysemic risk, a ransmission from sysemic risk o counry risk premiums, and in underscoring he relevance of sysemic risk shocks for world economic aciviy as well as for counry oupu gaps. In addiion, for analysis purposes, he paper proposes a reamen of he rade balance and a simple approximaion o he curren accoun. The paper is also relaed wih Neumeyer and Perri (5) and he references herein. Neumeyer and Perri conclude ha in emerging counries oupu flucuaions are conneced wih counry risk See some of he financial fricions in he survey by Brunnermeier, Eisenbach and Sennikov (). Borio () characerizes he financial cycle as he cycle in credi and asse prices. Apparenly, a similar mehodology migh have been followed by he RBC lieraure. The echnology facor was assumed exogenous. Knowledge was developed on growh and flucuaions; he echnolgy facor sill remains shomewha of a mysery.

6 premiums. Owing o he inclusion of he global financial crisis in he sample, we obain ha in all economies oupu flucuaions are conneced wih counry risk premiums, and paricularly wih sysemic risk. The paper has he following six secions: inroducion, model, daa, resuls, conclusions, and appendix. The model secion firs presens he global ransmission channels. I hen describes he equaions where he model has some original wis, namely, he equaions for he oupu gap, rade balance, curren accoun, he price of oil, food commodiy prices, counry energy and food prices, and he uncovered ineres rae pariy. The model secion coninues, for he sake of compleeness, wih a descripion of he equaions ha are sandard. The daa secion covers he daa sources and also includes oher daa aspecs of he model, namely, he model calibraion and esimaion. The resuls secion presens he responses o he main shocks, he smoohing resuls, he error decomposiion resuls, and he model forecasing properies. The conclusions can be manifold, given he number of feaures incorporaed ino he model, bu deal mainly wih he role of sysemic risk and counry risk premium shocks, as well as oher demand-relaed shocks, in explaining oupu gaps, he rade balance, unemploymen, and counry energy and food prices. An appendix presens he derivaion of equaions for he oupu gap, rade balance, and he curren accoun. II. The Model The model incorporaes hree main opics ino a global projecion model. The firs opic is sysemic risk and is ransmission o counry risk premiums. The second opic, he ransmission from counry risk premiums o demand-relaed variables such as he oupu gap, he rade balance and unemploymen. The hird opic, he ransmission from commodiy prices o counry inflaion. Wih hese feaures, he model can be operaed o analyze financial booms and buss (he cycle in sysemic risk), he effec of booms and booss on oupu, he rade balance, and unemploymen, as well as commodiy-price shocks and heir effec on inflaion. 5 The model is in he spiri a simple gap model of he ype cenral banks use in heir inflaion argeing procedures. A cenral bank gap model is normally based on wo ransmission channels, he aggregae demand channel and exchange rae channel. The former is he effec of ineres raes on aggregae demand, inflaion, and he ineres feedback rule. The laer is he effec of ineres raes on he exchange rae, aggregae demand, inflaion, and he ineres rae feedback rule. Besides hese radiional ransmission channels in he small open economy, we define hree global ransmission channels. The global channels are, firs, he sysemic risk channel, second, he foreign aggregae demand channel, and hird, he foreign exchange rae channel. The sysemic risk channel is he effec of sysemic risk on counry risk premiums. The foreign aggregae demand channel consiss of he chain: foreign risk premium, foreign oupu gap, impors from abroad, and domesic oupu gap. The foreign exchange rae channel is he effec of foreign risk premium shocks on domesic oupu and rade balance gaps. A rise in a foreign risk premium appreciaes he exchange While Neumeyer and Perri call EMBI spreads ineres raes, we call EMBI spreads counry risk premiums. 5 The aim of he model is as a ool for policy analysis, in his ligh i is no a parsimonious explanaion of a single opic. A general equilibrium model would no be vulnerable o he Lucas criique bu is ouside he scope of he paper.

7 7 rae. The appreciaion causes a rise in impors and a drop in expors. The oupu gap drops and he rade balance gap deerioraes. In addiion o hese global channels, he sandard ransmission channels in he open economy may be exended o incorporae counry risk premiums as follows: he domesic aggregae demand channel is he effec of a shock o he counry risk premium on he counry oupu gap and inflaion; and he domesic exchange rae channel consiss of he effec of he counry risk premium on oupu and rade balance gaps via he exchange rae. The model covers counries ha accoun for abou 85 percen of world GDP. The counries are arranged ino six regions or counries, hose of he IMF Global Projecion Model of Douglas Laxon and colleagues (see Carabenciov e al ()). The counries are he Unied Saes, Europe, Japan, Eas Asia, Lain America, and he remaining counries. The model has 9 core equaions (7 behavioral equaions and ideniies a he global level and behavioral equaions a he counry level). The number of equaions in he model rises o owing o he number of counries, he ype of variables involved (in deviaion and laen form), he several definiions used for growh and inflaion, a se of equaions for auo correlaed residuals, and anoher se of equaions for exogenous inervenions on he oupu gaps. 7 Sysemic risk and ransmission o counry risk premiums Sysemic risk is esimaed in a common facor model embedded ino he global model. As a common facor, sysemic risk is no foreign or domesic bu a common facor of boh. Sysemic risk and counry risk premiums, ˆϕ and ˆρ i, are given by he following wo equaions ha, accouning for each of he counries, sand for a se of seven equaions: ˆϕ = α ˆϕ + εˆϕ, () and ˆρ = α ˆρ + α ˆϕ + εˆρ, () wih one equaion of he form () for each of he six counries. (Noaion omis counry subscrips for simpliciy.) In equaions () and (), counry risk premiums are observed while sysemic risk is unobserved. In addiion, sysemic risk and counry risk premiums are he sum of heir deviaion and laen The 7 core equaions a he global level are behavioral equaions for he following variables: global risk, he price of oil, commodiy food prices; as well as ideniies for he following variables: global oupu gap, world inflaion, world real ineres raes, and world unemploymen. The core equaions a he counry level are on one hand behavioral equaions for he following variables: risk premium, oupu gap, rade balance gap, capial flows, core inflaion, energy prices, food prices, ineres raes, unemploymen, expor prices, impor prices, real exchange rae; and on he oher hand ideniies for he variables foreign risk premiums, foreign real ineres raes, real mulilaeral exchange rae, erms of rade, absorpion CPI inflaion, nominal exchange rae, real ineres rae, and a breakdown of he UIP residual. 7 The sochasic processes and ideniies for laen variables amoun o 9 equaions. Differen measures of inflaion and growh (annual, quarerly, CPI, food, energy, and core) amoun o equaions. Auo correlaed errors in each of he behavioral equaions accoun for anoher se of 7 equaions. Finally, he exogenous inervenions on oupu gaps accoun for anoher se of equaions.

8 8 componens ϕ = ˆϕ + ϕ, () and ρ = ˆρ + ρ. () In urn, laen sysemic risk is given by ϕ = Σ i α i ( ρ i ρ i,ss ) + ϕ ss + ε ϕ. (5) The difference beween sysemic risk shocks and counry risk premium shocks sand ou. While sysemic risk shocks affec all counry risk premiums via he sysemic risk channel, counry risk shocks do no affec sysemic risk. The reason is ha, by equaion (), sysemic risk is explained solely by sysemic risk shocks. In like fashion, sysemic risk is differen from he foreign risk premium. In effec, while sysemic risk is he common facor of all counry risk premiums, he foreign risk premium is a weighed average of he rade parners counry risk premiums. The curren accoun All flow variables in he model are measured in real erms, excep for he curren accoun which is measured in percen of GDP. In order o ake ino accoun his change in unis, he curren accoun ẑ is obained as ẑ = ẑ + ˆ + εẑ, () which is he sum of he rade balance ẑ and he erms of rade ˆ. The inuiion behind equaion () is ha he curren accoun is approximaed by he rade balance in real erms; in addiion, he erms of rade help ransform he rade balance from real unis ino percen of GDP (see he Appendix for he derivaion). In equaion (), he erms of rade are defined as 8 ˆ xˆq X, mˆq M,, (7) where x is he share of expors in GDP, m is he share of impors in GDP, q X, p X, p is he real price of expors, and q M, p X, p is he real price of impors. Noe ha he erms of rade are commonly measured as he index ˆ ˆq X, ˆq M,. In comparison wih his index, he measure of he erms of rade saed in equaion (7) weighs real expor and impor prices by he expor and impor shares in GDP. In his form, he erms of rade are measured in unis of GDP. 9 8 Throughou he paper, a bar wih ime subscrip, as in he case of ȳ, denoes a laen variable, while a bar wihou he ime subscrip, as in he case of m, denoes share of GDP. In hese examples, ȳ denoes poenial oupu and m denoes he share of impors in nominal GDP. 9 For example, if he price of expors is en percen above he long erm and he share of expors in GDP is., he erms of rade are ˆ (.)(.) =.. Or he addiional income due o a high expor price is percen of GDP. Noe ha his addiional income is due purely o a price effec and hence does no ener real GDP or he real rade balance because real quaniies in he naional accouns do no ake ino accoun changes in real prices.

9 9 The overall curren accoun is obained as z = ẑ + z, (8) where laen curren accoun is where z = z + + c, (9) = x q X, m q M,, () c = c + γ c + ε c, () and γ c = γ c + ε γ c. () In equaion (9), he erm c helps reconcile he differences beween he rade balance and he curren accoun due o ne ransfers, ne facor income, and errors and omissions. The rade balance The rade balance z depends on scale and subsiuion effecs (see he Appendix for he derivaion), zẑ = σ zẑ + + σ zẑ + mσ (ˆr + ˆρ ) xσ (ˆr F + ˆρ F ) () ς(ˆr ˆr F ˆρ + ˆρ F ) + εẑ, One of he scale effecs is he response of impors o domesic demand, he hird erm a he righ hand side of equaion (), he reason is ha domesic demand responds o he domesic ineres rae ˆr and he counry risk premium ˆρ. Anoher scale effec is he response of expors o foreign demand. This is he fourh erm a he righ hand side of equaion (), since foreign demand responds o he foreign ineres rae ˆr F and he foreign risk premium ˆρ F. The fifh erm a he righ hand side of equaion () sands for he subsiuion effecs; if his erm rises he real exchange rae appreciaes and hus he rade balance deerioraes. Furher inuiion abou equaion () can be obained by making m x. Under his condiion equaion () becomes zẑ = σ zẑ + + σ zẑ + ( mσ ς)(ˆr ˆr F ) + ( mσ + ς)(ˆρ ˆρ F ) + εẑ. () In his form, he rade balance equaion shows ha he scale and subsiuion effecs depend on he real ineres rae and risk premium differenials. Given ha ς >, a rise in he spread differenial The expecaions operaor is denoed as k + E k + for any variable k, as in he case of ẑ + in equaion (). All coeffi ciens are nonnegaive.

10 ˆρ ˆρ F improves he rade balance., Oher equaions relaed o he rade balance are z = z + γ z + ε z, (7) and γ z = γ z + ε γ z, (8) z z + zẑ. (9) As o he definiion of he real ineres rae in equaion (), i is given by r i π + () and In urn, he foreign ineres rae ˆr F is defined as ˆr = r r, () ˆr F Σ k ω kˆr k, () which is an expor-share weighed sum of counry ineres raes, where k denoes he expor parners, r k he ineres rae of he expor parners, and he ω k he expors shares. The foreign risk premium ˆρ F is defined similarly. Global imbalances Given ha global imbalances involve several dimensions, we use as working definiion ha hey are he par of he rade balance explained by mispriced risk and mispriced exchange raes. Mispriced risk is he norm a imes of euphoria or pessimism in financial markes. Mispriced exchange raes are hose ha are disored by massive cenral bank inervenion combined wih conrols on capial flows. Wih his definiion, he shifs in he rade balance ha correspond o reasonable repricing of risk and exchange raes are no imbalances. While evens of mispriced risk due o euphoria end o be ransiory, cases of mispriced exchange raes due o policies end o be more permanen. In equaion (9), he firs erm a he righ hand side, z, is laen rade balance in percen of GDP. The second erm, zẑ, is he deviaion of he rade balance from laen rade balance also in percen of GDP. Noe ha ẑ is in percen deviaion from he seady sae and ha muliplying a deviaion from he seady sae by he share in GDP z gives approximaely a percen of GDP. We have proposed behavioral equaions for oupu and he rade balance. A behavioral equaion for absorpion would simply be a risk augmened Euler equaion As his equaion would be redundan, we insead obain absorpion as c = c + σ (r + ρ ) (5) ĉ = ŷ ẑ. ()

11 In equaion (9) he rade balance is defined as he sum of he laen and deviaion componens. While imbalances due o mispriced risk would more likely ener he deviaion par of he rade balance, hose due o policies and mispriced exchange raes may beer ener he laen componen. Consider he deviaion componen and define he curren accoun in percen of world oupu as z = λ s ẑ () where λ s is he share of a given counry s oupu in world oupu evaluaed a marke prices. The quesion is wha par of he curren accoun z is an imbalance and which par is no. Wih an eye on equaion (), adjusmens in he rade balance due o real ineres rae adjusmens should no be viewed as imbalances because hey are due o he inernaional allocaion of expendiure and savings. Movemens in he rade balance due o movemens in counry risk premiums may be considered imbalances o he exen ha movemens in counry risk premiums are excessive euphoria or pessimism in financial markes. All in all, an imbalance could be seen as a mispriced-risk-driven curren accoun (). Oupu gap The oupu gap ŷ also depends on scale and subsiuion effecs ŷ = σ ŷ + + σ ŷ ( m)σ (ˆr + ˆρ ) xσ (ˆr F + ˆρ F ) ς(ˆr ˆr F ˆρ + ˆρ F ) + εŷ. () Noe ha he fourh and fifh erms a he righ hand side of equaion () correspond o he erms a he righ hand side of he rade balance equaion and sand for he scale and subsiuion effecs on he rade balance. The hird erm a he righ hand side of equaion () is he scale effec on absorpion, since absorpion follows Euler equaion (5). Laen oupu is given by he equaions ȳ = ȳ + γȳ + εȳ, (5) and while oupu iself follows γȳ = η 7γ + ( η 7 )γȳ,ss + ε γȳ, () y = ȳ + ŷ. (7) To enhance he analyical properies of he model, we added exogenous inervenions o he counry oupu gaps. The oupu gap is resriced o fulfil he equaion ŷ = ŷ P oin + ε P oin, (8) where ŷ P oin is a vecor of poin inervenions imposed on he oupu gap and σ εp oin is he slack in he aainmen of he inervenions. Equaion (8) enables us o fulfill exogenous resricions on he oupu gap, for insance, he esimaed oupu gap may be made equal o a given number a a cerain dae.

12 Commodiy prices and ransmission o counry inflaion The model incorporaes wo ransmission mechanisms, one from he price of oil o domesic energy prices, he oher one from food commodiy prices (or global food prices) o counry food prices. The price of oil ˆq Oil follows supply and demand facors ˆq Oil = β ˆq Oil + β ŷ W orld + εˆqoil, (9) Supply is given by he error erm εˆqoil, a sandard supply shock. Demand is given by he world oupu gap ŷ W orld. In (9), he price of oil is in real erms, and defined as q Oil p Oil p US. The laen price of oil follows and q Oil = q Oil + _ γ Oil q + ε qoil, () γ qoil = β γ qoil q Oil + εγ. () Food commodiy prices also follow supply εˆqf ood and demand ŷ W orld facors, ˆq F ood = β ˆq F ood β 5 ŷ W orld ood + εˆqf. () A look a equaions (9) and () shows ha a rise in income increases he real price of oil and decreases real commodiy food prices. The ransmission from he price of oil o domesic energy prices ˆq e follows ˆq e = ν 7ˆq e + ν 8 (ˆq Oil + ν ˆq ) + εˆqe, () while he ransmission from food commodiy prices o counry food prices ˆq f is given by ˆq f = ν 5(ˆq F ood + ν ˆq ) + εˆqf. () I bears emphasis ha ˆq e and ˆq f in equaions () and () are real prices a he counry level while and ˆq F ood are real prices a he global level., 5 ˆq Oil Laen counry energy and food prices follow processes similar o hose of equaions () and () for he price of oil. As for he effec of hese relaive prices on inflaion, inflaion in he energy, food, and overall CPI indexes are obained wih he ideniies π e π + (q e q e ), (5) π f π + (q f qf ), () In equaion () he price of oil is observed. In conras, in equaion () he commodiy price of food is unobserved. We preferred o obain he commodiy price of food as unobservable because available food commodiy price indexes appeared o be poorly correlaed wih counry and regional food prices. 5 Noe ha q US US =.

13 and π π c + ν f (q f qf ) + ν e(q e q e ), (7) where π is CPI inflaion, π c is core CPI or inflaion excluding food and energy, q e = p e p is he counry real price of energy, q f = pf p is he counry real price of food, and ν f and ν e are he weighs of food and energy in he CPI. A measure of non core relaive prices will be used in he analysis. This measure is an aggregae of domesic energy and food prices relaive o he CPI. In deviaion form, he aggregae is ˆq NC = ν e ν x ˆq e + ν f ν x ˆq f, (8) where ν x = ν f ν e. The firs difference of his aggregae is approximaely equal o he deviaion of CPI inflaion from core inflaion. In urn, core CPI inflaion follows a Phillips curve of he form π c = ( ν )π c + + ν π c + ν ŷ + ν ˆq RER + ε πc. (9) Laen prices Counry risk premiums, real ineres raes, and inflaion in Eas Asia and he remaining counries exhibi imporan ransiions hroughou he period of sudy. The rends in hese variables pose a problem for error decomposiion exercises in a model where exchange raes depend on foreign counry risk premiums and ineres raes. We hen broke down laen counry risk premiums, ineres raes, and implici inflaion arges ino rend and derended componens. The breakdown of laen counry risk premiums is as follows ρ = ρ De + ρ T rend, () and ρ De = α ρ De + ( α ) ϕ + α ρ De,ss + ε ρde, () ρ T rend = ρ T rend + rend rend γ ρt + ε ρt. () rend rend γ ρt = γ ρt + ε γ q Oil. () The ransiion rend ρ T rend linear rend model. is deemed as observed. We esimaed hese ransiion rends wih a local The counry risk premium is given by ρ = ˆρ + ρ, () in levels and by ρ De ρ ρ T rend (5) in derended level form or he counry risk premium ha would have obained had no ransiion Following Caravenciov e al (), an error erm ε π is added o equaion (7) π = π x +ν f (q f q f )+νe(qe q e )+ε π o accoun for changes in ν f and ν e over ime. This error erm is no economically meaningful; i merely ensures consisency of equaion (7).

14 aken place. 7 Laen real ineres raes and implici inflaion arges follow processes similar o hose of equaions () o (). Transiion rends are presen in counry risk premiums in Europe and Lain America, real ineres raes of Lain America and he remaining counries, and implici inflaion arges of Lain America and he remaining counries. 8 Uncovered ineres rae pariy The risk-adjused UIP condiion is q j US = q j US + (rj,de r US,De ρ j,de + ρ US,De ) + χ j US, () for j = EU, JA, EA, LA, and RC, where q j US counry j agains he US, r j,de counry risk premiums and χ j US is he log of he real bilaeral exchange rae of and r US,De are he real ineres raes, ρ j,de and ρ US,De are he is a UIP shock. The laen bilaeral real exchange rae of counry j agains he US q j US follows q j US = γ qj US + q j US + ε qj US, (7) and γ qj US _ j US = ζγ q + ( ζ)γ qj US,ss + ε γ q j US. (8) =, hen ρ De Noe ha if ρ T rend sandard, risk-augmened UIP equaion. ρ and r T rend =, hen r De r and hence equaion () is a Noe ha unlike oher equaions in he model, equaion () does no refer o a variable in deviaion form. In his ligh, he UIP residual χ j US involves deviaion and laen componens. To ease he undersanding (and calibraion) of he UIP residual broke i down ino a deviaion and laen componens χ j US = ˆχj US + χj US. (9) The laen componen is defined as he residual of he UIP equaion in laen form χ j US qj US q j US + + ( rj,de r US,De ρ j,de + ρ US,De ). (5) Using he breakdown in equaion (9) i is possible o obain deviaion and laen componens for he exchange rae in a way ha is sandard or comparable o oher variables in he model. 7 While he measure ˆρ is zero mean and used in he rade balance and oupu gap equaions; he measure ρ De is nonzero mean and used in he UIP condiion. 8 Transiion rends can make error decomposiion analysis problemaic. Trends in some counries may spli ino he error decomposiion exercises of oher counries because ineres raes and risk spreads are conneced by he UIP condiions. As ransiion rends are no presen in all variables and regions, hey may be se equal o zero where needed. However, we mainained ransiion rends in risk spreads, real ineres raes, and implici inflaion arges in all regions because his improved he evoluion of laen global risk.

15 5 Remaining model equaions here for compleeness. The remaining model equaions are sandard and are explained The firs equaions are hose for he nominal and real mulilaeral exchange raes. While real exchange raes are obained using he real UIP condiion, nominal exchange raes are obained from ideniies. The nominal exchange rae of counry j vis a vis he US s j US is obained as s j US s j US + qj US q j US + (πj πus ). (5) where π US RC. and π j are he US and counry inflaion raes for counries j = EU, JA, EA, LA, and Real effecive exchange raes q RER,i are a baske of real bilaeral exchange raes 9 q RER,EU ω EU US q EU US + ω EU JA q EU JA + ω EU EA q EU EA + ω EU LA q EU LA + ω EU RC q EU RC, (5) Noe ha real exchange raes in expression (5) are a weighed sum of real bilaeral exchange raes agains US and non US counries. While exchange raes agains he US are called simply exchange raes, exchange raes agains non US counries are he cross exchange raes. Cross real exchange raes are obained from exchange raes agains he US. For example, he cross real exchange rae of Europe agains Japan is given by q EU JA = q EU US q JA US, (5) Laen cross real exchange raes are given by j = EU, JA, EA, LA, and RC. q j k US = q j US As o he policy rule, The nominal ineres raes follows _ q k US. (55) i = δ i + ( δ ) [ r + π + δ (π +5 π +5 ) + δ ŷ ] + ε i, (5) where π is annual inflaion and π he inflaion arge. As for cyclical unemploymen û i, i is given by û = ϑ û + ϑ ŷ + εû, (57) In urn, he NAIRU ū i follows ū = ϑ ū + γū + εū, (58) 9 In he special case of he US he real effecive exchange rae is obained as q RER,US ω US EU q EU US ω US JA q JA US ω US EA q EA US ω US LA q LA US ω US RC q RC US. (5)

16 and γū = ϑ γū + ε γū, (59) Finally, unemploymen is he sum of is cyclical and NAIRU componens u = û + ū. () Finally, he global oupu gap is a weighed sum of counry oupu gaps ŷ W orld Σ i λ i ŷ i. () where he GDP weighs are adjused by PPP, i = US, Eur, Jap, EA, LA, and RC, and ŷ i are he counry oupu gaps. III. The Daa Counry risk and sysemic risk As suggesed by Biasis (), any measure of sysemic risk mus necessarily be incomplee. For our purposes we would ideally use a measure of sysemic risk derived from daa from each of he counries, covering a handful of financial markes, and for he enire period of sudy (saring in 99Q). In realiy here are no markes for he same financial insrumens in all counries so ha here are no comparable daa for homogenous financial insrumens. Hence, he working definiion of sysemic risk we use is a common facor of daa for differen financial markes, he daa ha was available for each of he counries or regions. The advanage is ha an heerogeneous incomplee lis could suffi ce because sysemic risk is pervasive. All in all, we measure he counry risk premium wih he implied sock volailiy (he vix) in he US, corporae bonds in Europe and Japan, and an index of mosly governmen bonds in Eas Asia and Lain America (he EMBI). Daa Sources The source of he vix index is Bloomberg Financial Services. The source of corporae bond spreads for Germany and Japan is Haver Analyics. The source of EMBI spreads for Eas Asia and Lain America is Bloomberg Financial Services. The sources for he balance in curren accoun are he OECD saisics daabase and he WEO daabase. The source for implici rade deflaors is he OECD saisics daabase. Daa from he laer source was pu ino quarerly erms wih he Kalman filer. The daa sources appear in Table. The global oupu level may be obained as y W orld [ ] log Σ iλ i exp(y) i. () This equaion may be calculaed ouside he model so as o mainain he soluion mehod linear. An equaion similar o () applies no only o world oupu bu also o world poenial oupu. Noe ha no variable in he model depends on hese oupu levels. In he case of CDS spreads, for insance, here are no suffi cienly long comparable ime series. We use German corporae bond spreads for Europe owing o he weigh of Germany in Europe, and given ha he ime series for oher European (crisis) counries are no suffi cienly long.

17 7 Model calibraion The calibraion covered 99 parameers and 55 sandard deviaions; of he calibraed parameers served as priors for he Bayesian esimaion. The calibraion was fine uned by analyzing impulse response funcions, he evoluion of laen variables, equaion fi, error decomposiions, and model forecas performance. The calibraed parameers appear in Table. The forward-looking componen of he oupu gap and rade balance equaions σ was se a. so as o make he equaions mosly backward looking. The backward-looking componen of hese equaions σ was se a a smaller value in Japan and he emerging counries. The persisence in he risk premium equaions ν 7 was se a.55, ineres rae smoohing δ a., he backward looking componen of Phillips curves ν was se a lower levels in emerging counries, persisence in Okun equaions ϑ was se a lower levels in Japan and he emerging counries, persisence in counry energy equaions ν 7, expor and impor prices σ and σ, he price of oil β, and commodiy food prices β was se a diverse levels. The response of he oupu gap o he counry risk premium and he real ineres rae, given by he subse of parameers σ ρ and σ r, was calibraed wih he aide of a VAR. Arkeloff and Shiller (9) documen he absence of confidence variables in VAR sudies (page 7). Here we run a VAR ha includes a confidence variable, he counry risk premium. Oher variables in he VAR are oupu gaps and ineres raes. The VAR is specified as follows: ˆρ j, = Σ i j c iˆρ i, + εˆρ j () î k, = c î k, + c ŷ + εîk ŷ k, = c ŷ k, + c ρ k, + c ˆr k, + c ŷk, F + εŷk ŷk, F Σ i k ω k i ŷ i, for j = US, EU, JA, EA, LA, and k = US, EU, JA, EA, LA, RC. Daa for counry risk premiums, nominal ineres raes and oupu in he VAR are in deviaion form. Daa in deviaion form was obained from a preliminary run of he model. Noe ha foreign oupu is consruced as an ideniy. In addiion, he ineres rae eners he VAR in nominal erms because in deviaion form i has smaller shor erm variaion ha he real ineres rae bu is highly correlaed wih he real ineres rae. The VAR was also resriced. In effec, he relaive effec he counry risk premium and he ineres rae on he oupu gap in he VAR was made equal o he raio of he same relaive effec in he calibraion of he model. This resricion urned ou o be useful o find a negaive sign in he effec of he ineres rae on he oupu gap in he VAR. The calibraion of parameers σ ρ and σ r in he model pursued an approximaion beween he response o counry risk premium and ineres rae shocks in he model and ha of he VAR. The peak response of he oupu gap o counry risk premium shocks in he model and in he VAR appears in Panel A of Figures and. The shocks are a uni, auocorrelaed shock o he counry risk premium and o he ineres rae. The calibraion of he remaining 5 parameers and 55 sandard deviaions is no repored. Nominal ineres raes in deviaion form as defined as î = i π r.

18 8 Model esimaion The esimaion covered a subse of 77 parameers ha were more relevan for he hree main opics included in he model. The model was esimaed by wih full Bayesian mehod. Priors means where hose seleced in he calibraion of he model. The inerval for esimaion was seleced as ±. imes he prior mean. This inerval was judged o srike a balance beween wo crieria; firs, o allow suffi cien room for he daa o speak; second, o preserve he economic properies of he calibraed model; properies such as reasonable impulse responses, equaion fi, hisoric error decomposiions, and model convergence. Prior sandard deviaions were repeaedly reduced in a series of esimaions so as o ensure ha he esimaion of each parameer converged o a maximum. Final sandard deviaions were in he range of. o. imes he prior mode. The esimaed parameers appear in Table. Overall, he esimaion confirms he qualiy of he calibraed parameers. Indeed, he difference beween he prior and poserior means is above a enh of he prior mode in bu a few parameers. In he full Bayesian esimaion he poserior disribuions (no repored) move in comparison o he prior disribuions. When esimaing he enire subse of 77 parameers he poserior disribuions show more densiy around he poserior mean compared o he prior disribuions. The higher concenraion of he poserior disribuions shows ha he daa and he esimaion bring informaion o he model. IV. Resuls The resuls secion discusses he hree opics deal wih in he paper. Firs, he ransmission from sysemic risk o counry risk premiums. Second, he ransmission from counry risk premiums o aggregaed demand relaed variables such as he oupu gap, he rade balance gap, and unemploymen. Third, he ransmission from commodiy prices o counry energy and food prices. In addiion, impulse response analysis include a shock o he policy ineres rae, given ha his shock provides an illusraion of he ransmission mechanisms of moneary policy. A shock o sysemic risk A shock o sysemic risk involves hree seps and channels. Firs, he sysemic risk channel ransmis sysemic risk o counry risk premiums. Second, he domesic aggregae demand channel ransmis he effec of counry risk premiums o oupu gaps. Third, he foreign aggregae demand channel ransmis he effec of foreign risk premiums o domesic oupu gaps. The sysemic risk channel has effecs ha are large and widespread. As explained below, boh he sysemic risk and aggregae demand channels accoun for he global-risk-relaed synchronizaion of oupu gaps across he board. Figure shows he behavior of world variables. In Panel A, a shock o sysemic risk causes a drop in he world oupu gap by cause of he sysemic risk channel, as well as he domesic and foreign aggregae demand channels. World unemploymen rises hrough he effec of counry oupu gaps on counry unemploymen. In Panel B, he shock is shown o cause a drop in he price of oil and a rise in he commodiy price of food. Figure shows he behavior of counry variables. The sysemic risk shock affecs counry risk

19 9 premiums, oupu gaps, and rade balance gaps across he board. Counry risk premiums and oupu gaps respond o a exen ha depends on he srengh of he sysemic risk channel (on loading facors α ) as well as on he aggregae demand channel. The effec of he shock on counry oupu gaps is large, paricularly when compared wih he effec of shocks o counry risk premiums, explained below. Trade balance gaps may improve or deeriorae depending on various facors, primarily on he srengh of he sysemic risk channel. In counries where loading facors α are large, such as he Unied Saes and he remaining counries, and o a lesser exen in Japan, counry risk premium rise furher, he counry risk premium differenial rises, and he rade balance improves as well. In counries where loading facors α are small, such as Eas Asia and Lain America, he counry risk premium rises less, he counry risk premium differenial drops, and he rade balance gap deerioraes. A shock o he counry risk premium Shocks o counry risk premiums have effecs on oupu gaps ha are smaller compared o he effec of sysemic risk shocks. The response of global variables o counry risk premium shocks appears in Figure. In Panel A, he world oupu gap drops in response o upward counry risk premium shocks. The larges response of he world oupu gap obains for hose counries wih he larges share in world oupu. Panels B o D show he response of world unemploymen and commodiy prices. The response is larger he higher he weigh of he counry in world oupu gap. The response of counry variables o counry risk premium shocks is also smaller han he response o a shock o sysemic risk. Noneheless, shocks o counry risk premiums enable us o consider he role of domesic versus foreign counry risk premium shocks. Figure 5, Panel A, shows he response of counry oupu gaps. Oupu gaps drop in response o an upward shock o he domesic risk premium. 5 Two channels are a work, he domesic aggregae demand and domesic exchange rae channels. Oupu gaps also drop in response o upward shocks o foreign risk premiums. Boh he foreign aggregae demand and foreign exchange rae channels end o cause a drop in oupu gaps. Oupu gaps reac o domesic risk premium shocks far more han o foreign risk premiums shocks. By exempion, oupu gaps may reac srongly o a foreign risk premium shock in very open economy because he aggregae demand channel is relaively srong while he exchange rae channel is relaively weak (see he cases of Eas Asia and he remaining counries). Concerning he response of he rade balance gap o counry risk premium shocks, in Figure 5, Panel B, rade balance gaps improve wih domesic risk premium shocks and drop wih foreign risk premium shocks. This is a consequence of equaion (). The srengh of he response of rade 5 The effec of a domesic risk shock on he domesic oupu gap is unambiguous for reasonable combinaions of parameer values. Noneheless, he effec is ambiguous in heory. The domesic aggregae demand and exchange rae channels exer forces on he oupu gap ha ac in opposie direcions. The aggregae demand channel ends o cause a drop in he oupu gap while he exchange rae channel ends o cause a rise. A differen raionale for he relevance of foreign risk premium shocks is a play in he case of Europe. Foreign risk premium shocks are relaively imporan in Europe because he sandard deviaion of shocks o he European risk premium is smaller. Among foreign risk premium shocks, hose from he remaining counries are imporan because he remaining counries are he main expor parner of Europe.

20 balance gaps o foreign risk premium shocks depends, mosly, on he expor share of he counry where he shock akes place. All in all, a shock o he counry risk premium impacs oupu and rade balance gaps via four channels, he domesic and foreign aggregae demand channels and domesic and foreign exchange rae channels. By he domesic exchange rae channel, a rise in he counry risk premium causes a drop in he oupu gap and a rise in he rade balance gap. By virue of he foreign exchange rae channel, a rise in a foreign risk premium causes a drop in he domesic oupu gap and a drop in he rade balance gap as well. Shocks o commodiy prices A shock o he price of oil is presened in Figures and 7. The response of global variables o a shock in he price of oil appears in Figure, Panels A and B. A one-sandard-deviaion shock is of abou en percen o he price of oil in real erms. The shock generaes a rise of half a percenage poin in world inflaion on impac and a drop of half of one enh of one percen on he world oupu gap in one year. The response of counry variables o a shock o he price of oil appears in Figure 7, Panel A. The response involves higher inflaion in hose counries wih higher weigh of energy in he CPI baske, paricularly in he Unied Saes. Moneary policy rules in hese counries prescribe larger ineres rae increases, hence, in hese counries currencies appreciae causing oupu gaps o drop furher. Alogeher, a shock o he price of oil has effecs on world and counry variables ha are widespread, alhough no as large as he effecs of a sysemic risk shock. A shock o he commodiy price of food appears in Figures and 7. The response of global and counry oupu gaps and inflaion raes is similar in kind and exen o ha of a shock o he price of oil. Some differences do arise as o he exen of he response of he nominal ineres rae and in he persisence of CPI inflaion. These differences are explained by he higher persisence of counry energy and food prices under shocks o he price of oil and commodiy food prices respecively. An ineres rae shock As in he case of shocks o counry risk premiums, he focus here is on he effec of ineres rae shocks on he world oupu gap, counry oupu gaps, and counry rade balance gaps. A he world level, he relevan shocks are hose ha ake place in large counries; a he counry level, he relevan shocks are hose o he own ineres raes while shocks o foreign ineres raes are relaively unimporan. Consider firs he response of he world oupu gap o counry ineres rae shocks in Figure 8. As before, he response is sronger when he shock akes place in counries ha are large in he world economy. Variables such as unemploymen and commodiy prices respond o hese shocks depending on he response of world oupu gap. Consider nex, under counry ineres rae shocks, he response of counry oupu gaps in Figure 9. Panel A shows a sandard response wih he domesic aggregae demand and exchange rae channels being involved.

21 Nex, consider he effec of ineres rae shocks on foreign-counry oupu gaps also in Figure 9, Panel A. Alhough he oupu gap response o a foreign ineres rae shock is quaniaively small, i helps explain he ransmission mechanisms in he model. The response is he resul of ransmission channels ha work in opposie direcions. In response o an increase in a foreign ineres rae, he foreign aggregae demand channel causes a drop in he oupu gap, he foreign exchange rae channel causes a rise in he gap. Boh effecs offse each oher o he exen ha he response of he oupu gap o a foreign ineres rae shock is unimporan. Nex, consider he effec of an ineres rae shock on he own rade balance gap in Figure 9, Panel A. The response may have a posiive or negaive sign depending on he srengh of he domesic aggregae demand and exchange rae channels. By he aggregae demand channel, a rise in he domesic ineres rae decreases aggregae demand and hence impors. Consequenly, he rade balance improves. Through he exchange rae channel, a rise in he domesic ineres rae appreciaes he exchange rae hus he rade balance deerioraes. Finally, consider he effec of a foreign ineres rae shock on he rade balance gap also in Figure 9, Panel B. By equaion (), he sign of he response of he rade balance gap o a foreign ineres rae shock is opposie o ha of a shock o he domesic ineres rae. Thus, he response of he rade balance gap o a foreign ineres rae shock is posiive where he response of he rade balance o he own ineres rae is negaive and vice versa. Smoohing resuls Repored smoohing resuls also deal wih he hree opics deal wih in he paper. Firs, he ransmission from sysemic risk o counry risk premiums. Second, he ransmission from counry risk premiums o aggregaed demand relaed variables such as he oupu gap, he rade balance gap, and unemploymen. Third, he ransmission from commodiy prices o counry energy and food prices. The firs of hese opics is presened in Figure, Panel A, and in Figure, Panels A o F. The esimaed, unobserved sysemic risk in Figure, Panel A, marks four episodes of global rerenchmen: he end-of-he-cenury crisis, he sock marke downurn of, he global financial crisis, and he Euro zone crisis. Laen sysemic risk rises owards he global financial crisis. Figure, shows counry risk premiums. In deviaion form, counry risk premiums move wih global and idiosyncraic evens. In laen form, counry risk premiums rise owards he global financial crisis in he Unied Saes, Japan, and he remaining counries; depic a srong downward ransiion rend in Lain America; and show a milder ransiion rend in Eas Asia. The second of he opics appears in Figures and. Peaks in counry risk premiums correspond wih buss in oupu and increases in unemploymen. The larges peak in risk and bus in oupu during he global financial crisis mached improvemens in he rade balance in some counries (Unied Saes, Lain America, and he remaining counries) and drops in oher counries (Europe, Japan and o a lesser exen Eas Asia). In he former group he rade balance improved a he ime ha he oupu gap dropped, absorpion dropped more han oupu. The improvemen of he rade balance required absorpion o drop more han oupu; in his ligh he rade balance is undersood o be pro cyclical. Conversely, in he laer group he rade balance is couner cyclical or sabilizing.

22 Figure presens he rade balance. Laen rade balance is given by he sochasic process in equaions (7) and (8). Alernaively, and inuiively, laen rade balance in Figure is equal o laen oupu minus laen absorpion. On he one hand, laen rade balance improves when laen oupu rises relaive o laen absorpion (Europe and Japan). On he oher hand, laen rade balance deerioraes when laen oupu drops relaive o laen absorpion (Lain America and he remaining counries). Laen rade balance drops and hen improves in he Unied Saes. An opposie behavior akes place in Eas Asia. The second opic also includes global imbalances, which akes us back o Figure, Panels D o F. While he opic of global imbalances normally refers o he relaionship beween he US and China, he Panels presen a relaionship beween he curren accoun of he blocks or regions used in he model in his paper. The curren accoun of he Unied Saes, Eas Asia, and Japan appear in hese panels in percen of world oupu. Clearly, Eas Asia and Japan help finance he curren accoun of he US, wih a large conribuion of Eas Asia. The relaionship appears o be clear for he curren accoun as a whole as well as for is deviaion from laen values. In deviaion form curren accouns are explained by he effec of sysemic risk and counry risk premiums on rade balances. This will be explained below in he error decomposiion of he rade balance gaps. The hird of he opics appears in Figure and in Figure, Panels G and H. The price of oil rises wih he world oupu gap while food commodiy prices decline (Figure, Panels G and H). Counry energy prices are relaed wih he price of oil (Figure, Panels A o F), in paricular in he Unied Saes, Europe, Japan, and he remaining counries. In Eas Asia and Lain America counry energy prices have lower correlaion wih he price of oil, probably due o price conrols. Finally, counry food prices depic some correlaion wih commodiy food prices (Figure, Panels G o L). Hisorical decomposiion resuls Repored hisorical decomposiions refer o global and counry variables under global, domesic, and foreign shocks. The global variables under sudy are sysemic risk, he price of oil, food commodiy prices, he world oupu gap, world unemploymen, and world energy and food prices. The counry variables ha we deal wih are he counry risk premium, he oupu gap, he rade balance gap, unemploymen, and counry energy and food prices. The global shocks are hose o he global behavioral equaions, namely, sysemic risk and global inflaion shocks. The laer are shocks o he price of oil and food commodiy prices. The domesic shocks are o counry risk premiums, oupu gaps and real ineres raes. The laer are a combinaion of shocks o nominal ineres raes and domesic inflaion. Shocks o domesic inflaion are hose o core inflaion, counry energy prices, and counry food prices. The resuls poin a a heavy effec of sysemic risk on aggregae demand relaed variables, o a rivial effec of counry risk premium shocks (excep on rade balance gaps), and o an imporan, more sandard effec of domesic variables such as real ineres rae and oupu gap shocks. Regarding he global variables, he hisorical decomposiion of sysemic risk appears in Figure, Panel A. Sysemic risk shocks are global in scope and financial in naure. The esimaed sysemic risk marks periods of global financial rerenchmen ha, as shown below, coincide wih buss in he world oupu gap. Peaks in sysemic risk and buss in he world oupu gap ook place during four major financial evens hroughou he sample, namely, he end of he cenury crisis, he sock marke