Should central banks react to risk premium?

Evidence
from emerging market economies
Patrick Ndzinisa and Christopher Malikane
Macro-Financial Analysis Group, School of Economic and Business Sciences,
University of the Witwatersrand, 1 Jan Smuts Avenue, Johannesburg 2050,
South Africa

Abstract
We investigate the risk premium and monetary policy nexus, hence its propagation to output and ination within a DSGE model in ten EMEs. Applying various shocks, we examine the responses of output and ination under
two monetary policy scenarios. In the baseline policy scenario the central
bank is constrained not to respond to the risk premium whilst it does in
the alternative scenario. The aim is to compare the performances of the
two policy scenarios based on their outcomes on output and ination. The
results demonstrate that responding to the risk premium amid the shocks reduce the variations of output and ination than in the baseline policy. This
policy further expedites the return of these variables to their steady state,
hence containing also the volatility of the interest rate. Amongst the shocks,
the demand shock explains a large portion of the variations in output and
ination in these economies.
c 2016
Keywords: Monetary DSGE model; Monetary policy; Financial stability;
Risk premium; Bayesian estimation.

1.

Introduction

This paper investigates the role of monetary policy in fostering nancial stability conducive to economic growth in ten EMEs. Pitterle et al. (2015),
note that many EMEs are vulnerable to nancial crises accompanied by slow
growths. Specically, we assess whether responding to changes in the risk
1

premium, a proxy for nancial stability, improves output growth and price
stability than otherwise. The repercussions of the recent nancial crisis intensied the need to explore the nexus between monetary policy and nancial
stability. A strand of studies concludes that these two are intertwined (Smets,
2014; Gadanecz et al., 2015). Baxa et al. (2013) ascertain that interest rates
falls during high nancial stress. Dri ll et al. (2006) argue that interest rate
smoothens to enhance the stability of nancial markets.
Understanding the nexus between monetary policy and the risk premium
provides the needed information on whether reacting to the risk premium is
necessary. Based on their relationship, policy makers are better informed of
the appropriate monetary policy stance to eect i.e. an expansionary or a
contractionary policy. This is crucial because studies yield conicting results.
For instance, Faia and Monacelli (2007) conclude that rising asset prices
induces a fall in interest rates. Castelnuovo and Nistico (2010) nd that a rise
in stock prices lead to a rise in monetary policy. If the relationship is found
to exist, it unveils additional and alternative channels for the transmission of
monetary policy. Gambacorta and Signoretti (2014) argue that it is necessary
to react to nancial stability when supply shocks are predominant and the
standard rule is rendered less eective.
The gap which the study intends to address is that existing studies do not
explore the risk premium from both the domestic and external perspectives.
Moron and Winkelried (2005) specify the risk premium for EMEs but only
focus on the external risk premium. Furthermore, the role of the foreign
interest rate is not considered in the determination of the risk premium.
Gadanecz et al. (2015), estimate a Taylor rule incorporating domestic bond
yield for EMEs. They, however, only consider output, exchange rate and domestic interest rate in their bond yield equation. Gambacorta and Signoretti
(2014) observe that higher interest rate reduces the net worth of borrowers by increasing interest payment on debt, leading to higher risk premium.
Considering the relatively high foreign debt in EMEs, foreign interest rates
are key determinants of the risk premium.
The contribution of this study is to present a more elaborate specication of
the risk premium than has been used in existing studies. In this regard, we
build on the work by Cespedes et al. (2000) by specifying a risk premium
with domestic and external risks, linked to the net worth of borrowers. To
2

capture persistence in the risk premium, a one period lagged risk premium
variable is incorporated. The roles of the domestic and foreign interest rates
are also considered in the risk premium. The former establishes a monetary policy feedback to the risk premium. The study diers from existing
empirical analysis of EMEs in that it uses Bayesian techniques in a DSGE
model incorporating NKPC and risk premium-augmented Taylor rule and IS
equations respectively.
The remainder of the paper is structured as follows: In section 2, we present
the theoretical model consisting of the IS curve, uncovered interest rate parity, exchange rate, risk premiums, new hybrid Phillips curve and the optimal
monetary policy rule. Section 3, present the data analysis and the methodology to be employed in carrying out the estimation of the equations. In section
4, the empirical results are presented and analysed. Section 5 concludes with
some policy recommendations.

2. The theoretical model

Our model is a simplied small open economy DSGE based on Clarida, Gali
and Gertler (1999, 2001, 2002), and Gali and Monacelli (2005). The risk
premium constituting both the domestic and foreign risk premiums is introduced in the model to consider its relevance in the households and monetary
policy decision makings. This is done by incorporating debts, which concerns
mainly the household sector, in a way that allows us to accommodate both
domestic and foreign currency denominated debts.
2.1. Households
The demand side of the economy is assumed to be inhabited by innitely-lived
households. Households attempts to maximize their present value of expected
utility by smoothing consumption over the innite horizon or their lifetime
subject to an intertemporal budget constraint. Similarly to Canzoneri et al
(2007) we adopt the Fuhrer (2000) utility function. The utility ow from
consumption is assumed to depend on both the levels of current and past
consumption where the coe cient h is interpreted as a measure of the degree
of habit formation in consumption. In tandem with Gertler and Karadi
(2011) and others, the real money balance is excluded in the utility function.
Hence the utility function which the household in period t seeks to maximize
is represented in the following form:
3

Ut = Et

1
X
i=0

"

(Ct+i

hC t+i 1 )1
1

N 1+
+ t+i
1+

(1)

Subject to the following inter-temporal budget constraint:

Ct +

At
Pt

+ 1 + rt

Qt Dt
Dt
W t Nt
At 1
+ Qt At
=
+ (1 + rt 1 )
Pt
Pt
Pt
Pt
Qt At 1
Qt Dt 1
Dt 1
(1 + it 1 )
(1 + it 1 )
Pt
Pt
Pt

(2)

Where At and At are households holdings of domestic assets and foreign

assets respectively. They are paid rt for the domestic assets and rt for the
S P
foreign assets. Q = tPtt is the real exchange rate and St is the bilateral
exchange rate expressed as the price of foreign currency in terms of domestic
currency. Wt and Nt are nominal wage rate and labour respectively. They
also borrow Dt from the domestic market and Dt from the foreign market
denominated in foreign currency. The debts have a maturity of one period
and households pays interest rates it for the domestic debt and it in respect
of the foreign debt.
The rst order conditions are:

Ct :

= (Ct hC t 1 )
Wt
Nt : N t = t
Pt
1
t
Dt :
= t+1
(1 + it )
Pt
Pt+1
qt
qt+1
Dt :
t =
t+1 (1 + it )
Pt
Pt+1
(Ct+1 hC t )
Pt
At : 1 = R t
Pt+1
(Ct hC t 1 )
t

(3)
(4)
(5)
(6)
(7)

The interest rates paid for domestic and foreign debt have risk premium (rpt )
embedded in them which is dened as follows:
it = rt + rpdt , hence rpdt = it
it = rt + rpft , hence rpft = it

rt
rt

And;
rpt = rpdt + rpft
Where rpdt and rpft are domestic and foreign risk premiums respectively.
The risk premiums can also be expressed as proportions of the total risk
premium (rpt ) such that rpdt = !rpt and rpft = (1 !)rpt , where ! measures
the degree of openness of the small open economy. Equating (3) and (5) and
using Taylor approximation to linearize the resulting expression around its
steady state we obtain the following consumption Euler.

b
ct =

h
b
ct
1+h

1
Etb
ct+1
1+h

1 h
(b
rt E t bt+1 )
(1 + h)

! (1 h)
rp
b (8)
(1 + h) t

Eq. (8) diers from the standard equation in that we include the risk premium variable. The risk premium aects households consumption negatively
through the balance sheet or net-worth position of the households. The variables with a hat represents their percentage deviation from the steady state.
As noted by Smets and Wouters (2003) the elasticity of the interest rate on
consumption consists not only the intertemporal elasticity of substitution,
but the habit persistence parameter.
As in Gali and Monacelli (2005) and Matheson (2009) perfect nancial markets are assumed and that there is no control on capital movements. Hence
the expected nominal return from the risk-free assets in domestic currency
terms must be the same as the domestic currency return on foreign assets. A
5

similar rst order condition as in eq. (7) holds for the representative household in a foreign country. Equating the intertemporal optimality conditions
for the domestic and foreign households yields eq.(9).
Ct+1
Ct

hC t
hC t

Pt
Pt+1

(Ct+1 hC t )
(Ct hC t 1 )

Pt
Pt+1

(9)

Assuming perfect nancial markets implies that consumption risk is perfectly

shared between the households of the domestic economy and those of the foreign economy. Consequently, the dierences in the relative marginal utilities
of consumption, in equilibrium, are captured by movements in the real exchange rate. Combined with the law of one price and using the real exchange
rate denition, then in equilibrium the consumption risk sharing condition
yields,
1

Ct

hC t

= (Ct

hC t 1 )qt

(10)

Where the habit formation parameter is assumed to be the same for the
domestic and foreign country and
is a constant. Generally, the above
1
equation can be expressed as Ct = Ct qt which after log-linearisation around
the steady state and assuming Ct = Yt we obtain eq. (11) .
b
ct = ybt +

qbt

(11)

In line with Clarida (2014) and as shown by Cole and Obstfeld (1991), there
is the terms of trade that clears the traded goods market such that the trade
account is in balance period by period leading to the following relationship
b
ct = ybt + !b
et . Where et is terms of trade. Combining the balanced trade
condition with the identical preferences goods market equilibrium condition,
the terms of trade is expressed as ebt = ybt ybt . Hence the above expression
becomes b
ct = (1 + !)b
yt !b
yt which upon solving for ybt and substituting into
(11) gives;
b
ct = ybt +

!
qbt
(1 + !)

(12)

Finally combining eq. (12) and the consumption Euler eq. (8) and expressing
the resulting expression in a reduced form we obtain the output-based IS
equation characterizing a small open economy.

Where:

ybt = $b ybt 1 + $f Et ybt+1 'c qbt + 'b qbt

rt Et bt+1 )
bt
r (b
rp rp

+ 'f Et qbt+1

(13)

h
1
!
!h
; $f =
; 'c =
; 'b =
;
1+h
1+h
(1 + !)
(1 + h) (1 + !)
!
1 h
! (1 h)
'f =
, r=
and rp =
(1 + h) (1 + !)
(1 + h)
(1 + h)

$b =

2.2. The nancial markets

Combining (5) and (6) yields the risk-adjusted uncovered interest rate parity
(UIP) eq. (14) from which after linearization we derive the exchange rate eq.
(15)

(1 + r) !rpt = (1 + r ) (1

qbt = Et qbt+1

Where;

qbt = Et qbt+1

!)rpt Et

(b
rt + ! rp
b t ) + rbt + (1

rbt + rbt +
rp

= (1

bt
rp rp

qt+1
qt
!)rp
bt

(14)

(15)

2!)

Deviating from many studies where the risk premium is assumed to be exogenously determined we follow Bernanke et. al. (2000), and Moron and
7

Winkelried (2005) by endogenizing the risk premium. The behaviour of the

risk premium is linked with the net worth of borrowers whose liability is
denominated in both domestic and foreign currencies. Gertler at al. (2007)
expressed the risk premium as a function of total net foreign indebtedness
and a random shock. An inverse relationship between the risk premium and
net worth is envisaged by many studies hence we assume a non-linear relation
of the following form where N Wt represent the net worth;

N Wt
Pt

rpt =

(16)

In the following analysis we present the derivation of the net worth then
domestic and foreign risk premiums based on the preceding relationship. The
net worth of the borrowers is the value of their assets minus their liabilities.
The foreign net worth position of the borrowers is expressed as follows;
NWt
N Wt
=
Pt
Pt

N Xt
Pt

1 + it

Qt

Dt 1
Pt

(17)

Where N Wt is foreign net worth in domestic currency, N Xt is the net export

expressed in domestic currency, Dt is foreign debt in foreign currency. Expressing eq. (17) as a ratio of foreign debt, using the expression it = rt +rpft ,
and linearizing leads to eq. (18) where nwdt and ydt and ydt are ratios of
net worth, domestic output and foreign output to foreign debt respectively.
dt =
nwd

w nwdt 1

x nxdt 1

bt 1
rr

bt
qq

bt 1
p rp

(18)

In line with McCallum and Nelson (2000) we express the ratio of net exports
to foreign debt as a function of the ratios ydt and ydt , and the real exchange
rate as follows;.
dt =
nxd

c +

f ydt

d ydt

bt
qq

(19)

Combining (18) and (19) yields eq. (20) indicating a positive relationship
between nwdt and ydt . The negative impact of domestic output to net
worth is explained by rising imports relative to exports in response to a rise
in domestic output, hence reduces net exports. Meanwhile, an increase in
interest rate, foreign risk premium will respectively reduce the net foreign
worth position of the borrowers.

d =
nwd
t

w nwdt 1

x d ydt + x f ydt

qt
x q )b

bt 1
rr

b ft 1
p rp

(20)

However, the eect of the real exchange rate on the net worth depends on the
magnitudes of the coe cients of q and q . Where the former measures the
negative eect of the exchange rate on net worth by increasing the liabilities of
the borrowers. Whilst the latter captures the positive impact of the exchange
rate on net worth through the net exports eect. Cspedes et al. (2003) noted
that a depreciation of the (real) exchange rate increases the value of debt
repayments, because of dollarization of liabilities, and reduces net worth.
From the risk premium expression in eq. (16), the foreign risk premium can
be expressed as in eq. (21) which after log-linearization and substituting into
eq. (20) becomes eq. (22).
rpft = nwdt

rp
b ft = ( w +
+ r rbt 1

b ft 1
p )rp

x d ydt

(21)

x f ydt

qt
x q )b
(22)

Analogous, the domestic risk premium is derived from the domestic net worth
position of the borrowers dened by eq. (23).
NWt
NWt
=
Pt
Pt

SVt
Pt

(1 + it 1 )

Dt 1
Pt

(23)

Where N W t is domestic net worth of borrowers, SVt is domestic savings, Dt

is domestic debt. Expressing eq. (23) as a ratio of domestic debt, linearizing
and using the expression it = rt + rpdt , yields;
dt =
nwd

w nwdt 1

bt 1
rr

s svdt

b dt 1
p rp

(24)

The savings equation can be expressed as in eq (25) where c denotes marginal propensity to consume. Substituting into (24) leads to eq. (26).

dt =
nwd

dt = (1
svd

w nwdt 1

s (1

(25)

c )ydt

b dt 1
p rp

bt 1
rr

c )ydt

(26)

Assuming homogeneity in foreign and domestic risk premiums the relationship between domestic net worth and domestic risk premium bears the same
elasticity as in eq. (16), hence eq. (27). Log-linearizing and substituting the
resulting expression into eq. (26) yields (28).
rpdt = nwdt
rp
b dt = (

b dt 1
p )rp

(27)

s (1

c +

bt 1
rr

c )ydt

(28)

Summing up eq. (22) and (28), and assuming that the eects of the ratios
of ydt and ydt on risk premium are dominated by the outputs than debt
hence replacing them with yt and yt respectively we obtain the combined
risk premium as in eq. (29).

Where:

rp
bt =

bt 1
rp rp

bt
yd y

bt
yf y

10

bt
qq

bt 1
rd r

bt 1
rf r

(29)

rp
yf

=(
=

x f;

w )( p
q

+
= (

p)
q

[ s (1
c)
q ); rd =
r and

yd
x

x d] ;
rf

As demonstrated by eq. (29) the evolution of the risk premium is driven

by six components. In addition to the domestic and foreign outputs, and
the exchange rate as outlined in Moron and Winkelried (2005), we departs
by incorporating the domestic and foreign interest rates in the risk premium
function. Fundamental, interest rates increases the debt burden of borrowers
and consequently raises the risk premium. As noted by Gambacorta and
Signoretti (2014) higher interest rate reduces net worth by increasing interest
payment on debt leading to higher risk premium. More importantly, the
domestic interest rate channel establish the feedback eects of the monetary
policy on the risk premium.
Domestic output exerts both contractional and expansionary pressures on the
risk premium through the net exports and the savings eects, respectively.
As observed by Cspedes et al. (2002) an increase in output raises the income
of capitalists and therefore increases net worth. This will ultimately reduce
the countrys risk premium. Moron and Winkelried (2005) have noted that
a fall in domestic output indicates low levels of investment, hence reduces
nancing needs and reduces the risk premium.
A similar argument can be advanced that the eect of the real exchange rate
term on the risk premium is uncertain. The net eect of the real exchange
rate can only be positive if the exchange rate eect on the liabilities is relatively higher than its eect on the net exports. The positive eect observed
by Cspedes et al. (2004), and Moron and Winkelried (2005) did not consider the negative eect arising from net exports. Conrmed by Garca and
Gonzlez (2013), as the debt service burden on borrowers rises due to the
exchange rate depreciation, the risk premium increases. Eq. (29) also introduces persistence in the risk premium captured by the one-period lagged risk
premium term, hence rendering the nancial system unstable.

11

2. 3. Firms
The supply-side of the small open economy is assumed to consist of nal
goods producing rms who seek to maximize prots by optimally adjusting
their prices subject to a demand constraint. As in many studies we follow
the Calvo (1983) framework by assuming that in every period a fraction of
rms (1
) adjust their prices independently of the price history of price
changes (Korenok 2005). The other fraction keep their prices unchanged
from the last period price.
Following Gali and Gertler (1999) and Gali at al. (2001) we expand from the
basic Calvo model to further assume that a sub-fraction (1
) of the rms
that adjust prices set prices with a forward looking behavior. The remaining
sub-fraction set prices in a backward looking way by considering the last
period aggregate price ination. Considering the prot maximization by
rms and the price setting assumptions, we follow Gali at al. (2001) to
formulate the hybrid version of the marginal cost-based Phillips curve as in
eq. (30).

b t 1

f Et t+1

Where:
= (1

)(1 )(1
)(1
[1+ (" 1)]

= +

[1

=
(1

+ mc
ct
1

(30)

)]

Hence is a function of the degree of price sickness, a discount factor,

the degree of curvature of the production function, " the elasticity of demand
and the degree of "backwardness" in price-setting.
In deriving the marginal cost we follow Batini et al. (2005) and Malikane
(2014) by assuming that there is a non-linear relationship between domestic
output and non-labour inputs such that Zt = Yt . Where Zt is the amount
of imported raw materials. Incorporating the non-labour input into the production function and building on Korenok (2008), our production function
becomes eq. (31) which in a reduced form yields eq. (32).
12

Yt = Nt Yt

(31)

Yt = Nt1

(32)

From eq. (31) we can express the total cost faced by rms as follows;

T Ct =

Wt
Nt + qt Yt
Pt

(33)

Where qt is the real exchange rate representing the price of imported raw
t
materials, Wt is the nominal wage rate. Solving for W
in eq. (4) and
Pt
substituting into (33) yields eq. (34) which after solving for N from (32)
and replacing in (33) we obtain (35).
T Ct = Nt1+ (Ct
1

(34)

hCt 1 ) + qt Yt

1+

T Ct = Yt

(Ct

(35)

hCt 1 ) + qt Yt

Dierentiating eq. (35) with respect to Yt , log-linearizing around the steady

state and using eq. (12) we obtain the marginal cost as follows:

mc
ct =

1+

!
(1 + !)

qbt

h!
qbt
(1 + !)

ybt

hb
yt

(36)

Finally, substituting eq. (36) into eq. (30) we obtain the hybrid new Keynesian Phillips curve which also known as the aggregate supply (AS).

bt =
+

b bt 1

f Et bt+1

ybt

+
hb
yt

1+
1

13

!
(1 + !)

qbt

h!
qbt
1+!

(37)

Which in a reduced form becomes;

bt =

b bt 1

2.4. Monetary policy

f Et bt+1

bt
cy

bt 1
by

bt
cq

bt 1
bq

(38)

The monetary policy reaction function by the central bank is sketched along
the lines of Rudebusch and Svensson (1999), and Evans and Honkapohja
(2003). The structure of the economy coupled with the preferences of the
central bank determines the behaviour of the optimal policy rule. Following
the above authors, the central bank is assumed to be seeking to choose a path
for the nominal interest rate so as to minimize the following loss function;

Et

1
P

j1

j=0

With

Lt = bt2 +

S.t.
bt =

b bt 1

f Et bt+1

bt2
yy

bt
cy

(39)

Lt+j

(40)

bt 1
py

bt
cq

bt 1
bq

From the minimization problem of the central bank the following rst order
conditions are obtained under a discretion specication:

ybt :

bt : bt +
bt
yy

qbt :

t+1

b t+1

c t

p t+1

t+1

(41)

=0

(42)
(43)

c
c

14

c b)

bt

(44)

Substituting eq. (41) into (42) yields eq. (45) which after substituting eq.
(44) into it becomes (46). Eq. (47) is a reduced form of eq. (46).
bt
yy

c bt

bt
yy

c b

p)

c b
b

bt
yy

t+1

bt = 0

c b

bt = 0

(45)

=0

(46)
(47)

Finally, substituting the IS eq. (13) and the Phillips curve eq. (37) into (47)
and solving for the interest rate yields;

rbt =

bt+1 +

bt + yf ybt+1 + yb ybt 1 + qc qbt + qb qbt 1 + qf qbt+1

yc y

bt
rp rp

with the coe cients dened as;

r

yc

qc

yf

$f

'c

c
r

qb

yb

$b

'b

b
r

qf

(48)

'f
r

rp

rp
r

The outstanding feature of our interest rate equation from many studies is
in the inclusion of the risk premium as a possible additional target for the
monetary policy leading to an augmented Taylor rule. This is in tandem with
Curdia and Woodford (2008) where they added a spread adjustment term
in the standard Taylor rule. According to our model, a higher risk premium
than what was expected at time t may require the central bank to respond
by reducing the interest rate to maintain nancial stability in the nancial
system.

15

3. Methodology and data analysis

The study estimates a small open monetary DSGE model for ten EMEs using the Bayesian estimation techniques. This approach has been applied in
a number of studies such as in Ratto et al. (2009), Castelnuovo and Nistico (2010), and Rasaki and Malikane (2015). The parameters considered as
standard in the literature are calibrated as in Ireland (2003), and Christensen
and Dib (2008). The ten EMEs are Brazil, Chile, India, Indonesia, Korea,
Malaysia, Mexico, Poland, South Africa and Thailand. We use seven variables: domestic GDP, foreign GDP, exchange rate, risk premium, domestic
interest rate, foreign interest rate and domestic ination rate. Quarterly data
is employed for a sample spanning from 1990 to 2014. The data sources are
the IMF, World Bank, OECD and central banks.
As noted by Granville and Mallick (2009), and Allen and Wood (2006) there
is no consensus on the measure of the nancial stability. However, oscillation of some variables are often considered in line with the purpose of the
study (Dri ll et al. (2006). Granville and Mullick (2009) present nancial stability as changes in share prices, interest rate spreads, the nominal
eective exchange rate, house price ination, and bank deposit-loan ratio, respectively. In our study nancial stability is dened in terms of the nancial
risk premium measured by the interest rate spreads. In the spirit of Curdia
and Woodford (2011), Woodford (2012), Cecchetti and Kohler (2014), we
measure the domestic risk premium by the spread between the key policy
rate and the lending rate.
As in Moron and Winkeried (2005), the external risk premium is measured
by the dierential between interest rate on external debt and the domestic
lending rate (the opportunity cost of nancing with domestic resources).
Based on the uncovered interest rate parity condition, the interest rate on
external debt is proxied by the summation of the foreign interest rate and the
change in the exchange rate. Consequently, the external risk premium consist
of risks emanating from both the foreign interest rate and the exchange rate.
The system of equations to be estimated in reduced form are summarized
below:
IS:

ybt = $b ybt 1 + $f Et ybt+1 'c qbt + 'b qbt

rt Et bt+1 )
bt
r (b
rp rp
16

+ 'f Et qbt+1

NKPC:
MPR:
RP:
RER:

bt =

b bt 1

f Et bt+1

rbt = bt+1 + yc ybt +

+ qf qbt+1
bt
rp rp
rp
bt =

bt 1
rp rp

qbt = Et qbt+1

bt
yd y

rbt + rbt +

4. Empirical results

bt
cy

bt+1
yf y

bt
yf y

bt
rp rp

+
+

bt 1
py

bt 1
yb y
bt
qq

+
+

bt
cq

bt
qc q

bt 1
rd r

bt 1
bq

bt 1
qb q

bt 1
rf r

4.1. Calibration and posterior estimates of the parameters

Prior to the Bayesian estimation, the parameters of the model, presented in
a reduced form in line with Benchimol and Fourans (2012), are calibrated.
As in Beatriz de Blas (2009), the prior values of the parameters, particularly
those considered standard, comes from previous related literature. Similar
to Garcia and Gonzalez (2013), the same prior values are applied in the ten
countries. For instance, the prior values of the parameters r and rp in the
output equation have been upward adjusted from the respective average values of 0.03 and 0.07 by Moron and Winkelried (2005) . There is no consensus
on the weights of the backward and forward looking variables in the ination
equation. We therefore assume a 0.5 equal weight for b and f respectively.
The monetary policy rule parameters are calibrated in line with Kontonikas
and Ioannidis (2005) by assuming more weight on the expected ination
parameter then output parameters and moderate on the exchange rate and
the risk premium parameters. However, the prior values of the coe cients
of the risk premium are calibrated in line with Moron & Winkelried (2005)
and Gadanecz et al. (2015). In line with standard conventions, parameters
falling between zero and one are assigned the beta distributions whilst those
above one are assumed to follow the normal distribution. As in Smets and
Wauters (2003) the standard errors of the shocks follows an inverted Gamma
distributions whilst their prior means are set at 0.02.
The results of the Bayesian estimation are shown in Table1A and 1B indicating that all the parameters are signicantly dierent from zero. The parameters have been strongly identied by the data as indicated by the very
17

similar priors and posteriors. Hence, the convergence of the proposed distribution to the target distribution is satised. Figure1 presents diagnostics by
Brooks and Gelman (1998) of the overall convergence for the M-H sampling
algorithm. The draws from the posterior distribution have been obtained
by taking two parallel chains of 100, 000 runs of Metropolis. These measures relate to parameters mean (interval), variance (m2) and third moment
(m3). Convergence is achieved when the two lines are relatively horizontal
and converge to each other (Benchimol and Fourans; 2012). Convergence is
achieved at 30, 250 draws for all the countries except for India and South at
82, 500 draws.
The elasticity of the output with respect to real interest rate averages to a
posterior mean of 0.05 for the ten countries, slightly less than the prior mean
of 0.06. By way of comparison, Indonesia output is the least sensitive to interest rate changes with a mean of 0.02. Chile and Brazil have posterior mean
of 0.04 percent respectively. This is in conformity with the ndings of Moron and Winkelried (2005) for Latin America where they found elasticities of
0.032 percent and 0.031 percent for robust and vulnerable economies apiece.
Malaysia, South Africa and Thailand are highly vulnerable to changes in the
interest rate with a posterior mean of 0.06 respectively. The interest rate
posterior mean for India and Korea is estimated at 0.05, individually.
The posterior means of the parameter of the risk premium in the output
equation for Brazil, Chile, India and Korea are above the prior value of
0.09. This shows that these countries are more vulnerable to volatility in the
risk premium compared to South Africa with the least mean of 0.07. The
elasticity of the interest rate with respect to changes in the risk premium
ranges from the lowest posterior mean of 0.02 for Malaysia and Chile to the
highest mean of 0.06 for Mexico. This measures the degree of stabilization
of monetary policy when the risk premium is considered. Castelnuovo &
Nistico (2010) and Kontonikas & Ioannidis (2005) conclude the same using
the stock prices to represent nancial stability with a posterior mean value
of 0.12 for UK and USA respectively.
The posterior mean for the one period lagged risk premium variable ranges
from the lowest of 0.60 for Chile to 0.74 for Poland. At these levels, the
risk premium portrays high degree of persistence for emerging economies.
The results further suggest that the foreign variables signicantly aect the
18

risk premium. For instance, the posterior mean of the foreign output ranges
from 0.89 for India to 0.91 in Indonesia. The rest of the countries have a
mean of 0.90 respectively. These estimates are slightly below the mean of
0.94 reported in Moron & Winkelried (2005). The estimated posterior mean
of foreign interest rate is high at 0.80 for Korea and South Africa apiece.
Indonesia and Poland have the lowest mean of 0.75 respectively.
The coe cients of domestic output and exchange rate in the risk premium
equation assumes values in tandem with those in Gadanecz et al. (2015). The
posterior mean for the backward looking variable in the ination equation is
above 0.5 for all the ten countries. This suggests that more than 50 percent
of rms keep prices xed at the previous period level.

19

20
rp

rf

rd

yf

yd

rp

rp

qf

qb

qc

yb

yf

yc

rp

$b
$f
'c
'b
'f

par.

Prior
distr. mean
beta
0.65
beta
0.59
beta
0.04
beta
0.02
beta
0.03
beta
0.06
beta
0.09
beta
0.50
beta
0.50
norm 1.68
beta
0.37
beta
0.41
beta
0.38
beta
0.55
beta
0.10
beta
0.05
beta
0.05
beta
0.04
beta
0.05
beta
0.04
beta
0.04
beta
0.70
beta
0.10
beta
0.90
beta
0.10
beta
0.20
beta
0.80
beta
0.82
s.d.
0.05
0.04
0.02
0.01
0.01
0.03
0.02
0.10
0.10
0.05
0.05
0.10
0.05
0.10
0.05
0.03
0.03
0.02
0.03
0.02
0.02
0.10
0.05
0.10
0.05
0.05
0.10
0.10

Brazil
Posterior
mean s.d.
0.66 0.05
0.59 0.04
0.02 0.01
0.02 0.01
0.03 0.01
0.04 0.02
0.10 0.02
0.60 0.09
0.49 0.10
1.67 0.05
0.38 0.05
0.43 0.07
0.35 0.04
0.59 0.11
0.10 0.05
0.06 0.02
0.04 0.02
0.03 0.02
0.03 0.02
0.04 0.02
0.03 0.02
0.72 0.10
0.08 0.05
0.90 0.10
0.10 0.05
0.18 0.05
0.76 0.10
0.85 0.10

Chile
Posterior
mean s.d.
0.62 0.04
0.61 0.03
0.03 0.01
0.02 0.00
0.03 0.01
0.04 0.02
0.10 0.01
0.56 0.06
0.51 0.05
1.68 0.03
0.36 0.03
0.29 0.07
0.45 0.03
0.57 0.08
0.08 0.03
0.03 0.01
0.03 0.02
0.03 0.01
0.04 0.02
0.06 0.01
0.02 0.01
0.60 0.07
0.08 0.04
0.90 0.07
0.08 0.03
0.16 0.03
0.76 0.04
0.77 0.07

India
Posterior
mean s.d.
0.63 0.05
0.60 0.04
0.03 0.01
0.02 0.01
0.03 0.01
0.05 0.02
0.10 0.02
0.55 0.09
0.51 0.10
1.68 0.05
0.37 0.05
0.40 0.05
0.38 0.04
0.60 0.10
0.10 0.05
0.04 0.03
0.04 0.02
0.03 0.02
0.08 0.02
0.04 0.02
0.04 0.02
0.66 0.12
0.09 0.05
0.89 0.10
0.08 0.08
0.19 0.05
0.77 0.10
0.76 0.11

Indonesia
Posterior
mean s.d.
0.69
0.02
0.57
0.01
0.03
0.01
0.02
0.00
0.02
0.00
0.02
0.01
0.09
0.00
0.46
0.01
0.62
0.03
1.61
0.01
0.36
0.01
0.40
0.03
0.36
0.01
0.66
0.02
0.08
0.02
0.04
0.01
0.04
0.01
0.03
0.01
0.08
0.01
0.03
0.01
0.03
0.01
0.10
0.02
0.08
0.02
0.91
0.04
0.09
0.01
0.16
0.02
0.75
0.02
0.83
0.01

Korea
Posterior
mean s.d.
0.71 0.04
0.62 0.04
0.03 0.01
0.02 0.01
0.03 0.01
0.05 0.02
0.10 0.02
0.57 0.07
0.50 0.09
1.66 0.05
0.38 0.05
0.42 0.06
0.39 0.05
0.62 0.10
0.07 0.04
0.04 0.02
0.05 0.02
0.03 0.02
0.05 0.02
0.04 0.02
0.04 0.02
0.70 0.11
0.08 0.05
0.90 0.10
0.10 0.05
0.20 0.05
0.80 0.10
0.81 0.09

21
rp

rf

rd

yf

yd

rp

rp

qf

qb

qc

yb

yf

yc

rp

$b
$f
'c
'b
'f

par.

Prior
distr. mean
beta
0.65
beta
0.59
beta
0.04
beta
0.02
beta
0.03
beta
0.06
beta
0.09
beta
0.50
beta
0.50
norm 1.68
beta
0.37
beta
0.41
beta
0.38
beta
0.55
beta
0.10
beta
0.05
beta
0.05
beta
0.04
beta
0.05
beta
0.04
beta
0.04
beta
0.70
beta
0.10
beta
0.90
beta
0.10
beta
0.20
beta
0.80
beta
0.82
s.d.
0.05
0.04
0.02
0.01
0.01
0.03
0.02
0.10
0.10
0.05
0.05
0.10
0.05
0.10
0.05
0.03
0.03
0.02
0.03
0.02
0.02
0.10
0.05
0.10
0.05
0.05
0.10
0.10

Malaysia
Posterior
mean s.d.
0.75 0.01
0.58 0.01
0.01 0.00
0.01 0.00
0.03 0.00
0.06 0.00
0.09 0.00
0.56 0.01
0.48 0.02
1.65 0.00
0.33 0.00
0.35 0.02
0.37 0.01
0.65 0.01
0.08 0.01
0.08 0.01
0.04 0.01
0.02 0.00
0.10 0.00
0.03 0.00
0.02 0.00
0.68 0.02
0.07 0.01
0.90 0.01
0.10 0.02
0.20 0.01
0.80 0.02
0.75 0.01

Mexico
Posterior
mean s.d.
0.70 0.04
0.59 0.04
0.04 0.01
0.02 0.01
0.03 0.01
0.05 0.02
0.09 0.02
0.63 0.07
0.46 0.09
1.70 0.05
0.38 0.05
0.41 0.06
0.40 0.05
0.56 0.11
0.13 0.04
0.05 0.02
0.04 0.02
0.05 0.02
0.03 0.02
0.04 0.02
0.06 0.02
0.72 0.11
0.08 0.05
0.90 0.10
0.09 0.05
0.17 0.05
0.77 0.10
0.82 0.09

Poland
Posterior
mean s.d.
0.69 0.04
0.60 0.03
0.04 0.01
0.02 0.01
0.03 0.01
0.05 0.02
0.09 0.02
0.53 0.06
0.52 0.05
1.69 0.05
0.38 0.04
0.44 0.06
0.40 0.04
0.49 0.07
0.09 0.03
0.04 0.02
0.04 0.02
0.04 0.02
0.04 0.01
0.03 0.01
0.04 0.01
0.74 0.05
0.08 0.04
0.90 0.07
0.09 0.03
0.18 0.05
0.75 0.06
0.82 0.06

South Africa
Posterior
mean s.d.
0.69
0.05
0.58
0.04
0.04
0.01
0.01
0.01
0.03
0.01
0.06
0.03
0.07
0.02
0.58
0.08
0.45
0.08
1.66
0.05
0.37
0.05
0.38
0.08
0.38
0.05
0.52
0.10
0.08
0.04
0.02
0.02
0.03
0.02
0.03
0.02
0.04
0.02
0.04
0.02
0.04
0.02
0.69
0.11
0.08
0.05
0.90
0.10
0.10
0.05
0.18
0.05
0.77
0.10
0.84
0.08

Thailand
Posterior
mean s.d.
0.68 0.04
0.61 0.04
0.04 0.01
0.02 0.01
0.03 0.01
0.06 0.03
0.09 0.02
0.51 0.09
0.42 0.08
1.69 0.05
0.36 0.05
0.34 0.08
0.38 0.05
0.54 0.10
0.09 0.04
0.03 0.02
0.04 0.02
0.03 0.02
0.04 0.02
0.04 0.02
0.04 0.02
0.68 0.11
0.08 0.05
0.90 0.10
0.09 0.06
0.20 0.05
0.76 0.10
0.84 0.08

22
2

4.5

5.5

0.5

0.5

1.5

3.5

4.5

5.5

3.5

4.5

5.5

0.5

1.5

2.5

3.5

4.5

5.5

3.5

4.5

5.5

0.5

1.5

2.5

3.5

4.5

5.5

2.5
x 10

3.5

4.5

5.5

2.5

3.5

4.5

5.5

2.5

3.5

4.5

5.5

x 10

10

12

12
4

14
4

x 10

14

10

12

14
4

x 10

50

m3

x 10

100

1000

2000

10

10

m2

15

10

100

200

20

40

Interval

South Africa

1.5

0.5

1.5

2.5

3.5

4.5

5.5

0.5

0.5

1.5

m3

1.5

m2

1.5

Interval

Thailand

2.5

2.5

2.5

3
4

x 10

x 10

x 10

x 10

0.5

1.5

2.5

3.5

4.5

5.5
x 10

0.5

100

100

100

0
2.5

x 10

100

m3

x 10

200

200

m3

1.5

200

200

0.5

m3

1.5

10
1.5

0
1

20
0.5

x 10

0
1

x 10

10

m2

0.5

2.5

m2

5.5

10
3

20

x 10

1.5

4.5

40

2.5

0.5

3.5

100

20

x 10

14

200

20

m2

1.5

2.5

x 10

14

20

40

10

10
2

12

12

x 10

14

Interval

10

10

12

10
1.5

10

m3

m2

Mexico

10

0.5

15

Interval

Malaysia

x 10

15

15

10

0.5

x 10

15

Interval

Korea

2.5

15

1.5

200

0.5

100
3

x 10

m3

100

m3

x 10

400

2.5

200

200

1.5

20

10

0.5

40

20

x 10

20

m2

40

m2

x 10

2.5

10

2.5

10

1.5

10

0.5

20

15

15

Interval

Interval

Interval

3.5

India

Chile

Brazil

0.5

0.5

0.5

0.5

0.5

0.5

1.5

1.5

1.5

1.5

1.5

1.5

2.5

2.5

2.5

m3

m2

2.5

2.5

2.5

m3

m2

Interval

Poland

Interval

3.5

3.5

3.5

3.5

3.5

3.5

Indonesia

4.5

4.5

4.5

4.5

4.5

4.5

5.5

x 10

5.5

x 10

5.5

x 10

5.5

x 10

5.5

x 10

5.5

x 10

4.2. Variances and impulse responses analysis

To assess the performances of the two policy scenarios we present in Table
2A the variances of output and ination due to various structural shocks. In
the baseline scenario (no-reaction) the monetary policy of the central bank
is constrained to disregard the risk premium. In the unconditional monetary
policy scenario (reaction) the central bank does react to the risk premium.
The policy with relatively low variances for both output and ination is
considered the best. However, if both policies produce indecisive results a
decision is made based on the policy that minimizes the loss function of the
central bank. The applied shocks are increases in interest rate, risk premium
and ination rate. The others are reductions in the real exchange rate and
demand.
The output and ination variances due to the shocks reect conicting results
to decide which policy performs better than the other. Hence, we proceed to
evaluate their performances in terms of the policy that yields the minimum
loss. The only exception is in Mexico and Thailand where both the variances
of output and ination are low in the unconditional policy compared to those
of the baseline policy. Consequently, this makes the policy of reacting to
the risk premium more superior than the other in these countries. In India
the variance of output suggest that the baseline policy is better than the
unconditional policy, whilst that of ination implies the opposite. However,
it turns out that the unconditional policy produces a small loss relatively to
the baseline policy.
In Chile and Korea, the variance of output remains the same in both policies, hence inconclusive. Meanwhile, the variance of ination is in favour of
the unconditional policy. In terms of the loss function, reacting to the risk
premium in these economies reduces the loss of the central bank than otherwise. In Brazil, Indonesia, Malaysia, Poland and South Africa, the results
indicate that the unconditional policy produces lower output variances than
the baseline scenario. With respect to ination, the variances are high when
responding to the risk premium than if not. Evaluating the two policies of
these countries in terms of the loss function, the unconditional policy is much
preferable than the baseline policy.

23

24
0.0005
0.0015
0.0005
0.0011

Mexico
Poland
SA
Thai.

0.0543

0.0140

0.0124

0.0216

0.0861

0.0202

0.0499

0.0342

0.0203

0.0166

0.0010

0.0001

0.0002

0.0004

0.0002

0.0004

0.0003

0.0009

0.0003

0.0001

0.0404

0.0142

0.0129

0.0171

0.0867

0.0174

0.0500

0.0161

0.0185

0.0245

reaction

L=b2 +0.5b
y2

0.0549

0.0165

0.0132

0.0219

0.0871

0.0204

0.0504

0.0346

0.0205

no-reaction
CB loss
0.0268

The central bank (CB) minimum loss is calculated from the loss function

0.0019

0.0009

Indo.

Malay.

0.0007

India

0.0004

0.0003

Chile

Korea

0.0026

Brazil

no-reaction

Table 2a. Variances of output and ination under two policy scenarios

0.0409

0.0143

0.0130

0.0173

0.0868

0.0176

0.0502

0.0166

0.0186

reaction
CB loss
0.0261

Table 2B below present the variance decomposition under the two policy
scenarios. Here we provide further information on the contribution of each
shock on the variation of output and ination, respectively. The results show
that the variation of output and ination are dominated by the demand
shock. We note that the demand shock contribution to output variation is
lower in the unconditional policy for Brazil, India, Malaysia, South Africa and
Thailand. As regards the share of demand shock to the ination variation,
it is low for India, Malaysia, Mexico, South Africa and Thailand under the
unconditional policy. As for the risk premium shock, the responses of the
variables of interest appears to be somewhat insignicant and more so when
policy reacts to the risk premium.
The exchange rate, interest rate and ination shocks also play an important
role in explaining the uctuations in output and ination. In the case of
Brazil, Chile, Indonesia, Korea, Malaysia, and Poland, the impact of the interest rate shock on output and ination reduces when central banks respond
to the risk premium. This implies that interest rates revert back instantly
to their steady state under this policy scenario. In South Africa, the interest
shock under the unconditional policy account for a large part of the variations
in the variables of interest, particularly ination. A plausible explanation for
this could be that South Africa suers from inationary pressures. Hence, if
interest rates are reduced in response to the risk premium such pressures are
amplied.

25

26

y
y
y
y
y
y
y
y
y
y

Brazil

Chile

India

Indo.

Korea

Malay.

Mexico

Poland

SA

Thai.

risk prem.
not-react
0.12
0.04
0.04
0.02
0.02
0.01
0.01
0.01
0.02
0.01
0.01
0.01
0.23
0.06
0.20
0.08
0.19
0.05
0.03
0.01

shock
react
0.06
0.02
0.02
0.00
0.01
0.00
0.00
0.00
0.02
0.00
0.01
0.00
0.03
0.01
0.01
0.00
0.03
0.01
0.01
0.00

exch. rate
not-react
1.60
2.34
2.51
3.59
0.40
0.45
1.34
1.77
1.87
2.56
0.27
0.33
2.42
3.08
3.87
6.75
2.57
4.73
1.39
1.73

shock
react
1.81
3.25
1.77
2.71
0.56
0.61
0.24
0.29
1.42
2.12
2.20
2.29
1.45
1.58
1.76
2.12
3.40
2.44
1.96
3.08

inter. rate
not-react
6.01
31.65
5.28
8.22
0.46
1.50
0.68
2.83
1.18
4.37
1.88
3.76
1.81
5.65
9.09
21.42
3.02
8.87
0.94
2.39

shock
react
2.62
9.10
1.28
3.73
0.80
1.86
0.30
0.53
1.20
3.57
1.08
3.05
5.38
14.22
5.61
10.69
37.65
56.90
1.03
2.44

demand.
not-react
69.61
59.20
61.39
81.20
92.26
97.14
93.63
94.61
87.50
90.56
94.75
94.73
77.38
87.09
51.76
58.42
64.85
77.78
79.54
90.28

shock
react
46.45
73.16
83.19
90.55
91.45
95.62
94.12
98.46
88.95
92.58
93.58
93.82
79.00
78.59
63.41
77.78
40.52
34.61
29.07
35.72

in. rate
not-react
9.81
0.37
24.49
1.88
5.45
0.33
2.64
0.19
5.83
0.53
2.82
0.47
12.30
0.54
16.21
0.62
13.63
0.53
6.39
0.29

shock
react
12.99
0.85
8.95
0.64
5.16
0.23
4.48
0.17
5.61
0.48
1.65
0.05
6.17
0.43
10.76
0.87
5.73
0.25
6.06
0.82

Figures 3A - 3D below show the impulse responses of output and ination

to exchange rate and interest rate shocks under the two monetary policy
scenarios respectively. In general, the impulse responses resembles what has
been found above with respect to the variances. Consistent with economic
theoretical predictions, the shocks reduce output and ination under both
monetary policy scenarios. However, these variables fall by less when the
central bank reacts to the risk premium than otherwise. For instance, a
real exchange rate appreciation shock in the baseline policy causes output
and ination to fall and the central bank respond to the resultant decline in
output by lowering the interest rate. However, the monetary policy response
is not su cient enough to sterilize the negative eect of the shock on output.
As the interest rate reduces further to respond to induced rise in the risk
premium, output rises to shed some of its losses from the initial shock. In
line with falling interest rates under the unconditional policy, ination rises
to remain above that of the baseline policy. Consequently, output and ination initially remain above those in the baseline policy for many emerging
economies. Accordingly, these variables revert on impact to their long-run
equilibrium after about 16 to 46 quarters. The results conrms that interest
rate should fall to respond to the risk premium as in Faia and Monacelli
(2007). It appears, however, that there is a trade-o between achieving nancial stability and price stability in these economies. A similar outcome is
noted by De Graeve et al. (2007) for the German economy.

27

28
Thailand

Poland

Mexico

Malaysia

Korea

South Africa

Indonesia

India

Chile

Brazil

Figure 3A. Output impulse responses to exchange rate shock

29
Thailand

Malaysia

Korea

South Africa

Chile

Brazil

Mexico

India

Figure 3B. Ination impulse responses to exchange rate shock

Poland

Indonesia

30
Thailand

Mexico

Malaysia

Korea

South Africa

India

Chile

Brazil

Figure 3C. Output impulse responses to interest rate shock

Poland

Indonesia

31
Thailand

Malaysia

Korea

South Africa

Chile

Brazil

Mexico

India

Figure 3D. Ination impulse responses to interest rate shock

Poland

Indonesia

5. Conclusions
We investigate the risk premium and monetary policy nexus hence its propagation to output and ination within a DSGE model in ten EMEs. Applying
various shocks, we examine the responses of output and ination under two
monetary policy scenarios. In the baseline policy scenario the central bank
is constrained not to respond to the risk premium whilst they do in the
alternative scenario. The aim is to compare the performances of the two policy scenarios based on their outcomes on output and ination. The results
demonstrate that responding to the risk premium amid the shocks reduce
the variations of output and ination than in the baseline policy. This policy
further expedites the return of these variables to their steady state, hence
containing also the volatility of the interest rate. Amongst the shocks, the demand shock explains a large portion of the variations in output and ination
in these economies.
The ndings of the study have important policy implications for emerging
economies. In tandem with the high exposure to shocks, which aects output
and ination amongst others, it is recommended for interest rates to fall.
This recommendation is supported by the results indicating low variances for
output and ination when interest rates fall to respond to the risk premium.
Furthermore, if the risk premium is allowed to vary without being attended
to, it will trigger a rise in the cost of capital causing a fall in investment and
then output to slowdown. A similar conclusion is noted by Faia and Monacelli
(2007). In view of the vulnerability of emerging economies to demand shocks,
eecting an interest rate reduction turns out to be more relevant.
To coushin against the induced upward pressure on ination by falling interest rates to stabilize the risk premium, the smoothing of interest rates
approach is recommended. As noted by Dri ll et al. (2006) the aggressive use of monetary policy to achieve macroeconomic stability comes with
challenges, one of which could be the price instability. Hence, the lagged
interest rate should enter the policy rule equation. Moreover, in the spirit
of Faia and Monacelli (2007), we also recommend for central banks not to
be strongly anti-inationary in order to reap the benets of reacting to the
risk premium. On the other hand, Gadanecz et al. (2015) observes that as
the sample of EMEs central banks put more emphasis on nancial stability,
monetary policy is rendered less eective.
32

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