THE ROLE OF FOREIGN DEBT AND FINANCIAL FRICTIONS IN A SMALL OPEN ECONOMY DSGE MODEL

Abstract

We examine the role of foreign debt and financial frictions in the Korean business cycle using a small open economy DSGE (dynamic stochastic general equilibrium) model where domestic banks borrow external funds, denominated in foreign currencies, for a risk premium and make loans to domestic producers. We find that the Korean economy is 'financially vulnerable', which means that the risk premium increases when the domestic currency depreciates. As a result, depreciation could cause recession, rather than expansion, when there exist substantial amount of foreign debt or financial frictions. A simulation shows that the Korean business cycle would suffer less volatility with a lower steady-state level of foreign debt or no financial frictions.