Financial Frictions and Macro‐Economic Fluctuations in Emerging Economies

Abstract The country risk premium predicted by the dynamic real business cycle models in emerging markets is procyclical, whereas it is countercyclical in the data. This paper proposes a model in which a time‐varying risk premium emerges endogenously through a variant of the Bernanke–Gertler–Gilchrist financial accelerator mechanism. The estimated model can account for the volatility and the countercyclicality of risk premium as well as for other key business cycle moments. Time‐varying uncertainty in firm‐specific productivity significantly contributes to delivering a countercyclical default rate and explains more than half of the variances in the trade balance and risk premium.