Transmission Mechanism of Shocks Caused by Terrorism to a Small Open Economy

Given the difficulty in the prevention of terrorism, we have to figure out how to insulate our economy from a shock following a terrorist attack. For this purpose, it is indispensable to understand how terrorism can negatively influence the economy. In this paper, the focus is on the case of a small open economy where imports exceed exports. I pay a particular attention to the response of the country-specific risk premium on foreign borrowing to the terrorist-shock. As the terrorists intend to create intimidating atmosphere by using violence, we expect the residents of the targeted country to pay a higher risk-premium to borrow from abroad. The heightened risk-premium causes them to cut back on consumption, which reduces aggregate demand. At the same time, the premium reduces capital inflows and depreciates the local currency. The depreciation makes it expensive to import investment goods as well as consumption goods. The decreased import of investment goods slows capital accumulation, which in turn affects aggregate supply in near future. As such, the terrorist-shock propagates to the economy through the interaction among macroeconomic variables over time. For this reason, I propose to analyse the transmission mechanism of the terrorist-shock within a framework of dynamic general equilibrium models for small open economies.