A Country-Risk Approach to the Business Cycle

The essay holds that the country risk premium is the triggering factor of the business cycle in a small, financially open and highly volatile economy like that of Argentina. A rise of the premium determines a capital outflow, an aggregate demand contraction and a recession; a fall of the premium determines a capital inflow, an aggregate demand expansion and a boom. We build a model where country risk plays a central role in macroeconomic equilibrium. We evaluate the empirical relationship between country risk and GDP, consumption, investment, and the current account balance. We compare the country risk model with those of various schools of macroeconomic thought. Main conclusions: 1) The Say’s Law doesn’t hold in a recession. The world financial community determines the fraction of world income to be spent in the small country and its GDP adjusts passively to that fraction. 2) In the period 1985-1997, Argentine time series show a strong negative correlation between country risk and the above referred to aggregate variables, with causality going from the country risk premium to aggregate variables. I am grateful to A. Martínez, G. Coloma and M. Gallacher for their comments, to V. Dowding for her English assitance and to G. Bermúdez for providing me with important statistical data. This paper is a simplified and re-worked English version of a paper published in 2000 as chapter IV of my book Riesgo-Argentino & Performance Macroeconómica, Universidad del CEMA, Buenos Aires.