Question

Suppose the country risk premium of a large foreign country increased permanently. What happens to price level, nominal exchange rate, real exchange rate, investment, net exports and consumption in the domestic country in long run? Assume that the country is operating under floating exchange rate system.

Answer 1

Given : Country risk premium (CRP) increases

Interpretation : If risk premium goes up, the rating of the country downgrades.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/crryprem.htm

The above link will take you to a page, where you will be able to find country risk premiums for different countries.

If rating of the country is bad, then country risk is premium is high.

What happens to

1. Price level : Price level should decrease. Increase in CRP will increase interest rates in the country and thus reduces liquidity. Reduced liquidity should decrease price levels.

2. Real exchange rate : The currency will depreciate in front of other country's currency in nominal terms. It depends on the amount of inflation in this country and the other country whether the real exchange rate will increase or decrease. Also, the forex will flow out of the economy due to increased risk, so real exchange rate should be depreciating.

3. Investment : Investment in the economy will reduce due to increase in risk. The discount rates will increase reducing the NPV of the projects. So, lesser projects will be acceptable.

4. Net exports : Net exports should rise due to depreciating currency. But, this is not straightforward, elasticities of exports and imports matter too. You may apply Marshal elasticities approach to know whether this currency depreciation will increase net exports or not. Also, other macroeconomic factors play a role eg. unemployment.

5. Consumption : According to absorbtion approach, consumption should be reduced, due to reduced consumer sentiments. People in fear of risk of future will try to save more and consume less.