Risk shocks in a small open economy: Business cycle dynamics in Canada

Recent literature suggests that risk shocks - changes in the volatility of the cross-sectional uncertainty on entrepreneurial asset returns - play an important role in explaining business cycle fluctuations. In this paper, we study the effect of risk shocks in a small open economy with tradable and non-tradable sectors of production. In each sector, firms are subject to uncertainty when converting raw capital into effective capital. Due to financial frictions, when risk is high firms pay higher borrowing costs. This leads to a decline in investment and output. We conduct Bayesian estimation and draw implications on the sources of the Canadian business cycle. Our findings suggest that a significant fraction of the fluctuations in output, investment, risk premium and firms' net worth in the Canadian economy can be accounted for by sectorial level risk shocks. We further construct volatility measures based on firm-level stock returns in Canada and find that our model's out-of-sample performance is reasonably well.