At least since the euro area sovereign debt crisis, it is evident that country risk premium shocks have adverse economic effects, not only in emerging economies, but advanced economies as well. Using a Bayesian Panel Vector Autoregression model, we find that increases in the risk premium lower output under monetary union, yet not in countries with flexible exchange rates and independent monetary policies. We study the transmission mechanism in a two-country New Keynesian model and show that capital controls substantially attenuate the effects of risk premium shocks. However, the welfare gain of imposing capital controls hinges on the nature of the shock and the prevailing exchange rate regime.
JEL Classification: F32, F38, F41, F45
Keywords: Bayesian panel VAR, capital controls, exchange rate regime, welfare