The paper calibrates a small open economy dynamic stochastic general equilibrium (DSGE) model for emerging economies with financial frictions and an exogenous geopolitical risk (GPR) shock that affects the country’s risk premium and evaluates the stabilization ability of a combination of monetary policy, macroprudential and capital flows management policies.

^{by Thabo Mboweni, Sihle Sotwili and Eddie Musasiwa} 

The pre-model empirical evaluation shows that overall, the relationship between GPR and country risk is evident, however, it is heterogeneous across emerging markets and depends on the nature of the geopolitical event.

From the DSGE model, a positive GPR shock depreciates the domestic nominal and real exchange rates and is inflationary.

It also reduces aggregate demand and raises the nominal interest rate as a response.

The shock hampers the financial conditions by increasing both domestic and foreign borrowing rates, which leads to a decline in net worth of banks, causing a decline in the credit market.

Policy experiments show that macroprudential policy can stabilise credit, investment and output conditions from the negative GPR shock, however, the policy causes an inflation-output trade-off.

The results show that applying an optimal macroprudential policy rule in addition to the standard Taylor rule provides some additional benefit in terms of welfare in comparison to a combination of the standard Taylor rule and capital flows management policies.