Country Spreads and the Role of Sophistication

Purpose – As a central issue in international macroeconomics, numerous studies identify country-spread shocks as important sources of business cycles. This paper explores how a model with time-inconsistent preferences, represented as sophisticated perceptions, generates different macroeconomic and external dynamics compared with the standard model with time-consistent preferences. Design/Methodology – This paper constructs a dynamic stochastic general equilibrium (DSGE) model of a small open economy that features sophisticated households. Since the model incorporates newly constructed variables and parameters, it is estimated on Korean data using the Bayesian method. Since this paper considers both the sophisticated and standard models, I estimate them to facilitate a clear comparison of the results. Findings – The Korean economy is better characterized by the sophisticated model, as the short- run discount factor is substantially different from unity. Following a country-spread shock, the sophisticated model leads to a larger decline in consumption, a larger increase in labor, and a smaller fall in investment, which together translate into a larger rise in output and greater improvement in the trade balance in the short run. Furthermore, the sophisticated model yields lower levels of external debt, suggesting that the presence of sophisticated individuals enhances debt sustainability and contributes to long-term macroeconomic stability. Originality/value – None of the previous studies explore the macroeconomic implications of sophistication in a small open-economy model disturbed by an external financial shock. In this regard, this paper adds a behavioral dimension to an important topic in international macroeconomics.