# Lectures in Open Economy Macroeconomics1

Mart´ Uribe2 ın This draft, November 24, 2007

Preliminary and incomplete. I would like to thank Javier Garc´ ıa-Cicco, Felix Hammermann, and Stephanie Schmitt-Groh´ for comments and suggestions. Newer e versions of these notes are available at www.econ.duke.edu/∼uribe. Comments welcome. 2 Duke University and NBER. E-mail: uribe@duke.edu.

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Contents

1 A First Look at the Data 2 An 2.1 2.2 2.3 2.4 Endowment Economy The Model Economy . . . . . . . . . Response to Output Shocks . . . . . Nonstationary Income Shocks . . . Testing the Model . . . . . . . . . . 1 5 5 11 13 18 23 23 26 29 30 32 34 37 38 46 48 49 50 52 54 56 58 61 61 65

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3 An Economy with Capital 3.1 The Basic Framework . . . . . . . . . . 3.1.1 A Permanent Productivity Shock 3.1.2 A Temporary Productivity shock 3.2 Capital Adjustment Costs . . . . . . . . 3.2.1 Dynamics of the Capital Stock . 3.2.2 A Permanent Technology Shock .

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4 The Real Business Cycle Model 4.1 The Model . . . . . . . . . . . . . . . . . . . . . . . 4.2 The Model’s Performance . . . . . . . . . . . . . . . 4.2.1 The Role of Capital Adjustment Costs . . . . 4.3 Alternative Ways to Induce Stationarity . . . . . . . 4.3.1 External Discount Factor (EDF) . . . . . . . 4.3.2 External Debt-Elastic Interest Rate (EDEIR) 4.3.3 Internal Debt-Elastic Interest Rate (IDEIR) 4.3.4 Portfolio Adjustment Costs (PAC) . . . . . . 4.3.5 Complete Asset Markets (CAM) . . . . . . . 4.3.6 The Nonstationary Case (NC) . . . . . . . . 4.3.7 Quantitative Results . . . . . . . . . . . . . . 4.4 Appendix A: Log-Linearization . . . . . . . . . . . . iii

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. . . . .3 Terms-of-Trade Shocks in an RBC Model . . . . . . . . . . . . . . . . . . . . . . . .1 Deﬁning the Terms of Trade . . . . . . . Local Existence and Uniqueness of Equilibrium . . Impulse Response Functions . . . . . . . . . . . . . Functional Forms. . . .2 Firms . . .3.3. . . . . . . . . . . . . .2 Production of Consumption Goods . . . . . . . . . . . . . . . . . . . 137 6. 147
. . . . .2. . . . . . . . . . . and Parameter Values 142 6. . . .3 Production of Tradable Consumption Goods . . . . . . .3 Driving Forces . . . . Exercise . . . 5.1 An RBC Small Open Economy with an internal debtelastic interest-rate premium . . .7 4. . . . . . . 145 6. . . . . 5. . . . Higher Order Approximations .8 Calibration . . . . .4 Equilibrium. . . . . . . . 5. . . . . . . . . . . .4. . . .4. . . . . . . .11
CONTENTS Appendix B: Solving Dynamic General Equilibrium Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . and Nontradable Goods . . . . . . . . . . . . . . . . 120 6. . . . . 118 6. . . Second Moments .
6 Interest-Rate Shocks 115 6. . 67 78 79 83 83 84 85 85 87 88 88 90 99 99 102 103 104 106 106 107 107 111 113
5 The Terms of Trade 5. . 5. . . . . 5.1 Households . . . . . . . . . . 5. . .11. . 141 6. . . . . . . . . . . . . . . . . . . . . .6 4. .7 Competitive Equilibrium . . .3. .3 Variance Decompositions . . . . . . . . . . . . . . . . . . . . . . . . Exportable. . . . . . .3. 5. . . . . 131 6. . . . . . . . . . . . 5.1 Households . . . .4 Production of Importable. . . . . .6 The Endogeneity of Country Spreads . . .4. . . . . . . . .10 4. .5 Market Clearing . . . . . . . . . .iv 4. . . . . .3. 5. . . . . . . . . 5. . .3. .1 An Empirical Model . . 126 6. . . . .5 4. . . . . . . . . . . . . . . 4. . . . . . . . . . . . . . . .9 4. . . . .4. . . . . . . . . Matlab Code For Linear Perturbation Methods . . . . . 5. . . . . . . . . . . . . . . . . . . .6 Driving Forces .3. . . . . . . . . .4 A Theoretical Model . . . . . . . . . . . . . . . . .10 How Important Are the Terms of Trade? . . . .5 Theoretical and Estimated Impulse Responses . 5.2 Impulse Response Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Model Performance . . . . . . . . . . . . .2 Empirical Regularities . . . . . . .8 4.3.1 TOT-TB Correlation: Two Early Explanations . . .3. . . . . .3. . . . . . 132 6. . . . 5. . .

4 Saving and the Breakdown of Reputational Lending
v 151 . . . . . . .
.2 The Cost of Default . . . . 157 . . 7. .CONTENTS 7 Sovereign Debt 7. . . . . . . 152 . . . . . . . . . . . 166
.3 A Reputational Model of Sovereign Debt . .
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. . 7. . . . 7. . . . . . . . . 159 . . . .1 Empirical Regularities . . . . . .

vi
CONTENTS
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6 in Argentina and only 2. The group of developed economies is typically deﬁned by countries with high income per capita. The volatility of detrended output is 4. a critical distinction is between developed and emerging economies. Examples of developed small open economies are Canada and Belgium.1 illustrates this contrast by displaying key business-cycle properties in Argentina and Canada.Chapter 1
A First Look at the Data
In discussions of business cycles in small open economies. A striking diﬀerence between developed and emerging economies is that observed business cycles in emerging countries are about twice as volatile as in developed countries. Table 1.8 in Canada. and examples of small open emerging economies are Argentina and Malaysia. Another remarkable diﬀerence between developing and developed countries suggested by the table is that the trade balance-to-output ratio is much more countercyclical in emerging countries than in developed countries. Periods of economic boom (contraction) are characterized by relatively larger trade 1
. and the group of emerging economies is composed of middle income countries.

Kydland and Zarazaga (1997). xt−1 ) 0.61 corr(xt .4 2.0 3.1: Business Cycles in Argentina and Canada Variable GDP Argentina Canada Consumption Argentina Canada Investment Argentina Canada TB/GDP Argentina Canada Hours Argentina Canada Productivity Argentina Canada σx 4.8 5.54
0.31
0.3 9.
.5 13.3 1.94 0.70
0. GDPt ) 1 1 0.59 0.7 corr(xt . data on hours and productivity are limited to the manufacturing sector.6 2.84 -0.70
0.9 4.76 0.13 0.79 0.37
Source: Mendoza (1991).66
0.64 -0.48 0.0 1.1 2. For Argentina.96 0.2
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Table 1.8 2.80 0.

these variables move in tandem with output. and that in Argentina hours and productivity are less correlated with GDP than in Canada. Also. whereas the reverse is the case in Canada.Lectures in Open Economy Macroeconomics. One dimension along which business cycles in Argentina and Canada are similar is the procyclicality of consumption. hours.
. The data shown in the table is broadly in line with the conclusions drawn from the comparison of business cycles in Argentina and Canada. and productivity. In both countries. Two additional diﬀerences between the business cycle in Argentina and Canada are that in Argentina the correlation of the components of aggregate demand with GDP are twice as high as in Canada. For all countries. Table 1. the time series are at least 40 quarters long. The data is detrended using a bandpass ﬁlter that leaves out all frequencies above 32 quarters and below 6 quarters. investment. The diﬀerences between the business cycles of Argentina and Canada turn out to hold much more generally between emerging and developed countries. emerging countries are signiﬁcantly more volatile and display a much more countercyclical trade-balance share than developed countries. The table averages second moments of detrended data for 13 small emerging countries and 13 small developed countries (the list of countries appears at the foot of the table). consumption is more volatile than output in emerging countries but less volatile than output in developed countries. In particular. A third diﬀerence between Canadian and Argentine business cycles is that in Argentina consumption appears to be more volatile than output at businesscycle frequencies.2 displays average business cycle facts in developed and emerging economies. Chapter 1
3
deﬁcits (surpluses) in emerging countries than in developed countries.

Slovak Republic. Spain.32 3. Norway.71 -0.04 0.94 3. Finland. and Turkey. Ecuador. Source: Aguiar and Gopinath (2004). New Zealand. Israel. Philippines. Netherlands. Denmark.02 1.42 0. Emerging countries: Argentina.2: Business Cycles: Emerging Vs. Developed Economies Moment σy σ∆y ρy ρ∆y σc /σy σi /σy σtb/y ρtb/y. Korea.69 0.58 0.96 2. Malaysia.y Emerging Countries 2. Austria.26 0. Brazil.09 -0. Belgium. South Africa.75
Note: Average values of moments for 13 small emerging countries and 13 small developed countries.95 0.87 Developed Countries 1. Canada.86 0. Data are detrended using a band-pass ﬁlter including frequencies between 6 and 32 quarters with 12 leads and lags.y ρi.23 1. Peru. Developed Countries: Australia.
.y ρc. Portugal. Switzerland.74 0.9 0.87 0. Sweden.09 0. Thailand.4
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Table 1. Mexico.

1
The Model Economy
Consider an economy populated by a large number of inﬁnitely lived households with preferences described by the utility function
∞
E0
t=0
β t U (ct ).Chapter 2
An Endowment Economy
The purpose of this chapter is to build a canonical dynamic.1)
. general equilibrium model of the small open economy capable of capturing some of the empirical regularities of business cycles in small emerging and developed countries documented in chapter 1. 5
(2. The model developed in this chapter is simple enough to allow for a full characterization of its equilibrium dynamics using pen and paper.
2.

dt }∞ satisﬁes t=0 the no-Ponzi-game constraint with strict inequality. (1 + r)j
j→∞
lim Et
(2. ct − yt . This alternative allocation is clearly strictly preferred to the original one because the single period utility function is strictly increasing. which is assumed to be strictly increasing and strictly concave. The above constraint states that the change in the level of debt. with ct > ct for at least one date t ≥ 0. and excess expenditure over income. dt }∞ that also satisﬁes the no-Ponzi-game cont=0 straint and satisﬁes ct ≥ ct . (2. dt − dt−1 . The optimal allocation of consumption and debt will always feature this constraint holding with strict equality.6
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where ct denotes consumption and U denotes the single-period utility function. then one can choose an alternative allocation {ct .2)
where dt denotes the debt position assumed in period t.3)
This limit condition states that the household’s debt position must be expected to grow at a rate lower than the interest rate r. interest services on previously acquired debt.
. This endowment process represents the sole source of uncertainty in this economy. r denotes the interest rate. for all t ≥ 0. has two sources. and yt is an exogenous and stochastic endowment of goods. This is because if the allocation {ct . assumed to be constant. rdt−1 . Households are subject to the following borrowing constraint that prevents them from engaging in Ponzi games: dt+j ≤ 0. The evolution of the debt position of the representative household is given by dt = (1 + r)dt−1 + ct − yt .

β(1 + r) = 1. our model becomes essentially Hall’s (1978) permanent income model of consumption. 1 + r. and the following Euler condition: U (ct ) = β(1 + r)Et U (ct+1 ). its period-t utility falls by U (ct ). we assume that the period utility index is quadratic and given by 1 U (c) = − (c − c)2 . First we require that the subjective and pecuniary rates of discount.3) holding with equality.1) subject to (2.4)
The interpretation of this expression is simple.2). We make two additional assumptions that greatly facilitates the analysis. At the optimal allocation. If the household sacriﬁces one unit of consumption in period t and invests it in ﬁnancial assets. yielding β(1 + r)Et U (ct+1 ) utils. Chapter 2
7
The household chooses processes for ct and dt for t ≥ 0.Lectures in Open Economy Macroeconomics. (2. the Euler
1 After imposing this assumption. In period t + 1 the household receives the unit of goods invested plus interests.
. (2. Under these assumptions. that is.2) and (2.1 This particular functional form makes it possible to obtain ¯ a closed-form solution of the model. β and 1/(1 + r). Second. so as to maximize (2. the cost and beneﬁt of postponing consumption must equal each other in the margin. The optimality conditions associated with this problem are (2.5)
with c < c. ¯ 2
(2.
This assumption eliminates long-run growth in consumption.3). be equal to each other.

6)
which says that consumption follows a random walk. 1+r 1+r
(1 + r)dt−1 = yt − ct +
Repeat this procedure s times to get
s
(1 + r)dt−1 =
j=0
yt+j − ct+j dt+s + . households expect to maintain a constant level of consumption. at each point in time.
Lead this equation 1 period and use it to get rid of dt : yt+1 − ct+1 dt+1 + .
We now derive an intertemporal resource constraint by combining the household’s sequential budget constraint (2.3) holding with equality—also known as the transversality condition. j (1 + r) (1 + r)s
Apply expectations conditional on information available at time t and take the limit for s → ∞ using the transversality condition (equation (2.3) holding with equality) to get the following intertemporal resource constraint:
∞
(1 + r)dt−1 = Et
j=0
yt+j − ct+j .4) collapses to ct = Et ct+1 . (1 + r)j
.2) and the no-Ponzi-scheme constraint (2.8 condition (2. Begin by expressing the sequential budget constraint in period t as
(1 + r)dt−1 = yt − ct + dt .
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(2.

yt = ρyt−1 + t . The larger is ρ the more persistent the endowment process. Use this result to get rid of expected future consumption in the above expression and rearrange to obtain r Et 1+r
∞
rdt−1 + ct =
j=0
yt+j . Then. (1 + r)j
(2.Lectures in Open Economy Macroeconomics.d.
Now use the Euler equation (2. and to debt ser-
vice.7)
This expression states that the optimal plan allocates the annuity value of the income stream
r 1+r Et yt+j ∞ j=0 (1+r)j
to consumption.6) to deduce that Et ct+j = ct . we assume that the endowment process follows an AR(1) process of the form. this equation says that the country’s initial net foreign debt position must equal the expected present discounted value of current and future diﬀerences between output and absorption. ct .
Using this expression to eliminate expectations of future income from equa-
. 1) deﬁnes
the serial correlation of the endowment process. rdt−1 . Chapter 2
9
Intuitively. To be able to fully characterize the equilibrium in this economy. the j-period-ahead forecast of output in period t is given by
Et yt+j = ρj yt . where
t
denotes an i.i. innovation and the parameter ρ ∈ (−1.

. cat = −(dt − dt−1 ). we obtain r 1+r
∞
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rdt−1 + ct = yt =
j=0
ρ 1+r
j
r yt . we obtain r yt − rdt−1 .7).8)
Because ρ is less than unity. we have 1−ρ yt 1+r−ρ
tbt = rdt−1 +
and cat = 1−ρ yt . Because the current account equals the change in the country’s net foreign asset position.10 tion (2.e. 1+r−ρ
dt = dt−1 −
. respectively. i. it follows that the equilibrium evolution of the stock of external debt is given by 1−ρ yt . 1+r−ρ
Note that the current account inherits the stochastic process of the underlying endowment shock. we have that a unit increase in the endowment leads to a less-than-unity increase in consumption. the trade balance and the current account in period t. Letting tbt ≡ y − ct and cat ≡ −rdt−1 + tbt denote. 1+r−ρ
Solving for ct . 1+r−ρ
ct =
(2.

In this case. According to equation (2. the endowment shock is assumed to be purely transitory. when innovations in the endowment are purely temporary only a small part of the changes in income—a fraction r/(1 + r)—is allocated to current consumption. the more volatile is the current account. The intuition for this result is clear. which is close to the volatility of the endowment
. Households borrow to ﬁnance negative income shocks and save in response to positive shocks. ρ = 0. Two polar cases are of interest. In the ﬁrst case. It follows that the more temporary are endowment shocks. so that endowment shocks are positively serially correlated. Chapter 2
11
According to this expression. The longrun behavior of the trade balance is governed by the dynamics of external debt. Assume that 0 < ρ < 1. the standard deviation of the current account is given by σy /(1 + r).Lectures in Open Economy Macroeconomics.
2. an increase in the endowment shock leads to a permanent deterioration in the trade balance. external debt follows a random walk and is therefore nonstationary. Most of the endowment increase—a fraction 1/(1 + r)—is saved. the current account plays the role of a shock absorber. Because income is expected to fall quickly to its long-run level households smooth consumption by eating a tiny part of the current windfall and leaving the rest for future consumption. In the extreme case of purely transitory shocks. A temporary increase in the endowment produces a gradual but permanent decline in the stock of foreign liabilities.8).2
Response to Output Shocks
Consider the response of our model economy to an unanticipated increase in output. Thus.

consumption experiences a once-and-for-all increase. For. households are able to sustain a smooth consumption path by consuming the totality of the current income shock. which captures the essential elements of what has become known as the intertemporal approach to the current account. and. The other polar case emerges when shocks are highly persistent. as a result the current account is nil and the stock of debt remains constant over time. That is. households allocate all innovations in their endowments to current consumption. 1)) is illustrated in ﬁgure 2. when endowment shocks are permanent. especially in developing countries. it improves during expansions and deteriorates during contractions.12
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shock itself for small values of r. As a result. The intermediate case of a gradually trend-reverting endowment process (ρ ∈ (0. which requires a smaller trade surplus to be served. In response to the positive endowment shock. the current account is procyclical. the current account is countercyclical in small open economies. Note that the trade balance converges to a level lower than the preshock level. the trade balance and the current account improve. In this case. ρ → 1. as documented in chapter 1. This expansion in domestic absorption is smaller than the initial increase in income. This is because in the long-run the economy settles at a lower level of external debt. Summarizing. an increase in income today is not accompanied by the expectation of future income contractions.1. external borrowing is conducted under the principle: ‘ﬁnance tem-
. After the initial increase. As a result. This prediction represents a serious problem for this model. in this model. More importantly. Intuitively. these two variables converge gradually to their respective long-run levels.

rather than its level.’ A central failure of the model is the prediction of a procyclical current account.3
Nonstationary Income Shocks
Suppose now that the rate of change of output. Fixing this problem is at the heart of what follows in this and the next two chapters. let
∆yt ≡ yt − yt−1
. Speciﬁcally. adjust to permanent shocks. Chapter 2
13
Figure 2. displays mean reversion.
2.1: Response to a Positive Endowment Shock
porary shocks.Lectures in Open Economy Macroeconomics.

. shock with mean zero and variance σ 2 .i. thereby producing a countercyclical tendency in the current account. Figure 2. and ρ ∈ [0.2: Stationary Versus Nonstationary Endowment Shocks
denote the change in endowment between periods t − 1 and t. The following model formalizes this story.2 provides a graphical expression of this intuition.14
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Figure 2. the level of income is nonstationary. is an i. 1)
where
t
is a constant parameter.d. in the sense that a positive output shock (
t
> 0) produces a
permanent future expected increase in the level of output. consumption-smoothing households have an incentive to borrow against future income. According to this process. Suppose that ∆yt evolves according to the following autoregressive process:
∆yt = ρ∆yt−1 + t . This is the basic intuition why allowing for a nonstationary output process can help explain the behavior of the trade balance and the current account at business-cycle frequencies. Faced with such an income proﬁle.

The ﬁrst-order conditions associated with this problem are the sequential budget constraint. the no-Ponzi-game constraint holding with equality. Using
. which we reproduce here for convenience r Et 1+r
∞
ct = −rdt−1 +
j=0
yt+j . the model economy is inhabited by an inﬁnitely lived representative household that chooses contingent plans for consumption and debt to maximize the utility function (2.2) and the no-Ponzi-game constraint (2.Lectures in Open Economy Macroeconomics. we obtain
∞
cat = −Et
j=1
∆yt+j . According to the autoregressive process assumed for the endowment. (1 + r)j
Using this expression and recalling that the current account is deﬁned as cat = yt − ct − rdt−1 .6). Using these optimality conditions yields the expression for consumption given in equation (2.5) subject to the sequential resource constraint (2. we have that Et ∆yt+j = ρj ∆yt .3). (1 + r)j
This expression states that the current account equals the present discounted value of future expected income decreases.7). and the Euler equation (2. we can write r Et 1+r
∞
cat = yt −
j=0
yt+j . (1 + r)j
Rearranging. Chapter 2
15
As before.

which happens only if ∆yt is positively serially correlated. Recall that when the endowment level is stationary the current account increases in response to a positive endowment shock. the current account ceases to be countercyclical (is procyclical).
2
. as we saw in chapter 1. The intuition behind this result is clear. developing countries are characterized by consumption growth being more volatile than output growth. In eﬀect. We note that the countercyclicality of the current account in the model with nonstationary shocks depends crucially on output changes being positively serially correlated. For an unexpected increase in income to induce an increase in consumption larger than the increase in income itself. we wish to ﬁnd
2 2 out conditions under which σ∆c can be higher than σ∆y in equilibrium. Formally. we can write the current account as: −ρ ∆yt . Are implied changes in consumption more or less volatile than changes in output? This question is important because. this exercise is not comparable to the data displayed in chapter 1.16
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this result in the above expression. letting σ∆c and σ∆y denote the standard deviations of ∆ct ≡ ct − ct−1 and ∆yt . the current account deteriorates in response to a positive innovation in output.2 We
Strictly speaking. whereas in chapter 1 we reported statistics pertaining to the growth rates of consumption and output. This implication is an important improvement relative to the model with stationary shocks. or ρ > 0. it is necessary that future income be expected to be higher than current income. because here we analyze changes in consumption and output. 1+r−ρ
cat =
According to this formula. when ρ is zero (negative). respectively.

Chapter 2 start with the deﬁnition of the current account
17
cat = yt − ct − rdt−1 . Then.
Taking diﬀerences.
Noting that dt−1 − dt−2 = −cat−1 and solving for ∆ct . so their changes are equally volatile. It follows that there are values of
.9)
2 It follows directly from the AR(1) speciﬁcaiton of ∆yt that σ∆y (1−ρ2 ) =
σ 2 . we can write the standard deviation of consumption changes as σ∆c 1+r = σ∆y 1+r−ρ
1 − ρ2 . 1+r−ρ
(2. consumption and income move hand in hand.
The right-hand side of this expression equals unity at ρ = 0. The right hand side of the above expression is increasing in ρ at ρ = 0.Lectures in Open Economy Macroeconomics. This result conﬁrms the one obtained earlier in this chapter. we obtain:
∆ct = ∆yt − cat + (1 + r)cat−1 = ∆yt + = = ρ ρ(1 + r) ∆yt − ∆yt−1 1+r−ρ 1+r−ρ 1+r ρ(1 + r) ∆yt − ∆yt−1 1+r−ρ 1+r−ρ 1+r t. namely that when the level of income is a random walk. we obtain
cat − cat−1 = ∆yt − ∆ct − r(dt−1 − dt−2 ).

This is because as ρ → 1.4
Testing the Model
Hall (1978) was the ﬁrst to explore the econometric implication of the simple model developed in this chapter.
2. Campbell (1987). process with ﬁnite variance for all values of ρ ∈ [0. 1) for which the volatility of consumption changes is indeed higher than that of income changes.i. ∆ct follows an i. Hall tested the prediction that consumption must follow a random walk. as expression (2. Hall’s work motivated a large empirical literature devoted to testing the empirical relevance of the model described above.9) shows. denoted cat .7) as
∞
−(1 + r)cat = −yt + rEt
j=1
(1 + r)−j yt+j . deduced and tested a number of theoretical restrictions on the equilibrium behavior of national savings. Speciﬁcally. is given by yt − ct − rdt−1 we can write equation (2.
.18
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ρ in the interval (0. Noting that the current account in period t. 1). In the context of the open economy. Campbell’s restrictions are readily expressed in terms of the current account. We start by deriving a representation of the current account that involves expected future changes in income. whereas.d. the variance of ∆yt becomes inﬁnitely large as changes in income become a random walk. in particular. This property ceases to hold as ∆yt becomes highly persistent. Here we review these restrictions and their empirical validity.

the country chooses to build its net foreign asset position (runs a current account surplus) when income is expected to decline in the future. this expression states that the country borrows from the rest of the world (runs a current account deﬁcit) income is expected to grow in the future.
Consider now an empirical representation of the time series ∆yt and cat . Similarly. Deﬁne
∆yt xt = .
(2. Then.
Let Ht denote the information contained in the vector xt .Lectures in Open Economy Macroeconomics.10)
Intuitively. cat Consider estimating a VAR system including xt :
xt = Dxt−1 + t . it is simple to show that
∞ ∞
19
−yt + rEt
j=1
(1 + r)−j yt+j = (1 + r)
j=1
(1 + r)−j Et ∆yt+j . Chapter 2 Deﬁning ∆xt+1 = xt+1 − xt .
. we have that the forecast of xt+j given Ht is given by Et [xt+j |Ht ] = D j xt . from the above VAR system.
Combining the above two expression we can write the current account as
∞
cat = −
j=1
(1 + r)−j Et ∆yt+j . In this case the country saves for a rainy day.

Their data strongly rejects the above cross-equation restriction of the model. So the model implies the following restriction on the vector F :
F = [0
1].20 It follows that
∞
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(1 + r)−j Et [∆yt+j |Ht ] =
j=1
1 0
∆yt [I − D/(1 + r)]−1 D/(1 + r) . Now consider running a
regression of the left and right hand side of equation (2.
with an asymptotic p-value of 0.
Consider now an additional testable cross-equation restriction on the
. then the Wald statistic. we obtain that the regression coefﬁcient for the left-hand side regression is the vector [0 1]. They estimate the VAR system using Canadian data on the current account and GDP net of investment and government spending. Since xt includes cat as one element.1. The regression
coeﬃcients of the right-hand side regression is F . In computing F . which reﬂects the discrepancy of F from [0 1].04. cat
Let F ≡ −
1 0
[I − D/(1 + r)]−1 D/(1 + r).1 or higher only 4 out of 100 times.7 percent per year. would take a value of 16.10) onto the vector xt . The VAR system that Nason and Rogers estimate includes 4 lags. The Wald statistic associated with null hypothesis that F = [0 1] is 16.
Nason and Rogers (2006) perform an econometric test of this restriction. This p-value means that if the null hypothesis was true. The estimation sample is 1963:Q1 to 1997:Q4. they calibrate r at 3.

In particular. Nevertheless. equation (2.11)
According to this expression. will not hold. the orthogonality condition stating that cat+1 − (1 + r)cat − ∆yt+1 be orthogonal to variables dated t or earlier. if one runs a regression of this variable on current and past values of xt .5) by c + µt . and µt is an i. the variable cat+1 − (1 + r)cat − ∆yt+1 is unpredictable in period t.and right-hand sides of this expression on the information set Ht . for instance. This projection yields the orthogonality restriction [0 1][D −(1+r)I]−[1 0]D = [0 0].i. Chapter 2 theoretical model. replace c ¯ in equation (2.4 Both of the orthogonality conditions discussed here are strongly rejected by the data. because in general µt is correlated with cat . Nason and Rogers (2006) ﬁnd that a test of the hypothesis that all coeﬃcients are zero in a regression of
Consider projecting the left. In this environment.11) becomes
Et cat+1 − (1 + r)cat − Et ∆yt+1 = µt .d. all coeﬃcients should be equal to zero. This yields the orthogonality condition [0 1][D − (1 + r)I]D − [1 0]D2 = [0 0].
(2. From equation (2.3 This restriction is not valid in a more general version of the model featuring private demand shocks. where c is still a constant.10) it follows that
21
Et cat+1 − (1 + r)cat − Et ∆yt+1 = 0. 4 In particular.
3
. Speciﬁcally. Consider.
Clearly. in this case we have that cat+1 − (1 + r)cat − ∆yt+1 should be unpredictable given information available in period t − 1 or earlier. one can consider projecting the above expression onto ∆yt−1 and cat−1 . a variation of the model economy where the bliss point is a random variable. ¯ ¯ shock with mean zero.Lectures in Open Economy Macroeconomics.

01.22
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cat+1 − (1 + r)cat − ∆yt+1 onto current and past values of xt has a p-value of 0.06.
. The p-value associated with a regression featuring as regressors past values of xt is 0.

and U denotes the period utility function. assumed to be strictly increasing.
t=0
(3.1
The Basic Framework
Consider a small open economy populated by a large number of inﬁnitely lived households with preferences described by the utility function
∞
β t U (ct ). In this chapter. strictly concave. β ∈ (0.1)
where ct denotes consumption. Households seek to maximize this utility function subject to the following three 23
.Chapter 3
An Economy with Capital
A theme of chapter 2 is that the simple endowment economy fails to predict the countercyclicality of the trade balance. 1) denotes the subjective discount factor.
3. we show that allowing for capital accumulation can help resolve this problem. and twice continuously diﬀerentiable.

strictly concave. The Lagrangian associated with the household’s problem is
∞
L=
t=0
β t {U (ct ) + λt [(1 + r)bt−1 + kt + θt F (kt ) − ct − kt+t − bt+1 ]} . For the sake of simplicity. and bt+j ≥ 0. We relax this assumption later. The variable θt denotes an exogenous nonstochastic productivity factor. kt denotes the stock of physical capital. we assume that the capital stock does not depreciate.3)
where bt denotes real bonds bought in period t yielding the constant interest rate r > 0.2)
(3.
We wish to characterize the response of the economy to a permanent increase in θt . j→∞ (1 + r)j lim
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(3.
The ﬁrst-order conditions corresponding to this problem are
U (ct ) = λt . and it denotes investment. and to satisfy the Inada conditions. The function F describes the production technology and is assumed to be strictly increasing.24 constraints: bt = (1 + r)bt−1 + θt F (kt ) − ct − it .
λt = β(1 + r)λt+1 .
. kt+1 = kt + it .

Lectures in Open Economy Macroeconomics. t→∞ (1 + r)t lim
25
As in the endowment-economy model of chapter 2. This assumption together with the ﬁrst two of the above optimality conditions implies that consumption is constant over time. bt = (1 + r)bt−1 + θt F (kt ) − ct − kt+1 + kt . is an increasing function of the future expected level productivity. kt+1 .
κ1 > 0. to avoid inessential long-run dynamics. r. θt+1 .5)
for t ≥ 0. Chapter 3 λt = βλt+1 [1 + θt+1 F (kt+1 )]. The ﬁrst of these equilibrium conditions states that households invest in physical capital until the marginal product of capital equals the rate of return on foreign bonds. The above optimality conditions can be reduced to the following two expressions: r = θt+1 F (kt+1 ) and ct = rbt−1 + r 1+r
∞
(3. Formally.4)
j=0
θt+j F (kt+j ) − kt+j+1 + kt+j . we assume that β(1+r) = 1. κ2 < 0.4) that next period’s level of physical capital. and a decreasing function of the opportunity cost of holding physical capital.
kt+1 = κ(θt+1 . It follows from (3. (1 + r)j
(3.
. r). and the transversality condition bt = 0.

It follows that the optimal consumption path must also be
.2) to t t obtain the sequence of asset positions bs = b−1 for all t ≥ 0. says that consumption equals the interest ﬂow on a broad deﬁnition of wealth. That is. Obviously. so the proposed suboptimal allocation satisﬁes the no-Ponzi-game condition (3.1
A Permanent Productivity Shock
Suppose that up until period -1 inclusive the technology factor θt was con¯ stant and equal to θ. ct = c0 > c−1 for all t > 0. follow the same steps as in the derivation of its counterpart for the endowment economy studied in chapter 2. To show that the proposed allocation is feasible.1. To obtain this expression.
3. for t ≥ 0. Consumption experiences a permanent increase in response to the permanent technology shock. b−1 . which includes not only initial ﬁnancial wealth. but also the present discounted value of the diﬀerences between output and investment.3). where k denotes the t t ¯ initial level of capital. consider the suboptimal paths for consumption and investment ¯ ¯ cs = θ F (k) + rb−1 and is = 0 for all t. equation (3. Clearly. We have shown the existence of a feasible consumption path that ! is strictly preferred to the pre-shock consumption allocation.5). θt = θ for t < 0 and θt = θ for t ≥ 0. Suppose further that in period 0 there is a permanent.26
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The second equilibrium condition. let us plug the consumption and investment paths cs and is into the sequential budget constraint (3. That is. t limt→∞ b−1 /(1 + r)t = 0. because θ > θ. the consumption path cs is t ¯ ¯ strictly preferred to the pre-shock path. To
see this. given by θF (k) + rb−1 . ¯ ¯ unexpected increase in the technology factor to θ > θ.

r). 1+r 1+r
c0 = rb−1 +
The trade balance is given by tbt = θt F (kt ) − ct − it . note that output increases from θ F (k0 ) in period 0 to θ F (k ∗ ) in period 1. This together with the fact that the expression within square brackets in the above equation is unambiguously positive. r) > k. In period 0. To see this. Because k0 was chosen in period −1. 1+r
tb0 = −rb−1 −
Before period zero. where k is given by k = κ(θ. In period 1 the trade balance improves. Thus. This result together with the fact that the optimal consumption path is constant over time implies that consumption must jump up once and for all in period 0. On the demand side. The trade balance remains constant after
. necessarily goes up in period 1. given by output minus investment minus consumption. investment experiences a once-and-for-all increase that brings the level of ¯ ¯ capital up from k to a level k ∗ ≡ κ(θ . in period 1 investment falls to zero. when households expected θ0 to be ¯ ¯ ¯ ¯ ¯ equal to θ. while consumption remains unchanged. the trade balance. we have that k0 = k.5) and evaluating that equation at t = 0 we get r 1 ¯ ¯ θ F (k) − k ∗ + k + θ F (k ∗ ). Plugging this path for the capital stock into equation (3. we have 1 ¯ ¯ θ F (k ∗ ) − θ F (k) + (k ∗ − k) .Lectures in Open Economy Macroeconomics. the trade balance is simply equal to −rb−1 . Chapter 3
27
strictly preferred to the pre-shock consumption path. kt = k ∗ for t ≥ 1. Thus. Thus. implies that in response to the permanent technology shock the trade balance deteriorates in period zero.

The current account deteriorates in period zero and is nil from period 1 onward. Note that in response to the increase in future expected productivity. Another important factor in generating a decline in the trade balance in response to a positive productivity shock is the assumed absence of capital adjustment costs. dampening the increase in domestic absorption in the date the shock occurs. A permanent increase in productivity induces a strong response in domestic absorption. We will study the role of adjustment costs more closely shortly. investment falls to zero in period 1 and remains nil thereafter. To see this. note ﬁrst that from the vintage point of period zero. For the initial worsening of the external accounts in a context of expansion in aggregate activity is in line with the empirical evidence presented in chapter 1. Indeed. it pays to increase investment spending. As a result.
. θt . In obtaining a deterioration of the trade balance the assumed persistence of the productivity shock plays a signiﬁcant role. At the same time. investment spending is spread over a number of periods.28
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period 1. is expected to stay high in the future. In the presence of costs of adjusting the stock of capital. the entire adjustment in investment occurs in period zero. the propensity to consume out of current income is high. because the productivity of capital. households face an increasing path for output net of investment. The initial deteriorations of the trade balance and the current account implied by the model represent a signiﬁcant improvement with respect to the endowment economy studied in chapter 2.

As a result. θ0 = θ > θ. Suppose also that in period -1 people assigned ¯ a zero probability to the event that θ0 would be diﬀerent from θ. Specifically. equation (3. households would like to have more capital in that period. and therefore also ¯ investment. Investment in period zero can only increase the future stock of capital. everybody expects θt = θ for all t > 0. Namely. Chapter 3
29
3. where k is the level of capital inherited in period 0.Lectures in Open Economy Macroeconomics.2
A Temporary Productivity shock
To stress the importance of persistence in productivity movements in inducing a deterioration of the trade balance in response to a positive output shock. suppose that up until period -1 inclusive the productivity factor θt ¯ was constant and equal to θ.4) implies that the capital stock. That is. are unaﬀected by the productivity shock. But k0 is ﬁxed in period zero. That is.1. a zero probability event happens. it is worth analyzing the eﬀect of a purely temporary shock. That is ¯ ¯ y0 = y−1 + (θ − θ)F (k). But agents have no incentives to have a higher capital stock in the future. however. In this case. Furthermore. In period ¯ 0. This output eﬀect
. kt = k for all ¯ t ≥ 0. The positive productivity shock in period zero does produce an increase ¯ ¯ ¯ in output in that period. The productivity of capital unexpectedly increases in period zero. suppose that everybody correctly expects the productivity shock ¯ to be purely temporary. from θF (k) to θ F (k). ¯ ¯ where y−1 ≡ θF (k) is the pre-shock level of output. because its productivity is expected to go back down to its ¯ historic level θ right after period 0. This is intuitive.

3. Capital adjustment costs are typically introduced. 1+r
c0 = c−1 +
¯ ¯ where c−1 ≡ −rb−1 + θF (θ) is the pre-shock level of consumption. The reason for this counterfactual response is simple: ‘Firms have no incentive to invest. as the increase in the productivity of capital is short lived. households invest the entire increase in output in the international ﬁnancial market and increase consumption by the interest ﬂow associated with that ﬁnancial investment.30
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induces higher consumption. Combining the above two expressions and recalling that investment is unaﬀected by the temporary shock. Basically.5) we have that r ¯ ¯ (θ − θ)F (k). we get that the trade balance in period 0 is given by 1 ¯ (θ − θ)F (k0 ) > 0. in small open economy models to dumpen the volatility of investment over the business cycle (see. 1+r
tb0 − tb−1 = (y0 − y−1 ) − (c0 − c−1 ) − (i0 − i−1 ) =
This expression shows that the trade balance improves on impact. In eﬀect.2
Capital Adjustment Costs
Consider now an economy identical to the one described above but in which changes in the stock of capital come at a cost.
.g. and consumers save most of the purely temporary increase in income in order to smooth consumption over time. e.. in diﬀerent forms. using equation (3.

1) subject to the above two restrictions and the no-Ponzi-game constraint (3. Chapter 3
31
Mendoza. the law of motion of the capital stock is given by kt+1 = kt + it . 1991. it = 0. Moreover.3). and Schmitt-Groh´.
The variables λt and qt denote Lagrange multipliers on the sequential budget constraint and the law of motion of the capital stock. 1998).6)
(3. The ﬁrst-order conditions associated with the household problem are:
it = (qt − 1)kt 1 (1 + r)qt = θt+1 F (kt+1 ) + (it+1 /kt+1 )2 + qt+1 2
(3. The Lagrangian associated with this optimization problem is
∞
L=
t=0
β t U (ct ) + λt (1 + r)bt−1 + θt F (kt ) − ct − it −
1 i2 t − bt + qt (kt + it − kt+1 ) 2 kt
.Lectures in Open Economy Macroeconomics. Suppose that the sequential e budget constraint is of the form 1 i2 t . both the level and the slope of this function vanish at the steady-state value of investment. As in the economy without adjustment costs. capital adjustment costs are given by i2 /(2kt ) and are a strictly cont vex function of investment.7)
. Households seek to maximize the utility function given in (3. We continue to assume that β(1 + r) = 1. respectively. 2 kt
bt = (1 + r)bt−1 + θt F (kt ) − ct − it −
Here.

instead of using qt units of goods to buy one unit of capital. In addition.7). nonlinear diﬀerence equations in kt and qt :
kt+1 = qt kt θt+1 F (qt kt ) + (qt+1 − 1)2 /2 + qt+1 .
j=0
The Lagrange multiplier qt represents the shadow relative price of capital in terms of consumption goods. The sum of these three sources of income form the right hand side of (3.7).9)
.1
Dynamics of the Capital Stock
Eliminating it from the above equations we get the following two ﬁrst-order. thereby increasing it . as qt increases agents have incentives to allocate goods to the production of capital.
3. This is the left-hand side of equation (3.7) compares the rates of return on bonds and physical capital: Adding one unit of capital to the existing stock costs qt .6). At the optimum both strategies must yield the same return. the agent can engage in a ﬁnancial investment by purchasing qt units of bonds in period t with a gross return of (1 + r)qt .32 kt+1 = kt + it ct = rbt−1 + r 1+r
∞
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θt+j F (kt+j ) − it+j − 1 (i2 /kt+j ) 2 t+j (1 + r)j
.2. Alternatively. Finally. This unit yields θt+1 F (kt+1 ) units of output next period. and is known as Tobin’s q. an extra unit of capital reduces tomorrow’s adjustment costs by (it+1 /kt+1 )2 /2. Equation (3. the unit of capital can be sold at a price qt+1 next period. According to equation (3. 1+r
(3.8)
qt =
(3.

rq = θF (qk) + (q − 1)2 /2.Lectures in Open Economy Macroeconomics. That is. Chapter 3
33
Figure 3. qt ) for which kt+1 = kt in equation (3. qt ) for which qt+1 = qt in equation (3.8). q = 1. The locus QQ corresponds to the pairs (kt .1: The Dynamics of the Capital Stock
q Q
S a • 1 K • K′
S′
Q′ k0 k* k
The perfect foresight solution to these equations is depicted in ﬁgure 3.
(3. (3. That is. the capital stock grows over time and below KK the capital stock declines over time. The horizontal line KK corresponds to the pairs (kt .1.10)
Above the locus KK .11)
.9).

equations (3. The locus SS represents the converging saddle path. Then the new steady-state values of k and q are given by k ∗ and 1.1. both q and k converge monotonically to their steady states along the saddle path. the locus QQ is downward sloping. The
. This is not surprising. it is clear from equation (3. is not aﬀected in the long run. It follows that in response to a permanent increase in productivity.10) and (3. the long-run level of capital experiences a permanent increase. On the other hand. on the other hand.8)-(3. q increases over time and below and to the left of QQ . as noted earlier. In the period of the shock. If the initial capital stock is diﬀerent from its long-run level. For qt near unity.10) that the locus KK is not aﬀected by the productivity shock. which we denote by k ∗ . which is the same value obtained in the economy without adjustment costs.11) that the locus QQ shifts up and to the right. Suppose that the steady-state value of capital prior to the innovation in productivity is k0 in ﬁgure 3. qt . and the steady-state value of the Tobin’s q. The price of capital. Consider now the transition to the new steady state. because. q decreases over time. The system (3. adjustment costs vanish in the steady state. 1. The value of k ∗ is implicitly determined by the expression r = θF (k).
3.2
A Permanent Technology Shock
Suppose now that in period 0 the technology factor θt increases permanently ¯ ¯ from θ to θ > θ. Above and to the right of QQ .9) is saddle-path stable. the capital stock does not move.34
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Jointly.11) determine the steady-state value of the capital stock. It is clear from equation (3.2.

Lectures in Open Economy Macroeconomics, Chapter 3

35

price of installed capital, qt , jumps to the new saddle path, point a in the ﬁgure. This increase in the price of installed capital induces an increase in investment, which in turn makes capital grow over time. After the initial impact, qt decreases toward 1. Along this transition, the capital stock increases monotonically towards its new steady-state k ∗ . The equilibrium dynamics of output, investment, and capital in the presence of adjustment costs are quite diﬀerent from those arising in the absence thereof. In the frictionless environment, investment, output, and the capital stock all reach their long-run steady state one period after the productivity shock. Under capital adjustment costs, by contrast, these variables adjust gradually to the unexpected increase in productivity. The more pronounced are adjustment costs, the more sluggish is the response of investment, thereby making it less likely that the trade balance deteriorates in response to a positive technology shock as required for the model to be in line with the data.1 This observation opens the question of what would the model predict for the behavior of the trade balance in response to output shocks when one introduces a realistic degree of adjustment costs. We address this issue in the next chapter.

It is straightforward to see that the response of the model to a purely temporary productivity shock is identical as that of the model without adjustment costs. In particular, capital and investment display a mute response.

1

36

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Chapter 4

The Real Business Cycle Model

In the previous two chapters, we arrived at the conclusion that a model driven by productivity shocks can explain the observed countercyclicality of the current account. We also established that two features of the model are important in making this prediction possible. First, productivity shocks must be suﬃciently persistent. Second, capital adjustment costs must not be too strong. In this chapter, we extend the model of the previous chapter by allowing for three features that add realism to the model’s implied dynamics. Namely, endogenous labor supply and demand, uncertainty in the technology shock process, and capital depreciation. The resulting theoretical framework is known as the Real Business Cycle model, or, succinctly, the RBC model. 37

The period-by-period budget constraint of the representative household is given by
dt = (1 + rt−1 )dt−1 − yt + ct + it + Φ(kt+1 − kt ). ht ). βh > 0.
(4. The reason why we adopt this type of utility function here is that it gives rise to a steady state of the model that is independent of initial conditions.1)
θ0 = 1. rt denotes the interest rate at which domestic residents can borrow in period t.
(4. θt+1 = β(ct .4)
where dt denotes the household’s debt position at the end of period t.2) (4. In particular.1
The Model
Consider an economy populated by an inﬁnite number of identical households with preferences described by the utility function
∞
E0
t=0
θt U (ct . ht )θt t ≥ 0.
(4. under these preferences the steady state is independent of the initial net foreign asset position of the economy. This preference speciﬁcation was conceived by Uzawa (1968) and introduced in the small-open-economy literature by Mendoza (1991).38
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4. This property is desirable from a purely technical point of view because it makes it possible to rely on linear approximations to characterize equilibrium dynamics.3)
where βc < 0. yt denotes domestic output. ct denotes consumption. it denotes gross
.

ht ). yt . ht . small open economy models typically include capital adjustment costs to avoid excessive investment volatility in response to variations in the foreign interest rate. The restrictions imposed on Φ ensure that adjustment costs are nil in the steady state and that in the steady state the interest rate equals the marginal product of capital net of depreciation. dt .6) and a no-Ponzi constraint of the form
j→∞
(4. The function Φ(·) is meant to capture capital adjustment costs and is assumed to satisfy Φ(0) = Φ (0) = 0. As pointed out earlier.6)
lim Et
dt+j j s=0 (1 + rs )
≤ 0. Households choose processes {ct .7)
Letting θt ηt and θt λt denote the Lagrange multipliers on (4. the ﬁrst-order conditions of the household’s maximization problem are (4.
(4. and kt denotes physical capital. The stock of capital evolves according to kt+1 = it + (1 − δ)kt .2)-(4.5)
where At is an exogenous stochastic productivity shock.3) and (4. kt+1 .Lectures in Open Economy Macroeconomics.
(4.3)-
. it .4). where δ ∈ (0. Chapter 4
39
investment.
Output is produced by means of a linearly homogeneous production function that takes capital and labor services as inputs. 1) denotes the rate of depreciation of physical capital. θt+1 }∞ so as to maxt=0 imize the utility function (4.
yt = At F (kt .1) subject to (4.

ht )
(4. ht ) − βh (ct . ht ) but instead Uh (ct .9) (4. yields rt = r. The world interest rate is assumed to be constant and equal to r. iterate the ﬁrst-order condition (4. Similarly.13)
.12) These ﬁrst-order conditions are fairly standard.40 (4. In turn. ht ) but rather by Uc (ct .11)
λt [1+Φ (kt+1 −kt )] = β(ct . ht ) − ηt βc (ct . ht ) + ηt βh (ct . The second term in this expression reﬂects the fact that an increase in current consumption lowers the discount factor (βc < 0).10) forward to obtain: ηt = −Et
∞ j=1 θt+j θt+1
U (ct+j . ht+1 ) + Et ηt+1 β(ct+1 . Equating the domestic and world interest rates. ht ) = λt At Fh (kt . To see this. ηt equals the present discounted value of utility from period t + 1 onward. ht+1 ) −Uh (ct .8)
λt = Uc (ct .10) (4. (4. ht )(1 + rt )Et λt+1
(4. ht )Et λt+1 At+1 Fk (kt+1 .7) holding with equality and:
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λt = β(ct . ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) (4. except for the fact that the marginal utility of consumption is not given simply by Uc (ct . ht )−βc (ct . a unit decline in the discount factor reduces utility in period t by ηt .
We assume free capital mobility. ht+j ). ht ) ηt = −Et U (ct+1 . ht )ηt . the marginal disutility
of labor is not simply Uh (ct . ht )ηt . Intuitively.

t ≥ 0. h) =
−1
β(c. h) = 1 + c − ω −1 hω F (k.
t+1
∼ N IID(0.9) and (4. d−1 .11) yields hω−1 = At Fh (kt . yt . and k0 and the exogenous process { t }.14)
A competitive equilibrium is a set of processes {dt .
−ψ1
The assumed functional forms for the period utility function and the discount factor imply that the marginal rate of substitution between consumption and leisure depends only on labor.
(4. Chapter 4 The law of motion of the productivity shock is given by:
41
ln At+1 = ρ ln At +
t+1 .Lectures in Open Economy Macroeconomics. λt . who uses the following functional forms for preferences and technology: c − ω −1 hω 1−γ
1−γ
U (c. combining equations (4. ht ).4)-(4. The left-hand side is the marginal rate of substitution of leisure for consumption. The above expres-
. kt+1 . given the initial conditions A0 . it .14).15)
The right-hand side of this expression is the marginal product of labor. t (4. 2 φ > 0. rt } satisfying (4. ht . which in equilibrium equals the real wage rate. ct . ηt . In eﬀect.
We parameterize the model following Mendoza (1991). σ 2 ). h) = k α h1−α Φ(x) = φ 2 x .

455 ψ1 . The value assigned to ψ1 is set so as to match the average Canadian trade-balance-to-GDP ratio.32 φ 0. equilibrium condition (4.04 δ 0.12) in steady state to get k = h α r+δ
1 1−α
.42
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Table 4.42 σ 0.0129
sion thus states that the labor supply depends only upon the wage rate and in particular that it is independent of the level of wealth. use equation (4. The time unit is meant to be a year. To see how in steady state this ratio is linked to the value of ψ1 .11 α .028 r 0. We also follow Mendoza (1991) in assigning values to the structural parameters of the model. All parameter values are standard in the real-business-cycle literature.
It follows from this expression that the steady-state capital-labor ratio is independent of the parameter ψ1 . Given the capital-labor ratio.
. The parameter values are shown on table 4.15) implies that the steady-state value of hours is also independent of ψ1 and given by k h
α
1 ω−1
h = (1 − α)
.1 ρ 0. Mendoza calibrates the model to the Canadian economy. This parameter determines the stationarity of the model and the speed of convergence to the steady state.1.1: Calibration of the Small Open RBC Economy γ 2 ω 1. It is of interest to review the calibration of the parameter ψ1 deﬁning the elasticity of the discount factor with respect to the composite c − hω /ω.

the larger is the trade-balance-to-output ratio. tb. we have that the transversality condition limj→∞ Et dt+j /(1 + r)j = 0 is always satisﬁed.4)-(4. ηt . At } ﬂuctuates in a small neighborhood around its nonstochastic steady-state level.
Approximating Equilibrium Dynamics
We look for solutions to the equilibrium conditions (4.8)-(4. This expression and equilibrium condition (4. Clearly. Chapter 4
43
Given the steady-state values of hours and the capital-labor ratio. independently of ψ1 . r. investment (i = δk).Lectures in Open Economy Macroeconomics. λt .
Recalling that y. yt . Because in any such solution the stock of debt is bounded. given α. The above expression can be solved for the trade balance-to-output ratio to obtain: (1 + r)1/ψ1 + tb i =1− − y y y
hω ω
−1
. The system
. we can ﬁnd directly the steady-state values of capital. rt . Now note that in the steady state the trade balance. it . which uses the speciﬁc functional form assumed for the discount factor. and output (y = k α h1−α ).8) imply the following steady-state condition relating the trade balance to ψ1 : [1 + y − i − tb − hω /ω]−ψ1 (1 + r) = 1. We thus focus on bounded solutions to the system (4. and ω. h. nd i are independent of ψ1 . is given by y − c − i.4)-(4.14) of ten equations in ten variables given by the elements of the vector xt .6) and (4. kt . ht . δ. the larger is ψ1 .14) where the vector xt ≡ {dt−1 . it follows that this expression can be solved for ψ1 given tb/y. ct .

where A and B are square matrices conformable with xt . say wt . Appendix A displays the linearized equilibrium conditions of the RBC model studied
. with output or investment. Note that ˆ for small deviations of wt from w it is the case that wt ≈ (wt − w)/w. where w denotes the steady-state value of wt .
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This expression describes a system of nonlinear stochastic diﬀerence equations..44 can be written as Et f (xt+1 . xt ) = 0. for instance. we deﬁne wt ≡ log(wt /w). Closed form solutions for this type of system are not typically available. For this type of variable. We therefore must resort to an approximate solution.e. The technique we will employ here consists in applying a ﬁrst-order Taylor expansion (i. with net interest rates or variables that can take negative values. we deﬁne wt ≡ wt − w. Before linearizing the equilibrium conditions. This is the case. linearizing) the system of equations around the nonstochastic steady state. For any such variable. This is the case. ˆ The linearized version of the equilibrium system can then be written as
Axt+1 = Bxt . The resulting linear system can be readily solved using well-established techniques. for instance. There are a number of techniques that have been devised to solve dynamic systems like the one we are studying. such as the trade balance. It is useful to express some variables in terms of percent deviations from their steady-state value. we introduce a convenient variable transformation. Some other variables are more naturally expressed in levels.

Chapter 4
45
here. The linearized system has three known initial conditions k0 . the elements of A and B. the terminal condition takes the form
j→∞
lim |Et xt+j | = 0. That appendix also shows how to compute second moments and impulse response functions. State variables are variables whose values in any period t ≥ 0 are either predetermined (i. that is. d−1 . ηt . To determine the initial value of the remaining seven variables.
Appendix B shows in some detail how to solve linear stochastic systems like the one describing the dynamics of our linearized equilibrium conditions. and yt . All the coeﬃcients of the linear system. Co-states are endogenous variables whose values are not predetermined in period t. 3 are ˆ state variables. namely. rt . kt .e. In our model. Of these 10 variables. λt . are known functions of the deep structural parameters of the model to which we assigned values when we calibrated the model. ˆ t . and At . ct . are ˆ ˆ h ˆ ˆ co-state variables. determined before ˆ t) or determined in t but in an exogenous fashion. we impose a terminal condition requiring that at any point in time the system be expected to converge to the nonstochastic steady state. kt and ˆ ˆ dt−1 are endogenous state variables and At is an exogenous state variable.Lectures in Open Economy Macroeconomics. it . Formally.
. The remaining 7 elements of xt that is. The vector xt contains 10 variables. dt−1 .. and A0 .

5 1.1 2.8 2.8 -0.15). Standard deviations are measured in percentage points. equilibrium condition (4.31 0.1 2.5 9.3 9.64 0.59 0.46
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Table 4.9
Model ρxt .
4. and the serial correlation of output.2: Empirical and Theoretical Second Moments Variable σx t y c i h
tb y ca y
Canadian Data ρxt .2
The Model’s Performance
Table 4.13 σx t 3.1 1. Empirical moments are taken from Mendoza (1991).3 ρxt .7 0.61 0.7 0. But the model performs relatively well along other dimensions.xt−1 0.61 0. Note in particular that the implied correlation between hours and output is exactly unity. On the downside.GDPt 1 0.54 0.GDPt 1 0.66 1 -0. In eﬀect.2 displays some unconditional second moments of interest implied by our model. For we picked values for the parameters σ .xt−1 0.94 0. it correctly implies a volatility ranking featuring investment above output and output above consumption. and ρ so as to match these three moments. Also in line with the data is the model’s prediction of a countercyclical trade balance-to-output ratio.61 0. φ.07 0.026
Note. the volatility of investment.66 ρxt . the model overestimates the correlations of hours and consumption with output.8 2 1.012 0. For instance. equating the marginal product of
. This prediction is due to the assumed functional form for the period utility index. It should not come as a surprise that the model does very well in replicating the volatility of output.33 0.5 2.

5 −1 0 2 4 6 8 10 1.1: Responses to a Positive Technology Shock
Consumption 2 1. displays the impulse response functions of a number of variables of interest to a technology shock of size 1 in period 0.5 −1 0 2 4 6 8 10 0 2 4 6 Investment 8 10 0. investment. can be written as hω = (1−α)yt . The model predicts an expansion in output.5 0 1 0.5 1 0. and hours.5 1 0. The log-linearized version of this condition t is ω ht = yt . consumption. Chapter 4
47
Figure 4. resulting in a deterioration of the trade balance. which implies that ht and yt are perfectly correlated.1.5 0 1.
.5 1 Output
0
2
4 Hours
6
8
10
0
2
4 6 8 Trade Balance / GDP
10
0
2
4 6 8 Current Account / GDP
10
labor to the marginal rate of substitution between consumption and leisure.5 0 −0.5 0 10 5 0 −5 1 0.Lectures in Open Economy Macroeconomics.5 0 −0. The increase in domestic absorption is larger than the increase in output. Figure 4.

48
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Figure 4. two conditions must be met for the model to generate a deterioration in the external accounts in response to a mean-reverting improvement in total factor productivity. we deduced that the negative response of the trade balance to a positive technology shock was not a general implication of the neoclassical model.2
0
−0. First. In particular.2: Response of the Trade-Balance-To-Output Ratio to a Positive Technology Shock
0. the productivity shock must be suﬃciently persistent.2
−0.6
−0.2 displays the impulse response function of the trade balance-to-GDP ratio to a technology shock of unit size in period 0 under three alternative parameter
.4
0.1
The Role of Capital Adjustment Costs
In previous chapters.6 benchmark high φ low ρ 0. ﬁgure 4.8
0
1
2
3
4
5
6
7
8
9
4. To illustrate this conclusion. Second.4
−0.2. capital adjustment costs must not be too stringent.

The broken line depicts an economy where the persistence of the productivity shock is half as large as in the benchmark economy (ρ = 0.3
Alternative Ways to Induce Stationarity
In the RBC model analyzed thus far households have endogenous discount factors. As a result. because the productivity shock is expected to die out quickly. As a result. the expansion in aggregate domestic absorption is modest. because the size of the productivity shock is the same as in the benchmark economy. ht depends only on kt and At ). At the same time. by equation (4. results in an improvement in the trade balance when productivity shocks are not very persistent. The combination of a weak response in domestic absorption and an unchanged response in output. the temporariness of the shock induces households to save most of the increase in income to smooth consumption over time.1. In addition. In this case.’
. high adjustment costs discourage ﬁrms from increasing investment spending by as much as in the benchmark economy. The solid line reproduces the benchmark case from ﬁgure 4.Lectures in Open Economy Macroeconomics. the response of investment is relatively weak. the initial responses of output and hours are identical in both economies (recall that.21). We will refer to that model as the ‘internal discount factor model. Chapter 4
49
speciﬁcations. a value three times as large as in the benchmark case. The crossed line depicts the case of high capital adjustment costs.
4. the response of aggregate domestic demand is weaker.084. leading to an improvement in the trade balance-to-output ratio. In this environment.15). Here the parameter φ equals 0.

1
External Discount Factor (EDF)
Consider an alternative formulation of the endogenous discount factor model where domestic agents do not internalize the fact that their discount factor depends on their own levels of consumption and eﬀort. Two problems emerge when the linear approximation possesses a unit root. etc. Our analysis follows closely Schmitt-Groh´ and Uribe (2003). such as standard deviations. but expands their analysis by including a e model with an internal interest-rate premium. suppose that the discount factor depends not upon the agent’s own consumption and eﬀort. First. correlations with output.3. In this section. serial correlations.50
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or IDF model. The inclusion of an endogenous discount factor responds to the need to obtain stationary dynamics up to ﬁrst order. Alternatively.
4. which are the most common descriptive statistics of the business cycle. the log-linearized equilibrium dynamics would have contained a random walk component. when the variables of interest contain random walk elements. we analyze and compare alternative ways of inducing stationarity in small open economy models. it is impossible to compute unconditional second moments. but rather on the average per capita levels of these
.. Had we assumed a constant discount factor. Second. one can no longer claim that the linear system behaves like the original nonlinear system— which is ultimately the focus of interest—when the underlying shocks have suﬃciently small supports.

˜ ˜ kt+1 .20) In equilibrium.17)
λt = Uc (ct . ht ) = λt At Fh (kt .2). (4. Formally.19)
λt [1+Φ (kt+1 −kt )] = β(˜t . ct = ct ˜ and ˜ ht = ht . and k0 and the stochastic process { t }.7). it . That is. (4. Chapter 4 variables. which ˜ the individual household takes as given. (4. ht )θt c ˜
t ≥ 0. ht )Et λt+1 At+1 Fk (kt+1 .17)-(4. ct . and
51
θt+1 = β(˜t . ht . individual and average per capita levels of consumption and eﬀort are identical.21)
A competitive equilibrium is a set of processes {dt . d−1 . given A0 . At } satisfying (4.14).
(4.
.16)
˜ where ct and ht denote average per capital consumption and hours.22) (4. ht )
(4. (4.22) all holding with equality.1).4)-(4. ct .18) (4. The ﬁrst-order conditions of the household’s maximization problem are (4.2). rt .13). λt . (4. ht ) −Uh (ct .Lectures in Open Economy Macroeconomics. preferences are described by (4.4)-(4. ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) c ˜ (4. ht )(1 + rt )Et λt+1 c ˜
(4.16) holding with equality and: λt = β(˜t . (4. (4.7). yt . ht .

10). Speciﬁcally.2
External Debt-Elastic Interest Rate (EDEIR)
Under an external debt-elastic interest rate. (4.1).52
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Note that the equilibrium conditions include one Euler equation less.
4. stationarity is induced by assuming that the interest rate faced by domestic agents. preferences are assumed to display a constant subjective rate of discount.23)
where r denotes the world interest rate and p(·) is a country-speciﬁc interest rate premium. Formally. The function p(·) is assumed to be strictly increasing. where β ∈ (0. The economy with a noninternalized discount factor features an externality.
1
.3. is increasing in ˜ the aggregate level of foreign debt. θt = β t . rt . which complicates signiﬁcantly the task of computing the equilibrium by value function iterations. which we denote by dt . These fewer elements facilitate the computation of the equilibrium dynamics using perturbation methods. A similar comment applies to the computation of equilibrium in a model with an interest-rate premium that depends on the aggregate level of extern! al debt to be discussed in the next subsection.1. 1) is a constant parameter. ηt . Preferences are given by equation (4. Unlike in the previous model.1 We evaluate the model using the same functional forms and parameter values as in the IDF model. than the standard endogenous-discountfactor model of subsection 4. and one variable less. equation (4. rt is given by ˜ rt = r + p(dt ).
It is remarkable that the degree of computational complexity is reversed when the computational technique consists in iterating a Bellman equation over a discretized state space.

27) Because agents are assumed to be identical. ct .14). (4. and σ using the values shown in table 4. ht . kt+1 . λt }∞ t=0 satisfying (4. it . that is.1.28) all holding with equality. We set the subjective discount factor equal to the world
. and k0 . and (4.
(4. ht ) = λt . −Uh (ct . rt . ˜ dt = dt . α. r. F .1. We calibrate the parameters γ. ω. dt+1 . We use the following functional form for the risk premium:
¯
p(d) = ψ2 ed−d − 1 . ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) . in equilibrium aggregate per capita debt equals individual debt. ¯ where ψ2 and d are constant parameters.Lectures in Open Economy Macroeconomics. (4.7). given (4. δ. Chapter 4
53
The representative agent’s ﬁrst-order conditions are (4. A0 . and Φ as in the IDF of subsection 4. yt .28)
˜ A competitive equilibrium is a set of processes {dt . φ.4)-(4. ht ) = λt At Fh (kt .4)-(4.24) (4.26)
λt [1+Φ (kt+1 −kt )] = βEt λt+1 At+1 Fk (kt+1 .25) (4.23)-(4. ht ).7) holding with equality and λt = β(1 + rt )Et λt+1 Uc (ct . ρ. d−1 . We adopt the same forms for the functions U .

If follows that in the steady state the interest rate premium is ¯ nil.3
Internal Debt-Elastic Interest Rate (IDEIR)
The model with an internal debt-elastic interest rate assumes that the interest rate faced by domestic agents is increasing in the individual debt position.3. 1+r
¯ The parameter d equals the steady-state level of foreign debt.7442 0. d. note that in steady state. in the IDEIR model the interest rate is given by rt = r + p(dt ). We set d so that the steady-state level of foreign debt equals the one implied by Model 1. the model is identical to the model featuring an external debt-elastic interest rate.3: Model 2: Calibration of Parameters Not Shared With Model 1 ¯ d β ψ2 0. dt .23) and (4. we set the parameter ψ2 so as to ensure that this model and Model 1 generate the same volatility in the current-account¯ to-GDP ratio. To see this.29)
. and ψ2 are given in Table 4.24) together with the assumed form of the interest-rate premium imply that 1 = β 1 + r + ψ2 ed−d − 1
¯
. the equilibrium conditions (4. Finally. The fact that β(1 + r) = 1 then implies
¯ that d = d. that is. Formally. β= 1 . (4.54
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Table 4.000742
interest rate.3. The resulting values of β.96 0.
4. In all other aspects.

is nil in the steady state.
¯ which. ht .27). the marginal country premium. In the household’s problem the only optimality condition that changes relative to the case with an external premium is the Euler equation for debt accumulation.29). However. (4. We assume the same functional forms and parameter values as in the model with an external interest-rate premium.
¯
(1 + d)ed−d = 1.4)-(4. it .7442. given (4.30). rt . as before. (4. given d = 0. Chapter 4
55
where. which now takes the form
λt = β[1 + r + p(dt ) + p (dt )dt ]Et λt+1 . A competitive equilibrium is a set of processes {dt .25)-(4.14). An
.30) imposes the following restriction on d. We note that in the model analyzed in this subsection the steady-state level of debt is no longer equal ¯ to d. Recalling that β(1 + r) = 1. λt }∞ t=0 satisfying (4. given by ∂[ρ(dt )dt ]/∂dt .30)
This expression features the derivative of the premium with respect to debt because households internalize the fact that as they increase their debt positions. so does the interest rate they face in ﬁnancial markets. ¯ The fact that the steady-state debt is lower than d implies that the country premium is negative in the steady state. d−1 .Lectures in Open Economy Macroeconomics.
(4. yields d = 0.7). kt+1 . ct . r denotes the world interest rate and p(·) is a householdspeciﬁc interest-rate premium. and (4. and k0 .4045212. the steady-state version of equation (4. all holding with equality. A0 . yt .

3. that is.4
Portfolio Adjustment Costs (PAC)
In this model.56
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¯ alternative calibration strategy is to impose d = d. 2
dt = (1 + rt−1 )dt−1 − yt + ct + it + Φ(kt+1 − kt ) +
(4.25)-(4.31)
¯ where ψ3 and d are constant parameters deﬁning the portfolio adjustment cost function. In contrast to what is assumed in the EDEIR model. The value of this increase in consumption in terms of utility is given by the left-hand side of the above
.31) holding with equality and ¯ λt [1 − ψ3 (dt − d)] = β(1 + rt )Et λt+1 (4. Preferences and technology are as in the EDEIR model of section 4.5)-(4.30) holds in steady state. In this case. The sequential budget constraint of the household is given by ψ3 ¯ (dt − d)2 .32)
This optimality condition states that if the household chooses to borrow an additional unit.
4.7). the country premium vanishes in the steady state.27). but the marginal premium is positive and equal ¯ to ψ2 d. (4. then current consumption increases by one unit minus the ¯ marginal portfolio adjustment cost ψ3 (dt − d).13) holds.3. The ﬁrst-order conditions associated with the household’s maximization problem are (4. equation (4. here the interest rate at which domestic households can borrow from the rest of the world is constant and equal to the world interest. stationarity is induced by assuming that agents face convex costs of holding assets in quantities diﬀerent from some long-run level. and adjust β to ensure that equation (4. (4.2.

The log-linearized versions of the resource constraints are the same in both models.13). (4. λt }∞ t=0 satisfying (4. As in model 2. We calibrate d so that the steady-state level of foreign debt equals the one implied by models IDF. ht .1. the marginal beneﬁt of a unit debt increase must equal its marginal cost. EDF. ρ. φ. the household must repay the additional unit of debt plus interest. we assign the value 0.25)-(4.13) and (4.32)). A competitive equilibrium is a set of processes {dt . (4.3).23)). Preferences and technology are parameterized as in the EDEIR model. Next period. the Euler equations associated with the optimal choice of foreign bonds (equations (4.14).1 generate the same volatility in the current-account-to-GDP ratio.27).4) and (4.31)).31). r. At the optimum. The value of this repayment in terms of today’s utility is given by the right-hand side. This assumption and equation (4. (4.00074 to ψ3 . δ.5)-(4. given (4. A0 . Chapter 4
57
equation. and σ take the values displayed in table 4.32) imply that the parameter ¯ ¯ ¯ d determines the steady-state level of foreign debt (d = d). the models share all equilibrium conditions but the resource constraint (equations (4. and k0 . yt . ω. Indeed. which ensures that this model and the IDF model of section 4. ct .7). and the interest rate faced by domestic households (equations (4. d−1 . This is because the log-linearized versions of models 2 and 3 are almost identical. α.Lectures in Open Economy Macroeconomics. kt+1 . Finally. This parameter value is almost identical to that assigned to ψ2 in the EDEIR model.24) and (4. The parameters γ. it . the subjective discount factor is assumed to satisfy β(1+r) = 1. rt . and EDEIR (see table 4. and (4.! The log-linear approximation to the domestic interest rate is given by 1 + rt = ψ2 d(1 + r)−1 dt in the EDEIR and by 1 + rt = 0 in the PAC
.32) all holding with equality.

Households are assumed to be subject to a no-Ponzi-game constraint of the form
j→∞
lim Et qt+j bt+j ≥ 0. the log-linearized versions of the Euler equation for debt are λt = ψ2 d(1 + r)−1 dt + Et λt+1 in model 2 and λt = ψ3 ddt + Et λt+1 in Model 3. it follows that 1/[Et rt+1 ] denotes the risk-free real interest rate in period t. Preferences and technology are as in model 2.34)
.5
Complete Asset Markets (CAM)
All model economies considered thus far feature incomplete asset markets. The period-by-period budget constraint of the household is given by
Et rt+1 bt+1 = bt + yt − ct − it − Φ(kt+1 − kt ). In turn.
(4. In the model studied in this subsection.
4. This assumption per se induces stationarity in the equilibrium dynamics.
(4. It follows that for small values of ψ2 and ψ3 satisfying ψ2 = (1 + r)ψ3 the EDEIR and PAC models imply similar dynamics.33)
where rt+1 is a stochastic discount factor such that the period-t price of a random payment bt+1 in period t + 1 is given by Et rt+1 bt+1 . agents have access to a complete array of state-contingent claims.3.58
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model. In those models agents have access to a single ﬁnancial asset that pays a risk-free real rate of return. Note that because Et rt+1 is the price in period t of an asset that pays 1 unit of good in every state of period t + 1.

Letting starred letters denote foreign variables or functions. The variable qt represents the stochastic discount factor between periods 0 and t.25)-(4.36)
Note that we are assuming that domestic and foreign households share the same subjective discount factor. (4. we have
λ∗ rt+1 = βλ∗ . (4. whereas under incomplete markets the above Euler equation holds only in expectations.35)
A diﬀerence between this expression and the Euler equations that arise in the models with incomplete asset markets studied in previous sections is that under complete markets in each period t there is one ﬁrst-order condition for each possible state in period t + 1. We have that qt satisﬁes q t = r 1 r2 .
In the rest of the world.6).33). agents have access to the same array of ﬁnancial assets as in the domestic economy. The ﬁrst-order conditions associated with the household’s maximization problem are (4. r t . Chapter 4
59
at all dates and under all contingencies.35). . Combining the domestic and foreign Euler
. one ﬁrst-order condition of the foreign household is an equation similar to (4. and (4.Lectures in Open Economy Macroeconomics. with q0 ≡ 1.5).27). (4. . t t+1
(4. (4. Consequently.34) holding with equality and λt rt+1 = βλt+1 . such that the period-0 price of a random payment bt in period t is given by E0 qt bt .

φ. it .5).1 and 4. We assume that the domestic economy is small. A0 . The parameters γ. where λ∗ is a parameter. ht . A competitive equilibrium is a set of processes {ct .36)—yields λ∗ λt+1 = t+1 . Formally. F . (4. and (4. and PAC models. given (4. δ. t
where ξ is a constant parameter determining diﬀerences in wealth across countries.37)
. and Φ are parameterized as in the previous models. ω. λt λ∗ t
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This expression holds at all dates and under all contingencies. where ψ4 ≡ ξλ∗ is a constant parameter. This means that the domestic marginal utility of consumption is proportional to its foreign counterpart.6).25)-(4. EDEIR.60 equations—equations (4.37). The parameter ψ4 is set so as to ensure that the steadystate level of consumption is the same in this model as in the IDF. The above equilibrium condition then becomes λ t = ψ4 .3. Because we are interested only t in the eﬀects of domestic productivity shocks. and σ take the values displayed in tables 4. ρ.
λt = ξλ∗ .35) and (4. β. kt+1 . we assume that λ∗ is constant t and equal to λ∗ .14).27). EDF. λt }∞ t=0 satisfying (4. This means that λ∗ must be taken as an exogenous variable. (4. The functions U . yt . (4. and k0 . α.

7). EDEIR.4 displays a number of unconditional second moments of interest implied by the IDF. ct . it .6
The Nonstationary Case (NC)
For comparison with the models considered thus far. Chapter 4
61
4.1. λt }∞ satisfying (4. (b) the interest rate at which domestic agents borrow from the rest of the world is constant (and equal to the subjective discount factor). and NC models. and (d) markets are incomplete in the sense that domestic households have only access to a single risk-free international bond. (c) agents face no frictions in adjusting the size of their portfolios.
.13).3.7
Quantitative Results
Table 4.14). This speciﬁcation of the model induces a random walk component in the equilibrium marginal utility of consumption and the net foreign asset position.24)t=0 (4. given (4. and k0 . CAM. we compute the equilibrium dynamics by solving a loglinear approximation to the set of equilibrium conditions. The Matlab computer code used to compute the unconditional second moments and
2 Model 5 is nonstationary. ht . rt . and (4.27) all holding with equality. IDEIR. We calibrate the model using the parameter values displayed in tables 4.1 and 4.3. EDF. d−1 .
4. In this model (a) the discount factor is constant.Lectures in Open Economy Macroeconomics. in this section we describe a version of the small open economy model that displays no stationarity. (4.4)-(4. A0 . kt+1 . and therefore does not have well deﬁned unconditional second moments. yt . PAC. A competitive equilibrium in the nonstationary model is a set of processes {dt . The appendix shows the log-linear version of the IDF model of subsection 4.2 For all models.3.

IDEIR. The low volatility of consumption in the complete markets model introduces an additional diﬀerence between the predictions of this model and the IDF.3 demonstrates that all of the models being compared imply virtually identical impulse response functions to a technology shock. the model’s predictions regarding second moments are virtually identical. The main result of this section is that regardless of how stationarity is induced. its role in determining the cyclicality of the trade balance is smaller. leads to a smaller decline in the trade balance in the period in which the technology shock occurs. This result is evident from table 4. Each panel shows the impulse response of a particular variable in the six models. Because consumption is smoother in the CAM model. Figure 4. consumption increases less when markets are complete than when markets are incomplete. EDEIR. the complete markets case. and PAC models. the CAM model predicts that the correlation between output and the trade balance is positive. the only small but noticeable diﬀerence is given by the responses of consumption and the trade-balanceto-GDP ratio in the complete markets model.62
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impulse response functions for all models presented in this section is available at www. which as expected predicts less volatile consumption. EDF. In response to a positive technology shock.edu/∼uribe. The only noticeable diﬀerence arises in the CAM model. the impulse response functions are so similar that to the naked eye the graph appears to show just a single line.
.duke. As a result. whereas the models featuring incomplete asset markets imply that it is negative. Again. This in turn.econ. For all variables but consumption and the trade-balance-to-GDP ratio.4.

7 9 2.89 0.66 1 -0.78 0.33 0.61 0.1 2. ct−1 ) corr(it . yt ) corr(ht .3 0.84 0.5 1.66 1 0.67 1 -0.7 0.041
EDEIR 3.07 0.7 9 2.1 2.61 0.6 1.61 0.1 1. cat−1 ) y y
EDF 3.8 1.
. Standard deviations are measured in percent per year.62 0.51 0.7 0. IDF = Internal Discount Factor.3 9.5 0.5 0.62 0. yt−1 ) corr(ct . EDF = External Discount Factor.85 0.1 1.3 9.4: Implied Second Moments IDF Volatilities: std(yt ) std(ct ) std(it ) std(ht ) std( tbtt ) y std( catt ) y corr(yt .76 0.1 1.9 9.07 0. NC = Nonstationary Case.025
IDEIR 3.1 2.32 0.05
PAC 3. yt ) y corr( catt .1 2.5 0.043 0.32 0.62 0. IDEIR = Internal Debt-Elastic Interest Rate. ht−1 )
t−1 corr( tbtt .6
3.1 1.5 9 2. tbt−1 ) y y t−1 corr( catt . EDEIR = External Debt-Elastic Interest Rate.026
Serial Correlations: 0.044 0.Lectures in Open Economy Macroeconomics.31 0.62 0.32 0.069 0.66 1 -0.07 0.61 0.068 0. PAC = Portfolio Adjustment Costs.78 0.1 1.1 2. it−1 ) corr(ht .43 0.62 0.61 0.94 0. yt ) corr(it .1 2.8 1. CAM = Complete Asset Markets. yt ) y 1 0.61 0.5 0.13
Note.67 1 -0.5 0.1 2.94 0.1 2.069 0. Chapter 4
63
Table 4.3 0.39
Correlations with Output: corr(ct .4 0.1 1.61 0.013 0.5 1.036 0.1 1.012 0.68 1 -0. yt ) corr( tbtt .051
CAM 3.62 0.

.5 1 0.5 1 Consumption
0
2
4 Hours
6
8
10
0
2
4 6 8 Trade Balance / GDP
10
0
2
4 6 8 Current Account / GDP
10
Note.5 0 1.5 −1 0 2 4 6 8 10 0 2 4 6 Investment 8 10 0. Dash-dotted line: Portfolio adjustment cost model. Circles: Model without stationarity inducing elements.5 −1 0 2 4 6 8 10 1. Dashed line: Debt-elastic interest rate model.5 0 −0. Dotted line: complete asset markets model.5 0 1 0. Squares: Endogenous discount factor model without internalization.5 0 10 5 0 −5 1 0.3: Impulse Response to a Unit Technology Shock in Models 1 .5 0 −0.5 1 0.64
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Figure 4.5
Output 2 1. Solid line: Endogenous discount factor model.

c
≡
= cUcc /Uc .
= hUch /Uc .
βch
≡ hβch /βc . sc ≡ c/y.
βc cc
≡ cβc /β.
In the log-linearization we are using the particular forms assumed for the
. where cUc /U .
ch
βcc
≡ cβcc /βc . Chapter 4
65
4.4
Appendix A: Log-Linearization
Let xt ≡ log(xt /¯) denote the log-deviation of xt from its steady-state value. stb ≡ tb/y.Lectures in Open Economy Macroeconomics. si = i/y. x Then. taking a ﬁrst-order log-linearization of the model we get: r rt−1 + stb (1 + r)dt−1 − r[yt − sc ct − si it ] 1+r yt = At + αkt + (1 − α)ht kt+1 = (1 − δ)kt + δ it λt = λt = (1 − β) c (1 − β) c − β [
βc
stb dt = stb
r rt + 1+r
cc ct
βc ct
+
βh ht
+ Et λt+1
βc
+
ch ht ]
−
β (1 − β)
c
−β
[ηt +
βc βc ct
βcc ct
+
βch ht ]
ηt = (1 − β)[ c Et ct+1 + (1 − β) h (1 − β) h + β [
βh hc ct + hh ht ]+
h Et ht+1 ]
+ β[Et ηt+1 + [ηt +
βh
+
βh ht ]
β (1 − β)
βh h
+β
βhc ct + βhh ht ]
= λt +At +αkt −αht
λt + φk kt+1 − φk kt =
βc ct
+
βh ht
+ Et λt+1 + β(β −1 + δ − 1)[Et At+1
+(1 − α)Et ht+1 − (1 − α)kt+1 + βφkEt kt+2 − βφk kt+1
rt = 0 ˆ ˆ At = ρAt−1 + t .
βh
≡ hβh /β.

66
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production function and the capital adjustment cost function.
.

Chapter 4
67
4. In addition.5
Appendix B: Solving Dynamic General Equilibrium Models
The equilibrium conditions of the simple real business cycle model we studied in the previous chapter takes the form of a nonlinear stochastic vector diﬀerence equation. the complete set of equi-
. In the previous chapter. it is impossible to solve such systems. xt+1 . yt .38)
where Et denotes the mathematical expectations operator conditional on information available at time t. (Beyond the initial condition. we show how to use the solution to compute second moments and impulse response functions. in general. Reduced forms of this sort are common in Macroeconomics. Here we explain in detail how to solve the resulting system of linear stochastic diﬀerence equations. we introduced one particular strategy. The initial value of the state vector x0 is an initial condition for the economy.Lectures in Open Economy Macroeconomics. consisting in linearizing the equilibrium conditions around the nonstochastic steady state. A problem that one must face is that. The equilibrium conditions of a wide variety of dynamic stochastic general equilibrium models can be written in the form of a nonlinear stochastic vector diﬀerence equation
Et f (yt+1 .
(4. But fortunately one can obtain good approximations to the true solution in relatively easy ways. xt ) = 0. The vector xt denotes predetermined (or state) variables and the vector yt denotes nonpredetermined (or control) variables.

3 The
is assumed to have a bounded support and to be independently
and identically distributed. The vector x1 consists of endogenous predetermined state t t t variables and the vector x2 of exogenous state variables. with mean zero and variance/covariance matrix ˜ I. We deﬁne n = nx + ny .
3 It is straightforward to accommodate the case in which the size of the innovations vector t is diﬀerent from that of x2 .38) is of the form: yt = g (xt ) ˆ and ˆ xt+1 = h(xt ) + ησ
t+1 .
t
are of order n × 1.) The state vector xt can be partitioned as xt = [x1 . σ) + η σ ˜ t+1 t where both the vector x2 and the innovation t vector
t
t+1 . like a no-Ponzi game constraint.68
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librium conditions also includes a terminal condition. x2 ] . The eigenvalues of the Jacobian of the function h with respect to its ﬁrst argument evaluated at the non-stochastic steady state are assumed to lie within the unit circle. t
. The function f then maps Rny × Rny × Rnx × Rnx into Rn . The solution to models belonging to the class given in equation (4.40)
The vector xt of predetermined variables is of size nx × 1 and the vector yt of nonpredetermined variables is of size ny × 1.
(4. We omit such a constraint here because we focus on approximating stationary solutions. Speciﬁcally. we t assume that x2 follows the exogenous stochastic process given by t ˜ x2 = h(x2 .39)
(4.

(4. σ ).
yt = g(xt . σ) + ησ
t+1 . x ¯
Taking a Taylor series approximation of the functions g and h around the point (x. σ) = (¯. σ) and xt+1 = h(xt . By a local approximation. η ˜
69
ˆ The shape of the functions h and g will in general depend on the amount ˆ of uncertainty in the economy.Lectures in Open Economy Macroeconomics. Chapter 4 The matrix η is of order nx × n and is given by ∅ η = .
Given this interpretation.42)
where the function g maps Rnx × R+ into Rny and the function h maps Rnx × R+ into Rnx . x ¯
. that is. The key idea of perturbation methods is to interpret the solution to the model as a function of the state vector xt and of the parameter σ scaling the amount of uncertainty in the economy. σ ) we have (for the moment to keep the notation simple. we mean an approximation that is valid in the neighborhood of a particular point (¯.41)
(4. a perturbation methods ﬁnds a local approximation of the functions g and h.

σ ) + hx (¯. x ¯ ¯ 2 The unknowns of an nth order expansion are the n-th order derivatives of the functions g and h evaluated at the point (¯. . We use a prime to indicate variables dated in period t + 1. σ ). σ). σ )(σ − σ ) x ¯ x ¯ ¯ x ¯ ¯ 1 + hxx (¯. σ) = h(¯. g(x. σ )(x − x)(σ − σ ) x ¯ ¯ x ¯ ¯ ¯ 2 1 + gσσ (¯. σ) ≡ Et f (g(h(x. Formally. h(x.
Here we are dropping time subscripts.43) = 0. σ )(x − x)2 x ¯ ¯ 2 +hxσ (¯. σ.
Fxk σj (x.70 let’s assume that nx=ny=1)
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g(x. σ )(x − x) + gσ (¯. σ )(x − x)(σ − σ ) x ¯ ¯ ¯ 1 + hσσ (¯. σ )(σ − σ ) x ¯ x ¯ ¯ x ¯ ¯ 1 + gxx (¯. . and deﬁne
F (x. σ) = 0
∀x.41) and (4. it must be the case that the derivatives of any order of F must also be equal to zero. σ )(σ − σ )2 + . σ).42) into equation (4. x) (4.
(4. σ )(σ − σ )2 + . σ) + ησ . σ ) + gx (¯. σ )(x − x)2 + gxσ (¯. . substitute the proposed solution given by equations (4. . k.38). x ¯ To identify these derivatives. . σ) = g(¯. Because F (x. σ) + ησ . x ¯ ¯ 2 h(x. σ )(x − x) + hσ (¯. σ) must be equal to zero for any possible values of x and σ. j.44)
.

σ) = g(¯. 0) of the form x
g(x. xt = x ¯ and σ = 0. ¯ x ¯ x then Et f = f . g(¯. note that if σ = 0. We deﬁne the non-stochastic steady state as vectors (¯. a particularly convenient point to approximate the functions g and h around is the non-stochastic steady state. 0)σ x x ¯ x As explained earlier. To see this. x ¯ The remaining unknown coeﬃcients of the ﬁrst-order approximation to g
. y . σ) = (¯. y ¯ ¯ ¯ It is clear that y = g(¯. 0)σ x x ¯ x
h(x. x. 0)(x − x) + gσ (¯. x) = 0. 0) + gx (¯. 0) and x = h(¯. σ) = h(¯. 0)(x − x) + hσ (¯.Lectures in Open Economy Macroeconomics. one can then ﬁnd the derivatives of the function F . The reason why the steady state is a particularly convenient point is that in most cases it is possible to solve for the steady state. As will become clear below. We are looking for approximations to g and h around the point (x. 0) = x. 0) = y x ¯ and h(¯. With the steady state values in hand. Chapter 4
71
where Fxk σj (x. y ) such x ¯ that f (¯. 0) + hx (¯. σ) denotes the derivative of F with respect to x taken k times and with respect to σ taken j times. 0).

0) = 0. σ) ≡ Et f (g(h(x. σ) + ησ . x
one can identify gσ and hσ : hσ fy + f y =0 gσ
fy gx + fx
. 0) = Et fy [gx (hσ + η ) + gσ ] + fy gσ + fx (hσ + η ) x = fy [gx hσ + gσ ] + fy gσ + fx hσ
This is a system of n equations. Then imposing
Fσ (¯. by equation (4. x and x Fx (¯. σ) + ησ . 0) = 0
To ﬁnd those derivatives let’s repeat equation (4.44).
Taking derivative with respect to the scalar σ we ﬁnd:
Fσ (¯. 0) = 0. h(x.72
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and h are identiﬁed by using the fact that. x) = 0. σ). it must be the case that: Fσ (¯. σ). g(x.43)
F (x.

Lectures in Open Economy Macroeconomics.
. Chapter 4
73
This equation is linear and homogeneous in gσ and hσ . Another important question that can in general not be addressed with ﬁrst-order perturbation techniques is how uncertainty aﬀects welfare. we have that hσ = 0. This result implies that in a ﬁrst-order approximation the expected values of xt and yt are equal to their non-stochastic steady-state values x and ¯ y . the policy function is independent of the variance-covariance matrix of
t. Because in many economic applications we are interested in ﬁnding the eﬀect of uncertainty on the economy. up to ﬁrst order. and gσ = 0. one need not correct the constant term of the approximation to the policy function for the size of the variance of the shocks. This question is at the heart of the recent literature on optimal ﬁscal and monetary stabilization policy. ﬁrst-order approximation techniques cannot be used to study risk premia. if a unique solution exists. They show that in general. that is. In this sense. For example. These two expressions represent an important theoretical result. Because in a ﬁrst-order accurate solution the unconditional expectation of a variable is equal to the non-stochastic steady state. Thus. any two policies that give rise to the same steady state yield. Thus. up to ﬁrst-order the mean of the rate of return of all all assets must be same.
This is an important limitation of
ﬁrst-order perturbation techniques. we can say that in a ﬁrst-order approximation the certainty ¯ equivalence principle holds.

43) with respect to x to obtain the following system
Fx (¯. 0) = fy gx hx + fy gx + fx hx + fx x
Note that the derivatives of f evaluated at (y . Note that both A and B are known.
Let xt ≡ xt − x. In this case. x) = (¯. x) are y ¯ ¯ ¯ known. The above expression represents a system of n × nx quadratic equations in the n × nx unknowns given by the elements of gx and hx . x . Imposing
Fx (¯.74 up to ﬁrst-order the same level of welfare. y .
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To ﬁnd gx and hx diﬀerentiate (4. then postmultiplying the above system equation ??) by ˆ ¯ xt we obtain: ˆ
I I A ˆ ˆ h x xt = B xt gx gx Consider for the moment. ˆ ˆ
I I A ˆ ˆ xt+1 = B xt gx gx
. y. a perfect foresight equilibrium. 0) = 0 x
the above expression can be written as:
[fx
I fy ] hx = −[fx gx
I fy ] gx
Let A = [fx
fy ] and B = −[fx
fy ]. x. hx xt = xt+1 .

z = .4 The generalized Schur decomposition of A and B is given by upper triangular matrices a and b and orthonormal matrices q and z satisfying:5 qAz = a and qBz = b. we use the generalized Schur decomposition of the matrices A and B. b = . x Then we have that ast+1 = bst Now partition a. z. b. gx ]ˆt . Let st ≡ z [I.
5 4
s1 t
. In particular.Lectures in Open Economy Macroeconomics. Chapter 4 We are interested in solutions in which
75
t→∞
lim |ˆt | < ∞ x
We will use this limiting conditions to ﬁnd the matrix gx . we will use the Schur decomposition method. To solve the above system. 2 0 a22 0 b22 z21 z22 st
More formal descriptions of the method can be found in Sims (1996) and Klein (2000). and st as a11 a12 b11 b12 z11 z12 a= . st = . Recall that a matrix a is said to be upper triangular if elements aij = 0 for i > j. A matrix z is orthonormal if z z = zz = I.

z12 is of order nx × ny . and that the number of ratios greater than one is equal to the number of state variables. ny . without loss of generality. it ˆ follows that it must be the case that
z12 + z22 gx = 0. t+1 t
or b−1 a22 s2 = s2 . x
Because this condition has to hold for any value of the state vector. (b) the product of two upper triangular matrices is upper triangular. nx . the eigenvalues of b−1 a22 are all less than unity in modulus. by t t+j the deﬁnition of s2 . By construction. that the ratios abs(aii /bii ) are decreasing in i. Then we have that a22 s2 = b22 s2 . Suppose further that the number of ratios less than unity is exactly equal to the number of control variables. t+1 t 22 Assume. 22 the requirement limj→∞ |s2 | < ∞ is satisﬁed only if s2 = 0. (c) The eigenvalues of an upper triangular matrix are the elements of its main diagonal.6 Thus. this restriction implies that t
(z12 + z22 gx )ˆt = 0. and s2 is of t order ny × 1.
6
. In turn.76
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where a22 and b22 are of order ny × ny . (a) The inverse of a nonsingular upper triangular matrix is upper triangular. xt .
Here we are applying a number of properties of upper triangular matrices. Namely.

t+1 t
or s1 = a11 −1 b11 s1 t+1 t Now s1 = (z11 + z21 gx)ˆt . we get
−1 −1
xt+1 = [z11 − z21 z22 ˆ
z12 ]−1 a11 −1 b11 [z11 − z21 z22
z12 ]ˆt . we have s1 = [z11 − z21 z22 t
−1
z12 ]ˆt . x
so that
−1 −1
hx = [z11 − z21 z22
z12 ]−1 a11 −1 b11 [z11 − z21 z22
z12 ].
. x t Replacing gx .Lectures in Open Economy Macroeconomics. x
Combining this expression with the equation describing the evolution of st shown two lines above. Chapter 4 Solving this expression for gx yields
−1
77
gx = −z22
z12 .
The fact that s2 = 0 also implies that t a11 s1 = b11 s1 .

Let’s ﬁrst consider the case that the number of eigenvalues of D with modulus greater than unity is equal to m < ny.78
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We can simplify this expression for hx by using the following restrictions: z11 z11 + z21 z21 z11 z12 + z21 z22 I =zz= z12 z11 + z22 z21 z12 z12 + z22 z22 to write:7
−1 hx = z11 a−1 b11 z11 . But not for every economy this is the case.6
Local Existence and Uniqueness of Equilibrium
In the above discussion. Then this square bracket becomes [z11 + z21 z21 z11 −1 ]. −1 Use this expression to eliminate z22 z12 From the square bracket in the expression for hx . Then the requirement that we wish to study equilibria in which limj→∞ Et |ˆt+j | < ∞ will only yield m restrictions. 11
4. 1) of z z to write z21 z21 = I − z11 z11 . and that the number of eigenvalues of D with modulus greater than one is equal to the number of state variables. we assumed that the number of eigenvalues of D with modulus less than unity is exactly equal to the number of control variables. 1) of z z to get z12 z11 = −1 −1 −1 −z22 z21 . Premultiply by z22 and post multiply by z11 to get z22 z12 = −z21 z11 −1 . ny .
. rather than x ny restrictions. In this case there is a unique local equilibrium. which is less than the number of control variables. nx . Using this equation to eliminate z21 z21 from the expression −1 in square brackets. which is simply z11 . It follows that one can choose arbitrary initial values for ny − m elements of y0 and the resulting ﬁrst order solution will still be
7 To obtain this simple expression for hx . Now use element (1. use element (2. we get [z11 + (I − z11 z11 )z11 −1 ].

In this case. ny .
4. In this case the equilibrium is indeterminate. On the other hand. But this can never be the case. Chapter 4
79
expected to converge back to the steady state. x This implies that m − ny elements of x0 must be functions of the remaining nx − (m − ny ) elements. then no local equilibrium exists. which is given by
xt+1 = hx xt + ση ˆ ˆ
t+1 . Let again m denote the number of eigenvalues of D greater than unity in modulus and assume that m > ny .Lectures in Open Economy Macroeconomics. if the number of eigenvalues of D with modulus greater than unity is greater than the number of control variables. Then in order to ensure that lim Et |ˆt+j | < ∞ we must set m elements of [x0 y0 ] equal to zero. because x0 is a vector of predetermined or exogenous variables and therefore its elements can take arbitrary values.
(4. we say no local equilibrium exists.7
Second Moments
Start with the equilibrium law of motion of the deviation of the state vector with respect to its steady-state value.
.45)
Covariance Matrix of xt Let Σ x ≡ E x t xt ˆˆ denote the unconditional variance/covariance matrix of xt and let ˆ Σ ≡ σ 2 ηη .

where the vec operator transforms a matrix into a vector by stacking its columns.
where F = hx ⊗ hx .
. Thus if the vec operator is applied to both sides of
Σx = hx Σx hx + Σ . B. and the symbol ⊗ denotes the Kronecker product.
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Method 1
One way to obtain Σx is to make use of the following useful result. and C be matrices whose dimensions are such that the product ABC exists. Then vec(ABC) = (C ⊗ A) · vec(B). Let A.80 Then we have that Σ x = h x Σx hx + Σ .
the result is
vec(Σx ) = vec(hx Σx hx ) + vec(Σ ) = F vec(Σx ) + vec(Σ ). We will describe two numerical methods to compute Σx .

called doubling algorithm. Because all eigenvalues of the matrix hx have by construction modulus less than one. One possible drawback of this method is that one has to invert a matrix that has dimension n2 × n2 .0 = I hx.t Σx.t+1 = hx.0
.t+1
.
Σx.t Σ .t + Σ hx.t
=Σ
. it follows that all eigenvalues of F are less than one in modulus.t + Σ Σx. This implies that (I − F) is nonsingular and we can indeed solve for Σx . may be faster than the one described above in cases in which the number of state variables (nx ) is large.0 = hx Σ
.t hx. The eigenvalues of F are products of the eigenvalues of the matrix hx . x x
Method 2 The following iterative procedure.t
= hx.t hx.Lectures in Open Economy Macroeconomics. Chapter 4 Solving the above expression for vec(Σx ) we obtain vec(Σx ) = (I − F)−1 vec(Σ )
81
provided that the inverse of (I −F) exists.t+1 = hx.t Σ
.t hx.

For instance. the co-state. consider the variance covariance matrix of linear combinations of the state vector xt . which we can write as: yt = gx xt . xt has been computed. more generally. or control vector yt is given by yt = y + gx (xt − x). x
for j ≥ 0.
. Then ¯ ¯ ˆ ˆ
E yt yt = Egx xt xt gx ˆˆ ˆ ˆ = gx [E xt xt ]gx ˆ ˆ = gx Σx gx
and. it is easy to ﬁnd other second moments of interest. Consider for instance the covariance matrix E xt xt−j for j > 0. ˆˆ
j−1
E xt xt−j = ˆˆ =
E[hj xt−j xˆ
+
hk µt−k ]ˆt−j x x
k=0 j hx E xt−j xt−j ˆ ˆ
= h j Σx x
Similarly.
E yt yt−j = gx [E xt xt−j ]gx ˆˆ ˆ ˆ = gx hj Σx gx . Let µt = ση t .82 Other second moments
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Once the covariance matrix of the state vector.

Chapter 4
83
4.9
Matlab Code For Linear Perturbation Methods
Stephanie Schmitt-Groh´ and I have written a suite of programs that are e posted on the courses webpage: www. letting x denote the innovation to the state vector in period 0.duke. x = ησ 0 .
The response of the vector of controls yt is given by ˆ IR(ˆt ) = gx ht x.econ. relative to what was expected at time t − 1. Using the law of motion Et xt+1 = hx xt for the ˆ ˆ state vector. and applying the law of iterated expectations we get that the impulse response of the state vector in period t is given by
IR(ˆt ) ≡ E0 xt − E−1 xt = ht [x0 − E−1 x0 ] = ht [ησ 0 ] = ht x. x ˆ ˆ x x x
t ≥ 0.htm.8
Impulse Response Functions
The impulse response to a variable.edu/~uribe/2nd_order.Lectures in Open Economy Macroeconomics. The program gx_hx. say zt in period t + j to an impulse in period t is deﬁned as:
IR(zt+j ) ≡ Et zt+j − Et−1 zt+j
The impulse response function traces the expected behavior of the system from period t on given information available in period t.m computes the matrices gx and hx using the Schur de-
. that is. y x
4.

But higher order approximations are relatively easy to obtain. Schmitt-Groh´ and Uribe (2004) describe in detail how to obtain a e second-order approximation to the solution of the nonlinear system and provide MATLAB code that implements the approximation. Namely. xt ) = 0.10
Higher Order Approximations
In this chapter.m computes second moments. we focused on a ﬁrst-order approximation to the solution of a nonlinear system of stochastic diﬀerence equations of the form Et f (xt+1 . for j > 1 and i < j. obtaining the coeﬃcients of the ith order terms of the appro! ximate solution given all lower-order coeﬃcients involves solving a linear system of equations.m computes impulse response functions. there is a sense in which higher order approximations are simpler than the ﬁrst order approximation. since the coeﬃcients of the linear terms are those of the ﬁrst order approximation.84
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composition method.
4. Indeed. then obtaining the second order approximation requires only to compute the coeﬃcients of the quadratic terms.
. So if the ﬁrst-order approximation to the solution is available. Speciﬁcally. The program ir. the coeﬃcients of the ith term of the jth-order approximation are given by the coeﬃcients of the ith term of the ith order approximation. More importantly. obtaining a higherorder approximation to the solution of the non-linear system is a sequential procedure. The program mom..

Φ. dt . Derive the model’s equilibrium conditions. 3. consumption. F . consumption.1
Exercise
An RBC Small Open Economy with an internal debtelastic interest-rate premium
Consider RBC open economy model with a debt elastic interest rate premium studied in Schmitt-Groh´ and Uribe (SGU) (JIE. Modify the model by assuming that agents internalize the dependence of the interest rate premium on the level of debt. and ψ2 using tables 1 and 2 in SGU. Compare these statistics to those associated with model 2 in SGU (reported in their table 3). section 3. α. Chapter 4
85
4. 2. φ. 1. Use the same forms for the functions U . hours. serial correlation. investment. suppose that the function p(·) depends upon the individual debt position. rather ˜ than on the aggregate per capita level of debt. 4. d. ω. 2003. σ . the trade balance-to-output ratio. and the current account-to-output ratio implied by the model.Lectures in Open Economy Macroeconomics.11. and correlation with output of output. ρ. Compute the unconditional standard deviation. hours. β. and p as in SGU.11
4. Compute the impulse response functions of output. e model 2). δ. r. ¯ Calibrate the parameters γ. dt . Compare these im-
. investment. the trade balance-to-output ratio. Calculate the model’s nonstochastic steady state and compare it to that of model 2 in SGU. and the current account-to-output ratio implied by the model. Speciﬁcally.

duke.econ.86
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Hint: You might ﬁnd it convenient to use as a basis the matlab code associated with the SGU paper. located at www.htm
.edu/~uribe/closing.

Explaining this striking contrast between emerging and industrialized economies is at the top of the research agenda in small-open-economy macroeconomics. (2) that private consumption spending is more volatile than output in emerging countries. the available theoretical explanations fall into two categories: One is that emerging market economies are subject to more volatile shocks than are developed countries. and (3) that the trade-balance-to-output ratio is signiﬁcantly more countercyclical in emerging markets than it is in developed countries. but less volatile than output in developed countries. Broadly. The second category of explanations argues that in emerging countries government policy tends to amplify business-cycle ﬂuctuations whereas in developed countries public policy tends to mitigate aggregate instability.Chapter 5
The Terms of Trade
Three key stylized facts documented in chapter 1 are: (1) that emerging market economies are about twice as volatile as developed economies. This and the following two chapters provide a progress report on the identiﬁcation and quantiﬁcation of exogenous sources of busi87
.

agricultural products.1 displays summary statistics relating the terms of trade to output. In the table. Typically. and the real exchange rate in the postwar era. Letting Ptx and Ptm denote indices of world prices of exports and imports for a particular country.1
Deﬁning the Terms of Trade
The terms of trade are deﬁned as the relative price of exports in terms of imports.
5. Because primary commodities display large ﬂuctuations over time.2
Empirical Regularities
Table 5. Speciﬁcally. The present chapter concentrates on terms-of-trade shocks. emerging countries are normally small players in the world markets for the goods they export or import. Then the real exchange rate is given by Ptc /Ptm .
5. or oil. let Ptc denote a domestic CPI index. A number of empirical regularities emerge from the table:
. At the same time. such as metals. emerging countries specialize in exports of a few primary commodities. the terms of trade can be regarded as an exogenous source of aggregate ﬂuctuations. It follows that for many small countries. the terms of trade for that country are given by tott ≡ Ptx /Ptm . the components of aggregate demand.88
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ness cycles in small open economies. the terms of trade have the potential to be an important source of business cycles in developing countries. the real exchange rate (rer) is deﬁned as the relative price of consumption in terms of importable goods.

The group of developing countries is formed by Argentina. and Japan. and the trade balance. the terms of trade.0 0. Algeria. Germany.52 0. Venezuela.47 0. Saudi Arabia. Italy. The group of oil-exporting countries is formed by Mexico. Indonesia. The group of developed countries is formed by the US. All variables are expressed in percent deviations from a HP trend constructed using a smoothing parameter of 100.42
Source: Mendoza (1995). Philippines. India. rer) Developed Countries 4.67 0.74 0. y) ρ(tot. Chapter 5
89
Table 5.38 0.1: The Terms of Trade and Business Cycles Summary Statistic σ(tot) ρ(tott .0 0. output.70 0.40 0. Brazil.28 0. consumption.50 1. Venezuela. Note: tot. and Nigeria. Mexico.07 Oil Exporting Countries 18. Taiwan. Cameroon.19 0. Korea. c. tables 1 and 3-6.33 0.77 0.Lectures in Open Economy Macroeconomics.34 0. investment. tb) ρ(tot. y. UK. The terms of trade are measured as the ratio of export to import unit values with 1900=100.
.78 0. Chile. tott−1 ) σ(tot)/σ(y) ρ(tot. The sample is 1955 to 1990 at annual frequency. All other variables are measured per capita at constant import prices. c) ρ(tot. and tb denote. i) ρ(tot. i.70 Developing Countries 10. respectively. Canada.40 0. and Thailand.39 0. France.45 0. Peru.30 0.24 0.

6. 4.
5. More than half a century ago. The terms of trade are positively correlated with the real exchange rate. 5. The information provided in table 5. They are twice as procyclical in developed countries as in developing countries. Later in this chapter. 3. 2. The terms of trade display positive but small serial correlation. Harberger (1950) and Laursen
.2. The terms of trade are procyclical. 75 percent as volatile as output in developing countries. The terms of trade are twice as volatile in emerging countries as in developed countries.90
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TOT-TB Correlation: Two Early Explanations
The eﬀects of terms-of-trade shocks on the trade balance is an old subject of investigation. The correlation between the terms of trade and the trade balance is positive but small.1 with the theoretical predictions of a fully speciﬁed dynamic general equilibrium model of the open economy. we attempt to answer this question by combining the empirical information contained in table 5. and they are almost twice as volatile in oil-exporting countries as in developing countries.1 is mute on the importance of terms
of trade shocks in explaining movements in aggregate activity. and 150 percent as volatile as output in oil-exporting countries. This correlation is high for developed countries but almost nil for less developed countries. The terms of trade are half as volatile as output in developed countries.

This view became known as the Obstfeld-Razin-Svensson (ORS) eﬀect.e.
where yt denotes output. concluded that the eﬀect of terms of trade shocks on the trade balance depends crucially on the perceived persistence of the terms of trade. the conclusion that rising terms of trade should be associated with an improving trade balance. gt denotes public consumption.. Consider the following behavioral equations deﬁning the dynamics of each component of aggregate demand. the HLM eﬀect) weakens as the terms of trade become more persistent and may even be overturned if the terms of trade are of a permanent nature. Chapter 5
91
and Metzler (1950) formalized.
The Harberger-Laursen-Metzler Eﬀect A simple way to obtain a positive relation between the terms of trade and the trade balance in the context of a Keynesian model is by starting with the national accounting identity
y t = ct + gt + it + xt − m t . In their model a positive relation between terms of trade and the trade balance (i. This conclusion became known as the Harberger-LaursenMetzler (HLM) eﬀect. This view remained more or less unchallenged until the early 1980s. it denotes private investment. xt denotes exports. within the context of a keynesian model. when Obstfeld (1982) and Svensson and Razin (1983). Public consumption and
. using a dynamic optimizing model of the current account. ct denotes private consumption.Lectures in Open Economy Macroeconomics. Let us look at the HLM and ORS eﬀects in some more detail. and mt denotes imports.

Output as well as all components of aggregate demand are expressed in terms of import goods. 1) and c > 0 are parameters. the value of exports in terms of importables. mt = µyt . the parameters α and µ are referred to as the marginal propensities to consume and import. whereas the term c + g + ¯ is referred to as the autonomous component of ¯ ¯ i domestic absorption. Imports are assumed to be ¯ proportional to output. xt . 1). Consumption is assumed to be ¯ i an increasing linear function of output
ct = c + αyt . Thus. In the jargon of the 1950s.92
Mart´ Uribe ın
private investment are assumed to be independent of output. The quantity of goods exported in period t is denoted by qt . respectively. ¯
with α ∈ (0. where g and ¯ are parameters. For simplicity. with µ ∈ (0. we will assume that these two varibles are constant over time and given by
gt = g ¯
and it = ¯ i. is given by xt = tott qt .
. respectively.

is assumed to be constant and vigen by qt = q . and the quantity of goods exported. we can write 1−α µ(¯ + g + ¯ c ¯ i) ¯ tott q − . as a larger fraction of income is used to buy foreign goods. ¯ where q is a positive parameter. It is worth noting that in the context of this model. gt . this theory implies that an improvement in the terms of trade (an increase in tott ) gives rise to an expansion in the trade surplus. and solving for output yields yt = ¯ c + g + ¯ + tott q ¯ ¯ i . the smaller is the marginal propensity ¯ to import. 1+µ−α 1+µ−α
tbt =
Clearly. the sign of the eﬀect
. q . a larger value of α reduces the TOT multiplier because it exacerbates the endogenous response of aggregate demand to a TOT shock through private consumption. it . qt .Lectures in Open Economy Macroeconomics. This positive relation between the terms of trade and the trade balance is stronger the larger is the volume of exports. The terms of trade are assumed to evolve exogenously. 1+µ−α
Letting tbt ≡ xt − mt denote the trade balance. Using the behavioral equations to eliminate ¯ ct . xt . Similarly. Chapter 5
93
where tott denotes the terms of trade. and the smaller is the marginal propensity to consume α. The reason why µ increases the TOT multiplier is that a higher value of µ weakens the endogenous expansion in aggregate demand to an exogenous increase in exports. µ. and mt from the national income identity.

The household. Suppose that the good the household consumes is diﬀerent from the good it is endowed with. open. with tott taking the place of yt .3) prevents the household from engaging in Ponzi games. endowment economy studied in chapter 2. therefore exports the totality of its endowment and imports the totality of its consumption. The resource constraint is then given by
dt = (1 + r)dt−1 + ct − tott . or the terms of trade. yt = 1 for all t. We can then use the results derived in chapter 2 to draw the
. The economy is small in world product markets.5). Let tott denote the relative world price of exported goods in terms of imported goods.
The Obstfeld-Razin-Svensson Eﬀect The ORS eﬀect is cast within the dynamic optimizing theoretical framework that diﬀers fundamentally from the reduced-form Keynesian model we used to derive the HLM eﬀect.
The borrowing constraint given in (2. This is the main contrast with the Obstfeld-Razin-Svensson eﬀect. so it takes the evolution of tott as exogenous. This is an economy inhabited by an inﬁnitely lived representative household with preferences described by the intertemporal utility function given in (2. The model is therefore identical to the stochastic-endowment economy studied in chapter 2. Assume for simplicity that the endowment of exportable goods is constant and normalized to unity.94
Mart´ Uribe ın
of a TOT shock on the trade balance is independent of whether the terms of trade shocks are permanent or temporary in nature. Consider the small.

When terms of trade are nonstationary. A simple way to do this is to modify the RBC model of chapter 4 by assuming again that households do not consume the good they produce. and the Middle East. shown with circles. Chapter 5
95
following conclusion: if the terms of trade are stationary then an increase in the terms of trade produces an improvement in the current account. Agents save in order to ensure higher future consumption. we should observe that countries experiencing more persistent terms-of-trade shocks should display lower correlations between the terms of trade and the trade balance than countries facing less persistent terms of trade shocks. The
.1 plots the serial correlation of the terms of trade against the correlation of the trade balance with the terms of trade for 30 countries. Africa. In this case. the value of income is expected to grow over time. An increase in the terms of trade produces an improvement in the trade balance if the terms of trade shock is transitory. including the G7 countries and 23 selected developing countries from Latin America. The cloud of points. table 1. This conclusion can be extended to a model with endogenous labor supply and capital accumulation. the productivity shock At can be interpreted as a terms-of-trade shock. The 30 observations were taken from Mendoza (1995).Lectures in Open Economy Macroeconomics. but as the serial correlation of the terms of trade shock increases. displays no pattern. Figure 5. so agents can aﬀord assuming higher current debts without sacriﬁcing future expenditures. In this case. an improvement in the terms of trade can lead to a deterioration in the current account driven by investment expenditures. Is the ORS eﬀect borne out in the data? If so. East Asia. an improvement in the terms of trade induces a trade balance deﬁcit.

2
−0. The solid line is the OLS ﬁt and is given by corr(T B. India.6 −0. 3 countries from the Middle East (Israel.35−0. Peru. The TOT serial correlation and the TB-TOT correlation are computed over the period 1955-1990.2 0. Chile. Korea. Indonesia.
. Sudan.7
Source: Mendoza (1995).96
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Figure 5. table 1. and 8 countries from Africa (Algeria.3 0. Saudi Arabia.8
0. Italy. and Japan).6
0. The dashed-dotted line is the OLS ﬁt after eliminating the G7 countries.14ρ(T OT ). Brazil.4
−0. France. 6 countries from Asia (Taiwan. Kenya.4 TB−TOT Correlation
0. and Tunisia).5
0. (Argentina.1: TOT Persistence and TB-TOT Correlations
0.2
0
−0.28+0. Cameroon.03ρ(T OT ). Venezuela). Note: Each point corresponds to one country. Saudi Arabia. United Kingdom.6
Argentina
0. Canada. Zaire. 6 countries from Latin America. Morocco.4 TOT Serial Correlation
0. T OT ) = 0.1
0. Philippines. Nigeria. T OT ) = 0. and Thailand). and Argentina from the sample and is given by corr(T B. The sample includes the G-7 countries (United States. and Egypt). Mexico. Germany.1
0
0.23 + 0. The dashed line is the OLS ﬁt after eliminating Argentina from the sample and is given by corr(T B.12ρ(T OT ). T OT ) = 0.

1.1 are likely to be large players in the world markets for the goods and services they import and/or export. The ﬁtted line using this reduced sample has a negligible slope equal to 0. the only country in the sample with a negative serial correlation of the terms of trade. shown with a solid line. however. The sign of the slope is indeed in line with the ORS eﬀect: As the terms of trade shocks become more persistent. Argentina. displays a small negative slope of -0. For these countries. Eliminating Argentina from the sample one obtains a positive OLS slope of 0.12. and Saudi Arabia. A number of countries in ﬁgure 5. It is apparent in the graph.
. that the negative slope in the OLS regression is driven by a single observation. they should be expected to induce a smaller response in the trade balance. Countries in this group would include all of the G7 nations. Chapter 5
97
OLS ﬁt of the 30 points. Does this conclusion suggest that the empirical evidence presented here is against the Obstfeld-Razin-Svensson eﬀect? Not necessarily.1. Eliminating these 8 countries (as well as the outlier Argentina) from the sample. Argentina is the only country whose elimination from the sample results in a positive slope. We conclude that the observed relationship between the TB-TOT correlation and the persistence of TOT is close to nil.14.1 The corresponding ﬁtted relationship is shown with a broken line on ﬁgure 5.03 and is shown with a dash-dotted line in ﬁgure 5. The ORS
1 Indeed. the largest economies in the world.Lectures in Open Economy Macroeconomics. the terms of trade are not likely to be exogenous. a major oil exporter. gives us a better idea of what the relation between the TB-TOT correlation and the TOT persistence looks for small emerging countries that take their terms of trade exogenously.

some of these shocks may directly aﬀect both the trade balance and the terms of trade. Moreover. Suppose further that this other country or set of countries generates a substantial fraction of the demand for exports or the supply of imports of the country in question. high world interest rates are associated with contractions in aggregate demand and improvements in the trade balance in emerging countries. as a result. and. low levels of economic activity in the developed world are likely to be associated with a weak demand for primary commodities. of which the terms of trade is just one. In this case. for that matter—is identiﬁcation. Under this scenario. judging the empirical validity of the ORS eﬀect only on the grounds of raw correlations would be misplaced. but attributing all of the movement in the trade balance to changes in the terms of trade would be clearly misleading. The raw data is in principle driven by a multitude of shocks. with deteriorated terms of trade for the emerging countries producing those commodities.98
Mart´ Uribe ın
eﬀect requires isolating the eﬀect of TOT shocks on the trade balance. High world interest rates may be associated with depressed economic activity in developed and emerging economies alike. suppose that domestic technology shocks are correlated with technology shocks in another country or set of countries. A case in point is given by world-interest-rate shocks. the terms of trade and the trade balance are moving at the same time. At the same time. Data analysis based purely on statistical methods will in general not result in a successful iden-
. In turn. As another example. Not controlling for these shocks may result in erroneously attributing part of their eﬀect on the trade balance to the terms of trade. An important step in the process of isolating terms-of-trade shocks—or any kind of shock.

3. The following exercise. Economic theory must be used be at center stage in the identiﬁcation process.Lectures in Open Economy Macroeconomics. a sector producing exportable goods. Similarly. A nontradable good is a good that is neither exportable nor importable.3
Terms-of-Trade Shocks in an RBC Model
Consider expanding the real-business-cycle model of chapter 4 to allow for terms-of-trade shocks. an exportable good is either an exported good or a good that is sold domestically but is highly substitutable with a good that is exported. In doing this. The economy is populated by a large number of identical house-
. Chapter 5
99
tiﬁcation of technology shocks. The household block of the model is identical to that of the standard RBC model studied in chapter 4.1
Households
This block of the model is identical to that of the RBC model studied in chapter 4. and a sector producing nontradable goods. An importable good is either an imported good or a good that is produced domestically but is highly substitutable with a good that is imported. which follows Mendoza (1995). represents an early step in the task of identifying the effects of terms-of-trade shocks on economic activity in emerging economies. The main diﬀerence with the model of chapter 4 is that the model studied here features three sectors: a sector producing importable goods. we follow the work of Mendoza (1995).
5.
5.

(5. ht ). which they rent at the rate ut . The stock of capital evolves according to the following law of motion:
kt+1 = (1 − δ)kt + it − Φ(kt+1 − kt ).
We established in chapter 4 that the endogeneity of the discount factor serves the purpose of rendering the deterministic steady state independent of the country’s initial net foreign asset position.
Households oﬀer labor services for a wage wt and own the stock of capital. kt .1)
where ct denotes consumption.
(5. h) = [1 + c(1 − h)ω ]−β . and U is a period utility function taking the form [c (1 − h)ω ]1−γ .100 holds with preferences described by the utility function
∞
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E0
t=0
θt U (ct . 1−γ
U (c.
(5. ht ). ht denotes labor eﬀort.3)
.2)
where the function β is assumed to take the form
β(c. h) =
The variable θt /θt−1 is a time-varying discount factor and is assumed to evolve according to the following familiar law of motion:
θt+1 = θt β(ct .

The parameter δ ∈ [0. t which serve the role of numeraire.2)(5.5)
The household seeks to maximize the utility function (5. Letting dt denote the debt position assumed by the household in period t and pc t denote the price of the consumption good. and ut are expressed in terms of importable goods. The function Φ introduces capital adjustment costs. Households are subject to a no-Ponzigame constraint of the form Et dt+j ≤ 0. Under these assumptions. the period budget constraint of the household can be written as
dt = (1 + r ∗ )dt−1 + pc ct + it − wt ht − ut kt . Chapter 5
101
where it denotes gross investment. capital adjustment costs help curb the volatility of investment in small open economy models like the one studied here. Households are assumed to be able to borrow or lend freely in international ﬁnancial markets by buying or issuing risk-free bonds denominated in units of importable goods and paying the constant interest rate r ∗ . As discussed in chapter 4.1) subject to (5. j→∞ (1 + r ∗ )j lim
(5. the ﬁrst-order conditions of the household’s maximization problem
. the steady-state level of capital is not aﬀected by the presence of adjustment costs.4). t
(5. which is assumed to be an importable good.2) and (5.5).Lectures in Open Economy Macroeconomics. wt .4)
The relative prices pc . Letting θt ηt and θt λt denote the Lagrange multipliers on (5. 1] denotes the capital depreciation rate. and is assumed to satisfy Φ(0) = Φ (0) = 0 and Φ > 0.

5) holding with equality.8)
λt [1 + Φ (kt+1 − kt )] = β(ct . Firms operate in perfectly competitive product and input markets.11)
with µ > −1. and
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Uc (ct . ht ) + ηt βh (ct .7) (5.10)
5. t t t t t where pT and pN denote. cT . ht+1 ) + Et ηt+1 β(ct+1 . (5. and nontradable consumption goods.4). the relative prices of tradable and t t nontradable consumption goods in terms of importable goods. ht )Et λt+1 ut+1 + 1 − δ + Φ (kt+2 − kt+1 ) (5.2). t t
(5. t t ct = [χ(cT )−µ + (1 − χ)(cN )−µ ]−1/µ . ht ) − ηt βc (ct . They choose output and inputs to maximize proﬁts. ht ) = λt wt λt = β(ct .2
Production of Consumption Goods
The consumption good. cN . respectively. ht )(1 + rt )Et λt+1
(5. ct . ht ) = λt pc t
(5.3. These ﬁrms operate a CES production function that takes tradable consumption goods. ht+1 ) (5. (5.102 are (5. which are given by pc ct − pT cT − pN cN .11)
. as inputs. The ﬁrstorder conditions associated with this proﬁt-maximization problem are (5.9) ηt = −Et U (ct+1 .6)
−Uh (ct . is produced by domestic ﬁrms. Formally.

t t increases.3. one observes that if the elasticity of substitution between tradables and nontradables is less than unity (or µ > 0). via a Cobbt t Douglas production function.
(5. t t t t t
. cX . and exportable consumption goods. From the second optimality condition. t t t increases as the relative price of tradables in terms of consumption.
1 1+µ
(5.12)
1 1+µ
. 1) is a parameter.13)
It is clear from the ﬁrst of these eﬃciency conditions that the elasticity of substitution between tradable and nontradable goods is given by 1/(1 + µ). Firms are competitive and aim at maximizing proﬁts. cM . pT /pc . t t t
(5. given by pT cT /(pc ct ). which are given by
pT cT − pX cX − cM . are produced using importable t consumption goods. Chapter 5 and cN t = cT t ct = cT t 1−χ χ 1 χ
103
1 1+µ
pT t N pt pT t pc t
1 1+µ
.Lectures in Open Economy Macroeconomics. denoted cT .3
Production of Tradable Consumption Goods
Tradable consumption goods.
cT = (cX )α (cM )1−α .
5. Formally. then the share of tradables in total consumption.14)
where α ∈ (0.

t
(5. Exportable.18)
. Note that because the importable good plays the role of numeraire. whereas nontradable goods are produced using labor services only. respectively.3. t
(5.104
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where pX denotes the relative price of exportable goods in terms of imt portable goods.14) and: pX cX t t =α pT cT t t cM t = 1 − α.4
Production of Importable.
5.17)
M M yt = AM (kt )αM . The optimality t conditions associated with this problem are (5. we have that the relative price of importables in terms of the numeraire is always unity (pM = 1). and Nontradable Goods
Exportable and importable goods are produced with capital as the only input. the three production technologies are given by
X X yt = AX (kt )αX . or the terms of trade. This implication is a consequence of the assumption of Cobb-Douglas technology in the production of tradable consumption.16)
These optimality conditions state that the shares of consumption of exportables and importables in total consumption expenditure in tradable goods are constant and equal to α and 1 − α. T cT pt t
(5. Formally.15)
(5.

yt denotes output of imN portable goods. The factors Ai t
denote exogenous and stochastic technology shocks in sectors i = X.
i The variable kt denotes the capital stock in sector i = X. and yt denotes output of nontradable goods. and as a consequence of the assumption of Cobb-Douglas technologies. t t
105
(5.
. X pX yt t M ut kt = αM . N . Firms t demand input quantities to maximize proﬁts. t t t
The optimality conditions associated with this problem are
X ut kt = αX .Lectures in Open Economy Macroeconomics. M yt
(5.21)
and wt hN t = αN .19)
X M where yt denotes output of exportable goods. input shares are constant. and the vari-
able hN denotes labor services employed in the nontradable sector. N pN yt t (5. M . M. Chapter 5 and
N yt = AN (hN )αN . which are given by
X M N X M pX yt + yt + pN yt − wt hN − ut (kt + kt ).22)
According to these expressions.20)
(5.

We assume that all shocks follow autoregressive processes of order one. That is. (4) Innovations to productivity shocks and terms-of-trade shocks are allowed to be correlated.3. (2) The sectorial productivity shocks are assumed to be perfectly correlated. the markets for capital.6
Driving Forces
There are four sources of uncertainty in this economy: One productivity shock in each of the three sectors (importable.3. exportable.
.
(5. and nontradables must clear. t and
N cN = yt .24)
ht = hN . (3) The technology shocks aﬀecting the production of importables and exportables are assumed to be identical.26)
5.5
Market Clearing
In equilibrium. t t t
(5. and nontradable).25)
Also.106
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5. and the terms of trade. t
(5.23) (5. Mendoza (1995) imposes four restrictions on the joint distribution of the exogenous shocks: (1) all four shocks share the same persistence.
X M kt = kt + kt . labor. in equilibrium the evolution of the net foreign debt position of the economy is given by
X M dt = (1 + r ∗ )dt−1 − pX (yt − cX ) − yt + cM + it .

cM .7
Competitive Equilibrium
A stationary competitive equilibrium is a set of stationary processes {ct . kt . t
X M N X M cX . it .
ln AX = ρ ln AX + t t−1 ln AM = ρ ln AM + t t−1 ln AN = ρ ln AN + t t−1
T t
T t .3. given the initial conditions t=0 k0 and d−1 and the exogenous processes {AX . pT . ηt . AN .6)-(5. wt . dt . the parameters ρ and σ
p
are set to match the average serial cor-
. T t . AM . t t t t t t t
λt }∞ satisfying equations (5. kt .3. cT . pX }∞ .
We are now ready to deﬁne a competitive equilibrium. t t t t t=0
5.26). cN . hN . ut .
T 2 T νt ∼ N (0. yt .8
Calibration
Mendoza (1995) presents two calibrations of the model. one matching key macroeconomic relations in developed countries.3) and (5. p t
107
ln pX = ρ ln pX + t t−1
∼ N (0. In calibrating the driving forces of the developed-country version of the model. yt . νt ) = 0. pc . N t . Chapter 5 These assumptions give rise to the following laws of motion:
p t.
= ψT
p t
T + νt . and the other matching key macroeconomic relations in developing countries. σ 2p ). kt .Lectures in Open Economy Macroeconomics. ht . σν T ). E( p . yt .
5. pN . t N t
= ψN
T t .

This implies that
2 2 ψT σ 2p + σν T = 0.165. This implies that ψT σ
p
= 0. Using the information presented in table 1 of Mendoza (1995) yields ρ = 0.165.014.2 displays the parameter values implied by the above restrictions. Mendoza (1995) sets the correlation between the productivity shock in the exportable sector and the terms of trade at 0.473.108
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relation and standard deviation of the terms of trade for the group of G7 countries.014
1 − ρ2 .
2 2 ψT σ 2p + σν T
Table 5. Mendoza (1995) sets the volatility of productivity shocks in the importable and exportable sectors at 0.019 and the volatility of the productivity shock in the nontraded sector at 0. and σ
p
= 0.
and ψN
2 2 ψT σ 2p + σν T = 0.019
1 − ρ2 .
.047
1 − ρ2 . This completes the calibration of the parameters deﬁning exogenous driving forces in the developed-country model.
Based on correlations between Solow residuals and terms of trade in ﬁve developed countries.
Using estimates of productivity shocks in ﬁve industrialized countries by Stockman and Tesar (1995).

028 2.70 0.3 2.04 0.Lectures in Open Economy Macroeconomics.56 0.041 0.017 0.35 0.032 0.74 0.08 0.15 0.04 0.74 0.1 0.2: Calibration Parameter σp σν T ρ ψT ψN r∗ αX αM αN δ φ γ µ α ω β Developed Country 0.5 0.011 0.156 0.41 -0.79 0.1 0.067 0. Chapter 5
109
Table 5.009
.34 0.028 1.49 0.47 0.22 0.57 0.009 Developing Country 0.61 -0.27 0.

12
1 − ρ2 . This yields the restrictions:
2 2 ψT σ 2p + σν T = 0.04
1 − ρ2 .46 to match the observed average standard deviation of GDP and the correlation of GDP with TOT in developing countries.04 and their correlation with the terms of trade at -0.414.74 as in the developed-country model.
and ψT σ
p
= −0.
2 2 ψT σ 2p + σν T
The implied parameter values are shown in table 5.
and σ
p
= 0. This implies:
ρ = 0. This means that the parameter ψN takes the value 0.2.46.
Mendoza (1995) assumes that the standard deviation of productivity shocks in the traded sector are larger than in the nontraded sector by the same proportion as in developed countries. the
parameter ρ and σp are picked to match the average serial correlation and standard deviation of the terms of trade for the group of developing countries reported in table 1 of Mendoza (1995).110
Mart´ Uribe ın In calibrating the driving forces of the developing-country model. Mendoza sets the standard deviation of productivity shocks in the traded sectors at 0. This completes the calibration of the exogenous driving forces for the developing-country version
.

19 .32 .37 .33 .86 C Data 1.44 Model . Chapter 5
111
Table 5.52 .72 .38 .78 .32 1.3.T OT G7 DCs 1 1 .28 .18 .25 .14 .5 GDP Data 1.49 .
.43 .44 .
2
See Mendoza.
of the model.01 I Data 1.94
ρxt .51 .2 also displays the values assigned to the remaining parameters of the model.62 Model 3.9
Model Performance
Table 5.66 .Lectures in Open Economy Macroeconomics.3: Data and Model Predictions Variable
σx σT OT
G7 TOT Data 1 Model 1 TB Data 1.41 .18 -.82 .68 . The following list highlights a number of empirical regularities and comments on the model’s ability to capture them.27 1.2
5.78 .81 .74 .26 .32 -.86 1.23 .57 1 1 .38 .0 RER Data 1.71
ρx.59 Model 1.41 .96 .25 .47 .11 .70 .85 .69 .47 1. 1995 for more details.57 Source: Mendoza
DCs 1 1 1.47 .45 1 1 .39 .49 .79 (1995).90 Model 2.39 .89 .84 .30 .95
ρx.80 .62 .78 .11 1 1 .60 .xt−1 G7 DCs .49 .42 .25
1.12 .58 .03 .08 .70 .69 Model .32 .99 .GDP G7 DCs .3 presents a number of data summary statistics from developed (G7) and developing countries (DCs) and their theoretical counterparts.75 .78 .17 -.67 . Table 5.34 .60 .

6. recall that the parameter ρ is set to pin down the serial correlation of the terms of trade in developing and G7 countries. the terms of trade are procyclical. 4. 5. The model captures this empirical regularity. The trade balance is countercyclical in DCs but procyclical in G7 countries. although much less so in developing countries than in G7 countries. The terms of trade are positively correlated with the trade balance. In the data. but underestimates the TB-TOT correlation. In the model. The model appears to overestimate the countercyclicality of the trade balance. for other authors estimate negative TB-GDP correlations for developed countries. The terms of trade are less volatile than GDP. 2. particularly for developing countries. In the model. the trade balance is countercyclical in both. The model captures this fact relatively well. This fact is matched by construction. The failure of the model to capture the procyclicality of the trade balance in developed countries should be taken with caution. the RER is deﬁned as the relative price of consumption in terms of importables and denoted by pc . 3.112
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1. trade-weighted average of foreign CPIs. In the data. the real exchange rate (RER) is measured as the ratio of the domestic CPI to an exchange-rate-adjusted. In the t
. The model fails to capture this fact. developed and developing countries. The observed terms of trade are somewhat persistent.

When output is measured in terms of domestic prices. the terms of trade explain about 66 percent of output movements. one can run the counterfactual experiment of computing equilibrium dynamics after shutting oﬀ all sources of uncertainty other than the terms of trade themselves. the RER is highly persistent.
5. with an autocorrelation above 0. When the same experiment is performed in the context of the developingcountry version of the model. The reason for this
. The RER is somewhat persistent (with a serial correlation of less than 0. Therefore. shutting oﬀ the variance of the productivity shocks results in an increase in the volatility of output. In the context of the model of this section. The model captures this fact.3. the volatility of output deviations from trend measured at import prices falls from 4. the RER is procyclical.6 percent. Mendoza (1995) ﬁnds that when the volatility of all productivity shocks is set equal to zero in the developed-country version of the model.1 percent to 3. In the model. in the model the terms of trade explain about 88 percent of the volatility of output.Lectures in Open Economy Macroeconomics.75 for both types of country.10
How Important Are the Terms of Trade?
To assess the contribution of the terms of trade to explaining business cycles in developed and developing countries. one must set all productivity shocks at their deterministic steady-state values.45 for both developing and G7 countries). although it overestimates somewhat the RER-GDP correlation. Chapter 5
113
data. 7. This is accomplished by setting σν T = ψT = 0.

114

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increase in output volatility is that in the benchmark calibration the terms of trade are negatively correlated with productivity shocks—note in table 5.2 that ψT < 0 for developing countries. Taking this result literally would lead to the illogical conclusion that terms of trade explain more than 100 percent of output ﬂuctuations in the developing-country model. What is wrong? One diﬃculty with the way we have measured the contribution of the terms of trade is that it is not based on a variance decomposition of output. A more satisfactory way to assess the importance of terms-of-trade and productivity shocks would be to deﬁne the terms of trade shock as

p t

and

T the productivity shock as νt . One justiﬁcation for this classiﬁcation is that p t

aﬀects both the terms of trade and sectoral total factor productivities,

T while νt aﬀects sectoral total factor productivities but not the terms of

trade. Under this deﬁnition of shocks, the model with only terms of trade shocks results when σν T is set equal to zero. Note that the parameter ψT must not be set to zero. An advantage of this approach is that, because the variance of output can be decomposed into a nonnegative fraction explained by

p t T and a nonnegative part explained by νt , the contribution of the terms

of trade will always be a nonnegative number no larger than 100 percent. Exercise 5.1 Using the model presented in this section, compute a variance decomposition of output. What fraction of output is explained by terms-oftrade shocks in the developed- and developing-country versions of the model?

Chapter 6

**Interest-Rate Shocks
**

Business cycles in emerging market economies are correlated with the interest rate that these countries face in international ﬁnancial markets. This observation is illustrated in ﬁgure 6.1, which depicts detrended output and the country interest rate for seven developing economies between 1994 and 2001. Periods of low interest rates are typically associated with economic expansions and times of high interest rates are often characterized by depressed levels of aggregate activity.1 Data like those shown in ﬁgure 6.1 have motivated researches to ask what fraction of observed business cycle ﬂuctuations in emerging markets is due to movements in country interest rate. This question is complicated by the fact that the country interest rate is unlikely to be completely exogenous to the country’s domestic conditions.2 To clarify ideas, let Rt denote the gross

The estimated correlations (p-values) are: Argentina -0.67 (0.00), Brazil -0.51 (0.00), Ecuador -0.80 (0.00), Mexico -0.58 (0.00), Peru -0.37 (0.12), the Philippines -0.02 (0.95), South Africa -0.07 (0.71). 2 There is a large literature arguing that domestic variables aﬀect the interest rate at which emerging markets borrow externally. See, for example, Edwards (1984), Cline

1

115

116

Mart´ Uribe ın

**Figure 6.1: Country Interest Rates and Output in Seven Emerging Countries
**

Argentina 0.15 0.1 0.05 0 −0.05 −0.1 94 95 96 97 98 99 00 01 94 95 96 97 98 Mexico 0.15 0.3 0.1 0.2 0.05 0.1 0 0 94 95 96 97 98 Peru 0.1 0.05 0 −0.05 94 95 96 97 98 99 00 01 0 0.1 99 00 01 −0.05 94 95 96 97 98 99 00 01 99 00 01 0.1 0.05 0 0.15 Brazil

Ecuador 0.4

Philippines

0.05

94

95

96

97

98

99

00

01

South Africa 0.06 0.04 0.02 0 94 95 96 97 98 99 00 01

Output

Country Interest Rate

Note: Output is seasonally adjusted and detrended using a log-linear trend. Country interest rates are real yields on dollar-denominated bonds of emerging countries issued in international ﬁnancial markets. Data source: output, IFS; interest rates, EMBI+. Source: Uribe and Yue (2006).

about the country spread St .e. or the
us country interest rate. borrow and lend from one another. its contribution to generating business cycles is nil. In response to this output increase. consider the following example. and Cline and Barnes (1997). however. Chapter 6
117
interest rate at which the country borrows in international markets. wrongly assumes that the interest rate is purely exogenous. erroneously attributes
(1995). like the U. Suppose now that a domestic productivity shock induces an expansion in output.. Because the interest-rate premium is country speciﬁc. The researcher.
is completely exogenous to the emerging country’s domestic conditions. who believes Rt is exogenous. etc. We can’t say the same. it is reasonable to assume that the world interest rate Rt .. Interpreting the country interest rate as an exogenous variable when in reality it has an endogenous component is likely to result in an overstatement of the importance of interest rates in explaining business cycles. The researcher. Rus denotes the world interest rate. as many emerging
us economies are.S. or the interest rate at which developed countries. If the country in question is a small player in international ﬁnancial markets. Suppose that the interest rate Rt is purely endogenous. a Colombian spread. for instance. To see why. or country interest-rate premium. may induce foreign lenders to lower spreads on believes that the country’s ability to repay its debts has improved. that Rt is countercyclical. and St denotes the gross country interest-rate spread. This interest rate can be expressed as Rt = Rt St .
. in the data we ﬁnd an Argentine spread. Assume. furthermore. the interest rate falls. however. foreign lenders reduce the country spread in response to expansions in aggregate activity. i.Lectures in Open Economy Macroeconomics. Thus.
Here. An increase in output.

1)
where yt denotes real gross domestic output. is that all of the movement in output is due to the productivity shock.
6.1
An Empirical Model
Our empirical model takes the form of a ﬁrst-order VAR system: yt ˆ yt−1 ˆ ˆt−1 ı tbyt−1 ˆ us Rt−1 ˆ Rt−1
y t i t tby t rus t r t
A
ˆt ı tbyt = B ˆ us Rt ˆt R
+
(6. The particular combination adopted in this chapter draws heavily from Uribe and Yue (2006). We measure Rt as the
3-month gross Treasury bill rate divided by the average gross US inﬂation
. it denotes real gross domestic
us investment. Necessarily. A hat on Rt and Rt denotes simply the log. the identiﬁcation process must combine statistical methods and economic theory.118
Mart´ Uribe ın
part of the increase in output to the decline in Rt . tbyt denotes the trade balance to output ratio. and Rt denotes the gross real (emerging) country interest rate. the ﬁrst step is to identify the exogenous components of country spreads and world interest rate shocks. It follows that in order to quantify the macroeconomic eﬀects of interest rate shocks. A hat on yt and it denotes log deviations from a log-linear
us us trend. Rt denotes the
gross real US interest rate. of course. The right conclusion.

it seems reasonable to assume that ﬁnancial markets are able to react quickly to news about the state of the business cycle. t
and
tby t )
aﬀect ﬁnancial
markets contemporaneously. This identiﬁcation strategy is a natural one. t
can equivalently be interpreted as a
Using a more forward looking measure of inﬂation expectations to compute the US real interest rate does not signiﬁcantly alter our main results. for all i = 4). Uribe and Yue (2006) adopt this restriction primarily because it is reasonable to assume that disturbances in a particular (small) emerging country will not aﬀect the real interest rate of a large country like the United States. Chapter 6
119
over the past four quarters.Lectures in Open Economy Macroeconomics. A4i = B4i =
0. P.
. Uribe and Yue (2006) impose the restriction that the matrix A be lower triangular with unit diagus onal elements.3 We measure Rt as the sum of J. Also. 4 Uribe and Yue (2006). conceivably.. is that the world
us interest rate Rt follows a simple univariate AR(1) process (i. this
identiﬁcation strategy presupposes that innovations in world interest rates (
rus ) t
and innovations in country interest rates ( r ) percolate into domestic t
real variables with a one-period lag. At the same time. The country-interest-rate shock. investment. t
i.4 An additional restriction imposed on the VAR system. and the trade balance are seasonally adjusted. decisions such as employment and spending on durable consumption goods and investment goods take time to plan and implement. To identify the shocks in the empirical model. for. Output. Morgan’s EMBI+ stripped spread and the US real interest rate. di! scuss an alternative identiﬁcation strategy consisting in placing ﬁnancial variables ‘above’ real variables ﬁrst in the VAR system. Because Rt and Rt appear at the bottom of the system.
3
r.e. the identiﬁcation scheme implies that real domestic shocks ( y .

the estimated residual of the newly deﬁned bottom equation.1). how and by how much do country spreads move in response to innovations in emerging-country fundamentals? Fourth. t
is identical to
r.2 displays with solid lines the impulse response function implied
. ˆt . how important are US-interest-rate shocks and country-spread shocks in explaining movements in aggregate activity in emerging countries? Fifth. To see this. how do US-interest-rate shocks and country-spread shocks aﬀect real domestic variables such as output. and tbyt associated with ˆ ı with
r. how important are USinterest-rate shocks and country-spread shocks in accounting for movements in country spreads? We answer these questions with the help of impulse response functions and variance decompositions. how do country spreads respond to innovations in US interest rates? Third. Uribe and Yue use it to address a number of questions central to disentangle the eﬀects of country-spread shocks and world-interest-rate shocks on aggregate activity in emerging markets: First. St ≡ Rt −Rt .
us Clearly. t
are identical to those associated
r t
Therefore. t
Moreover. investment. call it
s. consider substituting in equation (6. and the trade balance? Second. it is obvious that the impulse response
s t
functions of yt .
6.120
Mart´ Uribe ın
country spread shock. because Rt appears as a regressor in the bottom equation of the
VAR system. throughout the paper we indistinctly refer to
as a
country interest rate shock or as a country spread shock.1) the ˆ ˆ ˆ ˆ us country interest rate Rt using the deﬁnition of country spread. After estimating the VAR system (6.2
Impulse Response Functions
Figure 6.

and the country spread are expressed in percentage points.6 −0.4 0.3 5 10 15 20 0 −0.2 0 5
Country Spread
10
15
20
Notes: (1) Solid lines depict point estimates of impulse responses.2 −0.2 0.6 0.2 0 5 10 15 20 1 0.4 −0.25 −0.3 0.2 −0. the US interest rate.4 0.Lectures in Open Economy Macroeconomics.2 5 10 15 20 Investment
Trade Balance−to−GDP Ratio 1 0.4 0.6 0.5
10
15
20
Country Interest Rate 1 0. and broken lines depict two-standard-deviation error bands. The two-standard-error bands are computed using the delta method.1 −0.8 −1 −1.5 0.05 −0. Chapter 6
121
Figure 6.8 0.15 −0. the country interest rate.8 0.2: Impulse Response To Country-Spread Shock
Output 0 −0. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends.
.1 0 5 10 15 20 −1 5 0
World Interest Rate
−0. The responses of the Trade Balance-to-GDP ratio.

r. That is.122
Mart´ Uribe ın
by the VAR system (6. output and investment fall. However. t
Broken lines depict two-standard-deviation bands. are qualitatively similar to those associated with an innovation in the country spread. as indicated by the width of the 2-standard-deviation error bands. investment. In the two periods following the country-spread shock. This is reﬂected in the fact that the trade balance improves in the two periods following the shock. the quantitative eﬀects of an innovation in the US interest rate are much more pronounced than those caused by a country-spread disturbance of equal magnitude. The adverse spread shock produces a larger contraction in aggregate domestic absorption than! in aggregate output.3 displays the response of the variables included in the VAR system (6.
. Figure 6. They are unchanged in the period of impact. The half life of the country spread response is about one year. and the trade balance.1) to a one percentage point increase in the US interest rate shock. aggregate activity and gross domestic investment contract. however. and subsequently recover gradually until they reach their pre-shock level. For
5
These bands are computed using the delta method.1) to a unit innovation in the country spread shock.5 In response to an
unanticipated country-spread shock. the country spread itself increases and then quickly falls toward its steady-state level. while net exports improve.
rus . The point estimates of the impulse response functions of output. and the trade balance-to-output ratio respond as one would expect. investment. Output. t
The eﬀects of US interest-rate shocks on domestic variables and coun-
try spreads are measured with signiﬁcant uncertainty. because of our maintained assumption that external ﬁnancial shocks take one quarter to aﬀect production and absorption.

5 2 1.Lectures in Open Economy Macroeconomics.5 −1 5
Country Spread
10
15
20
Notes: (1) Solid lines depict point estimates of impulse responses.5 0 −0.2 0 0 5 10 15 20 5 1 0.6 1 0. the country interest rate. and the US interest rate are expressed in percentage points.3: Impulse Response To A US-Interest-Rate Shock
Output 1 0 0 −1 −0. and broken lines depict two-standard-deviation error bands.5 0.5 0.
.5 1 0.5 0 −0.5 1 0.5 −2 −3 −1 −4 −5 −1.8
World Interest Rate
10
15
20
Country Interest Rate 3 2.5 2 1.5 5 10 15 20 2. The responses of the Trade Balance-to-GDP ratio. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends.5 5 10 15 20 −6 5 10 15 20 Investment
Trade Balance−to−GDP Ratio 2 1.4 0. Chapter 6
123
Figure 6.

Thus. In eﬀect. Figure 6. The response of output. investment. The overshooting of country spreads is responsible for the much larger response of domestic variables to an innovat! ion in the US interest rate than to an innovation in the country spread of equal magnitude. The negative impact eﬀect is in line with the ﬁndings of Eichengreen and Mody (1998) and Kamin and Kleist (1999). They can reﬂect variations in total factor productivity. As a result. the terms-oftrade. that because the models estimated by these authors are static in nature.1). the country spread initially falls. the trough in the output response is twice as large under a USinterest-rate shock than under a country-spread shock.
y t. they are unable to capture the rich dynamic relation linking these two variables. The model is vague about the precise nature of output shocks. We note.124
Mart´ Uribe ın
instance. However. by construction. however. country spreads increase signiﬁcantly in response to innovations in the US interest rate but with a short delay. and the trade balance is very much in line with the impulse response to a positive productivity shock implied by the small open economy RBC model (see ﬁgure 4. The response of investment is about three times as large as that
.
impinge upon the variables of
our empirical model. etc.4 depicts the impulse response function to a one-percent increase in the output shock. It is remarkable that the impulse response function of the country spread to a US-interest-rate shock displays a delayed overshooting. the country spread recovers quickly and after a couple of quarters it is more than one percentage point above its pre-shock level. We now ask how innovations in output. in the period of impact the country interest rate increases but by less than the jump in the US interest rate.

4 −0.5
World Interest Rate
−0.2 −0.4 −0.6 −0. the country interest rate.2 −0.2 −0.Lectures in Open Economy Macroeconomics.4: Impulse Response To An Output Shock
Output 1 3 0.8 5 10 15 20 0 −0.4 −0.5 Investment
Trade Balance−to−GDP Ratio 1 0 −0.3 −0.1 −0. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends.2 0 5 10 15 20 0.5 2 1. and broken lines depict two-standard-deviation error bands.5
10
15
20
Country Interest Rate 0 −0.8 5
Country Spread
10
15
20
Notes: (1) Solid lines depict point estimates of impulse response functions. and the US interest rate are expressed in percentage points.5 0 5 10 15 20 2.8 0. The responses of the Trade Balance-to-GDP ratio.6 −0. Chapter 6
125
Figure 6.6 0.5 5 10 15 20 −1 5 0 0.
.4 1 0.

The countercyclical behavior of the country spread in response to output shocks suggests that country interest rates behave in ways that exacerbates the business-cycle eﬀects of output shocks. t
Because
rus t
and
r t
are orthogonal disturbances. Solid lines show the fraction of the variance of the forecasting error explained jointly by US-interest-rate shocks and country-spread shocks (
rus t
and
r ). The half life of the country spread response is about ﬁve quarters.
6. the increase in output produces a signiﬁcant reduction in the country spread of about 0. t
Broken lines depict the
fraction of the variance of the forecasting error explained by US-interestrate shocks (
rus ).5 displays the variance decomposition of the variables contained in the VAR system (6.126
Mart´ Uribe ın
of output. the trade balance deteriorates signiﬁcantly by about 0. the
vertical diﬀerence between the solid line and the broken line represents the variance of the forecasting error explained by country-spread shocks at dif-
.4 percent and after two quarters starts to improve.1) at diﬀerent horizons. At the same time. More interestingly.3
Variance Decompositions
Figure 6. converging gradually to its steady-state level.6 percent.

Lectures in Open Economy Macroeconomics, Chapter 6

127

**Figure 6.5: Variance Decomposition at Diﬀerent Horizons
**

Output 0.3 0.25 0.25 0.2 0.15 0.1 0.05 0 0.2 0.15 0.1 0.05 5 10 15 quarters 20 0 5 10 15 quarters World Interest Rate 2 0.4 1.5 0.3 1 20 Investment

Trade Balances−to−GDP Ratio

0.2

0.1

0.5

0

5

10 15 quarters Country Interest Rate

20

0

5

10 15 quarters Country Spread

20

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 5 10 15 quarters 20

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 5 10 15 quarters 20

rus

rus

+

r

Note: Solid lines depict the fraction of the variance of the kquarter-ahead forecasting error explained jointly by rus and r t t at diﬀerent horizons. Broken lines depict the fraction of the variance of the forecasting error explained by rus at diﬀerent t horizons.

128

Mart´ Uribe ın

ferent horizons.6,7 Note that as the forecasting horizon approaches inﬁnity, the decomposition of the variance of the forecasting error coincides with the decomposition of the unconditional variance of the series in question. For the purpose of the present discussion, we associate business-cycle ﬂuctuations with the variance of the forecasting error at a horizon of about ﬁve years. Researchers typically deﬁne business cycles as movements in time series of frequencies ranging from 6 quarters to 32 quarters (Stock and Watson, 1999). Our choice of horizon falls in the middle of this window. According to our estimate of the VAR system given in equation (6.1), innovations in the US interest rate,

rus , t

explain about 20 percent of move-

ments in aggregate activity in emerging countries at business cycle frequency. At the same time, country-spread shocks,

r, t

account for about 12 percent of

6 ˆ us ˆ These forecasting errors are computed as follows. Let xt ≡ [ˆt ˆt tbyt Rt Rt ] be the y ı vector of variables included in the VAR system and t ≡ [ y i tby !rus r ] the vector of t t t t t disturbances of the VAR system. Then, one can write the MA(∞) representation of xt as xt = ∞ Cj t−j , where Cj ≡ (A−1 B)j A−1 . The error in forecasting xt+h at time t j=0 for h > 0, that is, xt+h − Et xt+h , is given by h Cj t+h−j . The variance/covariance j=0 h matrix of this h-step-ahead forecasting error is given by Σx,h ≡ j=0 Cj Σ Cj , where Σ is the (diagonal) variance/covariance matrix of t . Thus, the variance of the h-stepahead forecasting error of xt is simply the vector containing the diagonal elements of Σx,h . In turn, the variance of the error of the h-step-ahead forecasting error of xt due to rus ,h a particular shock, say rus , is given by the diagonal elements of the matrix Σx, ≡ t !h (Cj Λ4 )Σ (Cj Λ4 ) , where Λ4 is a 5×5 matrix with all elements equal to zero except j=0 element (4,4), which takes the value one. Then, the broken lines in ﬁgure 6.5 are given by rus ,h the element-by-element ratio of the diagonal elements of Σx, to the diagonal elements x,h of the matrix Σ for diﬀerent values of h. The diﬀerence between the solid lines and the broken lines (i.e., the fraction of the variance of the forecasting error due to r ) is t computed in a similar fashion but using the matrix Λ5 . 7 We observe that the estimates of y , i , tby , and r (i.e., the sample residuals of t t t t the ﬁrst, second, third, and ﬁfth equations of the VAR system) are orthogonal to each us other. But because yt , ˆt , and tbyt are excluded from the Rt equation, we have that ˆ i rus the estimates of t will in general not be orthogonal to the! estimates of y , i , or tby . t t t However, under our maintained speciﬁcation assumption that the US real interest rate does not systematically respond to the state of the business cycle in emerging countries, this lack of orthogonality should disappear as the sample size increases.

Lectures in Open Economy Macroeconomics, Chapter 6

129

aggregate ﬂuctuations in these countries. Thus, around one third of business cycles in emerging economies is explained by disturbances in external ﬁnancial variables. These disturbances play an even stronger role in explaining movements in international transactions. In eﬀect, US-interest-rate shocks and country-spread shocks are responsible for about 43 percent of movements in the trade balance-to-output ratio in the countries included in our panel. Variations in country spreads are largely explained by innovations in US interest rates and innovations in country-spreads themselves. Jointly, these two sources of uncertainty account for about 85 percent of ﬂuctuations in country spreads. Most of this fraction, about 60 percentage points, is attributed to country-spread shocks. This last result concurs with Eichengreen and Mody (1998), who interpret this ﬁnding as suggesting that arbitrary revisions in investors sentiments play a signiﬁcant role in explaining the behavior of country spreads. The impulse response functions shown in ﬁgure 6.4 establish empirically that country spreads respond signiﬁcantly and systematically to domestic macroeconomic variables. At the same time, the variance decomposition performed in this section indicates that domestic variables are responsible for about 15 percent of the variance of country spreads at business-cycle frequency. A natural question raised by these ﬁndings is whether the feedback from endogenous domestic variables to country spreads exacerbates domestic volatility. Here we make a ﬁrst step at answering this question. ˆ Speciﬁcally, we modify the Rt equation of the VAR system by setting to zero the coeﬃcients on yt−i , ˆt−i , and tbyt−i for i = 0, 1. We then compute ˆ i

In particular. tbyt and Rt in the modiﬁed VAR system ˆ i at business-cycle frequency (20 quarters). Std. Dev. We follow this route next. As such.7696
ˆ the implied volatility of yt .5198 tby R 6. this counterfactual exercise is subject to Lucas’ (1976) celebrated critique. In eﬀect. the results of table 6.3846 3. Table 6. y ˆ 3.130
Mart´ Uribe ın
Table 6.4955 4. Of course.
.1060 11.1 shows that the presence of feedback from domestic variables to country spreads signiﬁcantly increases domestic volatility. the volatility of the country interest rate falls by about one third. ˆt .1 serve solely as a way to motivate a more adequate approach to the question they aim to address.1: Aggregate Volatility With and Without Feedback of Spreads from Domestic Variables Model Variable Feedback No Feedback Std. We compare these volatilities to those emerging ! from the original VAR model.0674 ˆ ı 14. the volatility of output falls by 16 percent and the volatility of investment and the trade balance-to-GDP ratio fall by about 20 percent. For one should not expect that in response to changes in the coeﬃcients deﬁning the spread process all other coeﬃcients of the VAR system will remain unaltered. when we shut oﬀ the endogenous feedback. when feedback is negated. The eﬀect of feedback on the cyclical behavior of the country spread itself is even stronger. This more satisfactory approach necessarily involves the use of a theoretical model economy where private decisions change in response to alterations in the country-spread process.9260 4. Dev.6450 3.

Lectures in Open Economy Macroeconomics, Chapter 6

131

6.4

A Theoretical Model

The process of identifying country-spread shocks and US-interest-rate shocks involves a number of restrictions on the matrices deﬁning the VAR system (6.1). To assess the plausibility of these restrictions, it is necessary to use the predictions of some theory of the business cycle as a metric. If the estimated shocks imply similar business cycle ﬂuctuations in the empirical as in theoretical models, we conclude that according to the proposed theory, the identiﬁed shocks are plausible. Accordingly, we will assess the plausibility of our estimated shocks in four steps: First, we develop a standard model of the business cycle in small open economies. Second, we estimate the deep structural parameters of the model. Third, we feed into the model the estimated version of the fourth and ﬁfth equations of the VAR system (6.1), describing the stochastic laws of motion of the US interest rate and the country spread. Finally, we compare estimated impulse responses (i.e., those shown in ﬁgures 6.2 and 6.3) with those implied by the proposed theoretical framework. The basis of the theoretical model presented here is the standard neoclassical growth model of the small open economy (e.g., Mendoza, 1991). We depart from the canonical version of the small-open-economy RBC model along four dimensions. First, as in the empirical model, we assume that in each period, production and absorption decisions are made prior to the realization of that period’s world-interest-rate shock and country-spread shock. Thus, innovations in the world interest rate or the country spread are assumed to have allocative eﬀects with a one-period lag. Second, preferences are as-

132

Mart´ Uribe ın

sumed to feature external habit formation, or catching up with the Joneses as in Abel (1990). This feature improves the predictions of the standard model by preventing an excessive contraction in private non-business absorption in response to external ﬁnancial shocks. Habit formation has been shown to help explain asset prices and business ﬂuctuations in both developed economies (e.g., B! oldrin, Christiano, and Fisher, 2001) and emerging countries (e.g., Uribe, 2002). Third, ﬁrms are assumed to be subject to a working-capital constraint. This constraint introduces a direct supply side eﬀect of changes in the cost of borrowing in international ﬁnancial markets, and allows the model to predict a more realistic response of domestic output to external ﬁnancial shocks. Fourth, the process of capital accumulation is assumed to be subject to gestation lags and convex adjustment costs. In combination, these two frictions prevent excessive investment volatility, induce persistence, and allow for the observed nonmonotonic (hump-shaped) response of investment in response to a variety of shocks (see Uribe, 1997).

6.4.1

Households

Consider a small open economy populated by a large number of inﬁnitely lived households with preferences described by the following utility function

∞

E0

t=0

β t U (ct − µ˜t−1 , ht ), c

(6.2)

where ct denotes consumption in period t, ct denotes the cross-sectional ˜ average level of consumption in period t, and ht denotes the fraction of time devoted to work in period t. Households take as given the process

Lectures in Open Economy Macroeconomics, Chapter 6

133

for ct . The single-period utility index U is assumed to be increasing in its ˜ ﬁrst argument, decreasing in its second argument, concave, and smooth. The parameter β ∈ (0, 1) denotes a subjective discount factor, and the parameter µ measures the intensity of external habit formation. Households have access to two types of asset, physical capital and an internationally traded bond. The capital stock is assumed to be owned entirely by domestic residents. Households have three sources of income: wages, capital rents, and interest income bond holdings. Each period, households allocate their wealth to purchases of consumption goods, purchases of investment goods, and purchases of ﬁnancial assets. The household’s periodby-period budget constraint is given by

dt = Rt−1 dt−1 + Ψ(dt ) + ct + it − wt ht − ut kt ,

(6.3)

where dt denotes the household’s debt position in period t, Rt denotes the gross interest rate faced by domestic residents in ﬁnancial markets, wt denotes the wage rate, ut denotes the rental rate of capital, kt denotes the stock of physical capital, and it denotes gross domestic investment. We assume that households face costs of adjusting their foreign asset position. We introduce these adjustment costs with the sole purpose of eliminating the familiar unit root built in the dynamics of standard formulations of the small open economy model. The debt-adjustment cost function Ψ(·) is assumed ¯ ¯ ¯ to be convex and to satisfy Ψ(d) = Ψ (d) = 0, for some d > 0. Earlier in chapter 4, we compared a number of standard alternative ways to induce stationarity in the small open economy framework, including the one used

They capture funds from foreign investors at the country rate Rt d and lend to domestic agents at the rate Rt . 2.
8
. the evolution of sit is given by
si+1t+1 = sit .8 The process of capital accumulation displays adjustment costs in the form of gestation lags and convex costs as in Uribe (1997).
(6. dt . that are increasing and convex in the volume of intermediation. The
The debt adjustment cost can be decentralized as follows. Bank proﬁts are assumed to be distributed to domestic households in a lump-sum fashion. 1. 1) denotes the rate of depreciation of physical capital. In addition. Then investment in period t is given by 1 4
3
it =
sit .6)
where δ ∈ (0.4)
In turn. banks face operational costs. Suppose there is a continuum of banks of measure one that behave competitively. This digression will be of use later in the paper when we analyze the ﬁrm’s problem. The problem of domestic banks is then to choose the volume dt so as to maximize proﬁts.
(6. 3.134
Mart´ Uribe ın
here. taking as given Rt and Rt . and conclude that they all produce virtually identical implications for business ﬂuctuations! .
i=0
(6. which are d d given by Rt [dt − Ψ(dt )] − Rt dt . It follows from the ﬁrst-order condition associated with this problem that the interest rate charged to domestic residents d R is given by Rt = 1−Ψ t(dt ) . Producing one unit of capital good requires investing 1/4 units of goods for four consecutive periods. Suppose that ﬁnancial transactions between domestic and foreign residents require ﬁnancial intermediation by domestic institutions (banks). Let sit denote the number of investment projects started in t − i for i = 0.10) below). which is precisely the shadow interest rate faced by domestic agents in the centralized problem (see the Euler condition (6.5)
The stock of capital obeys the following law of motion: s3t kt
kt+1 = (1 − δ)kt + kt Φ
. Ψ(dt ).

investment projects. adjustment costs are a convenient and plausible way to avoid excessive investment volatility in response to changes in the interest rate faced by the country in international markets.Lectures in Open Economy Macroeconomics. 2. ht+1 .2) subject to the budget constraint (6. R−1 d−1 . the laws of motion of total investment. Rt .
where λt .t+1 .3). The introduction of capital adjustment costs is commonplace in models of the small open economy. dt+1 }∞ so as to t=0 maximize the utility function (6. Households choose contingent plans {ct+1 . and sit for c t=0 i = 0. h0 .4)-(6. Chapter 6
135
process of capital accumulation is assumed to be subject to adjustment costs. ut }∞ as well as c0 . and λt qt are the Lagrange multipliers associated with con-
. These last two assumptions ensure the absence of adjustment costs in the steady state and that the steady-state level of investment is independent of Φ. and the capital stock given by equations (6. The Lagrangian associated with the household’s optimization problem can be written as:
∞
L = E0
t=0
β
t
U (ct − µ˜t−1 . which is assumed to be strictly increasing. k0 . The household takes as given the processes {˜t−1 .7)
that prevents the possibility of Ponzi schemes.6). and to satisfy Φ(δ) = δ and Φ (δ) = 1. λt νit . wt . ht ) + λt c s3t kt
1 dt − Rt−1 dt−1 − Ψ(dt ) + wt ht + ut kt − 4
2
3
sit − ct
i=0
+
λt qt (1 − δ)kt + kt Φ
− kt+1 + λt
i=0
νit (sit − si+1t+1 ) . 1. as deﬁned by the function Φ. s0. concave. 3. As discussed in chapters 3 and 4. and a borrowing constraint of the form dt+j+1
j s=0 Rt+s
j→∞
lim Et
≤0
(6.

8) (6.6).8) states that in period t households choose consumption and leisure for period t + 1 in such as way as to equate the marginal utility of consumption in period t + 1 to the expected marginal utility of wealth in that period. by equating
. ht+1 ) λt 1 − Ψ (dt ) = βRt Et λt+1 1 Et λt+1 ν0t+1 = Et λt+1 4 βEt λt+1 ν1t+1 = βEt λt+1 ν2t+1 = βEt λt+1 qt+1 Φ λt qt = βEt λt+1 qt+1 1 − δ + Φ β Et λt+1 + λt ν0t 4 β Et λt+1 + λt ν1t 4 = β Et λt+1 + λt ν2t 4 s3t+1 Φ kt+1 s3t+1 kt+1 (6. and (6. Equation (6.14)
s3t+1 kt+1 s3t+1 kt+1
−
+ λt+1 ut+1 . the variables ct+1 .9) deﬁnes the household’s labor supply schedule.11) (6. respectively.3). (6. because of our assumed information structure. Note that in general the marginal utility of wealth will diﬀer from the marginal utility of consumption (λt = Uc (ct − µ˜t−1 . ht+1 ) c c Et [wt+1 λt+1 ] = −Uh (ct+1 − µ˜t .13) (6.7) all holding with equality and Et λt+1 = Uc (ct+1 − µ˜t .136
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straints (6.3). The optimality conditions associated with the household’s problem are (6.5). (6. and s0t+1 all reside in the information set of period t. Equation (6.15)
It is important to recall that.4)-(6. bec cause current consumption cannot react to unanticipated changes in wealth. Et λt+1 . (6. ht+1 .10) (6.12) (6. ht )).9) (6.

because of the presence of frictions to adjust bond holdings. providing further incentives for households to save. say.10) is an asset pricing relation equating the intertemporal marginal rate of substitution in ! consumption to the rate of return on ﬁnancial assets. Chapter 6
137
the marginal disutility of eﬀort in period t + 1 to the expected utility value of the wage rate in that period. ht ). Note that. Equation (6. equation (6. Equation (6. to the discounted value of renting the unit of capital for one period and then selling it. or Tobin’s Q. qt .Lectures in Open Economy Macroeconomics.
yt = F (kt .14) links the cost of producing a unit of capital to the shadow price of installed capital. we have that Ψ (dt ) > 0 so that the shadow rate of return is higher than the market rate of return. It equates the revenue from selling one unit of capital today. Equations (6. when the household’s debt position ¯ is. Finally.16)
.4. above its steady-state level d. thereby reducing their debt positions. net of depreciation and adjustment costs. ut+1 + qt+1 . The price of an investment project in its ith quarter of gestation equals the price of a project in the i-1 quarter of gestation plus 1/4 units of goods.2
Firms
Output is produced by means of a production function that takes labor services and physical capital as inputs.13) show how to price investment projects at diﬀerent stages of completion. Intuitively. qt .
6.15) is a pricing condition for physical capital.11)-(6.
(6. the relevant rate of return on this type of asset is not simply the market rate Rt but rather the shadow rate of return Rt /[1 − Ψ (dt )].

Formally.
d The interest rate Rt will in general diﬀer from the country interest rate
Rt —the interest rate that domestic banks face in international ﬁnancial markets—because of the presence of debt-adjustment costs. and Rt ≡
Rt 1−Ψ (dt )
is the
interest rate faced by nonﬁnancial domestic agents. ht ) + wt ht + ut kt + πt − κt−1 + κt . Deﬁne the ﬁrm’s total net liabilities at the end of period t as at =
d Rt df − κt . evolves according to the t following expression
d df = Rt−1 df − F (kt . denoted by df . and concave. Firms hire labor and capital services from perfectly competitive markets. as shown in footnote 8. t t−1
d where πt denotes distributed proﬁts in period t. Then.
η ≥ 0. increasing in both arguments. we can rewrite the above expression as t d Rt − 1 d Rt
at = at−1 − F (kt .
where κt denotes the amount of working capital held by the representative ﬁrm in period t.138
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where the function F is assumed to be homogeneous of degree one.
. the working-capital constraint takes the form
κt ≥ ηwt ht . ht ) + wt ht + ut kt + πt + Rt
κt . The production process is subject to a working-capital constraint that requires ﬁrms to hold non-interest-bearing assets to ﬁnance a fraction of the wage bill each period. The debt position of the ﬁrm.

(6. This implies that the working-capital constraint will always bind.
The ﬁrm’s objective is to maximize the present discounted value of the stream of proﬁts distributed to its owners. and kt so as to maximize
∞
E0
t=0
βt
λt λ0
at − at−1 + F (kt . So we can use the working-capital constraint holding with equality to eliminate κt from the above expression to get at = at−1 − F (kt .Lectures in Open Economy Macroeconomics. λ0
We use the household’s marginal utility of wealth as the stochastic discount factor because households own domestic ﬁrms.17)
It is clear from this expression that the assumed working-capital constraint
d d increases the unit labor cost by a fraction η(Rt − 1)/Rt . which would be suboptimal. for otherwise the ﬁrm would incur in unnecessary ﬁnancial costs. which is increasing d in the interest rate Rt .
∞
max E0
t=0
βt
λt πt . ht ) + wt ht 1 + η d Rt
d Rt − 1 d Rt
+ u t kt + π t .
subject to a no-Ponzi-game borrowing constraint of the form at+j j d s=0 Rt+s
j→∞
lim Et
≤ 0.17) to eliminate πt from the ﬁrm’s objective function the ﬁrm’s problem can be stated as choosing processes for at . ht .
. Using constraint (6. Chapter 6
139
We will limit attention to the case in which the interest rate is positive at all times. the domestic residents. ht ) − wt ht 1 + η d Rt
d Rt − 1 d Rt
− u t kt . That is.

dt represents the country’s net debt position.
9
. ht ) − wt ht 1 + η
− u t kt
In this case.
(6. We assume that ﬁrms start out with no liabilities.
The precise form taken by this wedge depends on the particular timing assumed in modeling the use of working capital.17). or the higher the intensity of the working capital constraint. ht ) = wt 1 + η
(6. (Rt − d 1)/Rt . Here we adopt the shopping-time timing. the no-Ponzi-game constraint holding with equality. under a cashd in-advance timing the wedge takes the form 1 + η(Rt − 1). an optimal plan consists in holding no liabilities at all times (at = 0 for all t ≥ 0).140
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The ﬁrst-order conditions associated with this problem are (6. as well as the amount of debt intermediated by local banks. Alternative assumptions give rise to diﬀerent speciﬁcations of the wedge. This distortion is
d larger the larger the opportunity cost of holding working capital.9 We
also observe that any process at satisfying equation (6. Then. For instance. η.18)
Fk (kt . We also note that the above three equations together with the assumption that the production technology is homogeneous of degree one imply that proﬁts are zero at all times (πt = 0 ∀ t).10).19)
It is clear from the ﬁrst of these two eﬃciency conditions that the workingcapital constraint distorts the labor market by introducing a wedge between the marginal product of labor and the real wage rate. ht ) = ut .17) and the ﬁrm’s no-Ponzi-game constraint is optimal. with distributed proﬁts given by
d Rt − 1 d Rt
πt = F (kt . (6. and
d Rt − 1 d Rt
Fh (kt .

where
is an i. we produced empirical estimates of the coeﬃcients associated with
r t
and
rus t
in the MA(∞) representation
of the endogenous variables of interest (output. etc.). This process is the estimate of the bottom equation of the VAR system (6. we can generate the corresponding theoretical MA(∞) representation and compare it to its empirical counterpart. but also their contribution to business cycles in emerging economies. In formal terms.4.Lectures in Open Economy Macroeconomics. one only needs to know the laws of motion of Rt and Rt
to construct the coeﬃcients of the theoretical MA(∞) representation. Chapter 6
141
6.79ˆt + 0.11ˆt − 0.12ˆt−1 y y ı (6. It turns out that
us up to ﬁrst order. As indicated earlier. We therefore close our model by introducing the law of motion of the country interest rate Rt .19tbyt−1 +
r r t.031. the variable tbyt stands for the trade balance-
.63Rt−1 + 0. This is because we empirically identiﬁed not only the distribution of the two shocks we wish to study.i.50Rt + 0.35Rt−1 − 0.d. So using the economic model. investment.3
Driving Forces
One advantage of our method to assess the plausibility of the identiﬁed USinterest-rate shocks and country-spread shocks is that one need not feed into the model shocks other than those whose eﬀects one is interested in studying. disturbance with mean zero and standard deviation
0.20) ı + 0.1) and is given by ˆ ˆ ˆ us ˆ us Rt = 0.61ˆt−1 + 0.29tbyt − 0.

4
Equilibrium. ht+1 . yt
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tbyt =
(6.
(6.21)
Because the process for the country interest rate deﬁned by equation (6.
10
.007. sit+1 for ˜
d i = 0. λt . ˜
t ≥ −1. However. individual consumption equals average consumption across households. and Parameter Values
In equilibrium all households consume identical quantities.22)
where 0. ¯ because of our maintained assumption that Ψ (d) = 0. 2 satisfying
In an economy like the one described by our theoretical model. 2. Accordingly.142 to-GDP ratio and is given by:10 yt − ct − it − Ψ(dt ) . innovation with mean zero and standard deviation
6. we estimate Rt as follows an AR(1) process and obtain
ˆ us ˆ us Rt = 0. it follows that both measures of private consumption are identical up to ﬁrst order. 1. ct+1 . qt .23)
An equilibrium is a set of processes ct+1 .
is an i. kt+1 . which is assumed to be an exogenous
random variable.i. dt . Rt .
(6.20)
us involves the world interest rate Rt . Functional Forms. yt . it . 1. or
c t = ct . tbyt . 3. ut . wt .d. Thus. where the debtadjustment cost Ψ(dt ) are incurred by households. the national income and product accounts would measure private consumption as ct + Ψ(dt ) and not simply as ct . Rt . and νit for i = 0.83Rt−1 +
rus t
rus t .4. we must also include this variable’s law of motion as part of the set of equations deﬁning the equilibrium behavior of the theoretical
us model.

22) describing the evolution of the world interest
rate. capital adjustment costs.23). c−1 .3)-(6.21). ω = 1. We adopt the following standard functional forms for preferences. φ. and µ.455. the processes for the exogenous innovations
rus t
and
r. We therefore proceed to estimate them. 2 ψ ¯ (d − d)2 . the time unit is meant to be one quarter. There is no readily available estimates for these parameters for emerging economies. This value is consistent with an average US interest rate of about 4 percent and an average country premium of 7 percent. and (6. Following Mendoza (1991). Chapter 6
143
conditions (6. We set the steadystate real interest rate faced by the small economy in international ﬁnancial markets at 11 percent per year. both of which are in line with actual data. h) = k α h1−α . i0 . h) = c
−1
.
F (k. all holding with equality. i−1 .18)-(6. a standard value in business-cycle studies. c − µ˜ − ω −1 hω c 1−γ
1−γ
U (c − µ˜. Eichenbaum. (6. We set the depreciation rate at 10 percent per year.
Ψ(d) =
In calibrating the model. and debt adjustment costs.Lectures in Open Economy Macroeconomics.16). Our estimation procedure follows Christiano. we set γ = 2.32. technology. t
and equation (6. and α = . y−1 . h0 . 2 φ > 0. given c0 . and Evans (2001) and consists in choosing values
. η. ψ. There remain four parameters to assign values to. Φ(x) = x − φ (x − δ)2 .

φ.η. φ = 72. η. Thus. Speciﬁcally. let IRe denote the 192×1 vector of estimated impulse response functions and IRm (ψ.2. and µ = 0. On the other hand.
11
. For
A key diﬀerence between the exercise presented here and that in Christiano et al..µ} [IRe − IRm (ψ. capital adjustment costs appear as more signiﬁcant. is that here the estimation procedure requires ﬁtting impulse responses to multiple sources of uncertainty (i. Then our estimate of (ψ. whereas in Christiano et al. For ¯ example.00042. The resulting parameter estimates are ψ = 0. η = 1.2. η.e. φ.φ. µ) is given by
argmax{ψ.2 and the corresponding impulse responses implied by the model. to 2 shocks (the US-interest-rate shock and the country-spread shock). η. and the country interest rate). η. which is a function of the four parameters we seek to estimate. The implied debt adjustment costs are small. µ)] Σ−1e [IRe − IRm (ψ. IR where ΣIRe is a 192×192 diagonal matrix containing the variance of the impulse response function along the diagonal. the trade balance. investment. the set of estimated impulse responses used in the estimation procedure are originated by a single shock. φ. φ.8.11 In our exercise we consider the ﬁrst 24 quarters of the impuls! e response functions of 4 variables (output. a 10 percent increase in dt over its steady-state value d maintained over one year has a resource cost of 4 × 10−6 percent of annual GDP.144
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for the four parameters so as to minimize the distance between the estimated impulse response functions shown in ﬁgure 6. This matrix penalizes those elements of the estimated impulse response functions associated with large error intervals. we are setting 4 parameter values to match 192 points. µ)]. country-interest-rate shocks and world-interest-rate shocks. µ) the corresponding vector of impulse responses implied by the theoretical model.

8 0.455 0. Constantinides. and the country interest rate.5
Theoretical and Estimated Impulse Responses
Figure 6.88 percent.
.edu/∼uribe/uribe yue jie/uribe yue jie. investment. the capital stock increases by 0. The estimated value of η implies that ﬁrms maintain a level of working capital equivalent to about 3.2 2. Table 6.00042 0.g. 1990).
6.6 depicts impulse response functions of output.77% Description Subjective discount factor Inverse of intertemporal elasticity of substitution Habit formation parameter 1/(ω − 1) = Labor supply elasticity capital elasticity of output Capital adjustment cost parameter Debt adjustment cost parameter Depreciation rate (quarterly) Fraction of wage bill subject to working-capital constraint Steady-state real country interest rate (quarterly)
instance..32 72. the trade balance-to-GDP ratio.025 1. a 10 percent increase in investment for one year produces an increase in the capital stock of 0.Lectures in Open Economy Macroeconomics.2: Parameter Values Symbol β γ µ ω α φ ψ δ η R Value 0.econ.html. Finally.2 gathers all parameter values. In the absence of capital adjustment costs. the estimated degree of habit formation is modest compared to the values typically used to explain asset-price regularities in closed economies (e.96 percent. starting in a steady-state situation.12 The left col12 The Matlab code used to produce theoretical impulse response functions is available on line at http://www.6 months of wage payments.duke. Chapter 6
145
Table 6.973 2 0.204 1.

4 1.6 0.6: Theoretical and Estimated Impulse Response Functions
Response of Output to εrus 0 0 −0.5
5
10
15
20
Response of TB/GDP to εrus 2 0.5 0.8 0.3 0 5 10 15 20 Response of Output to εr
Response of Investment to εrus 0 −2 −4 −1 −6 0 5 10 15 20 0 0
Response of Investment to εr
−0.2 0 0
Response of Country Interest Rate to εr
5
10
15
20
Estimated IR
-x-x.2 0.1 −0.
.146
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Figure 6.3 1 0. and the second column displays impulse responses to a country-spread shock ( r ).5 0 5 10 15 20 −0.4 0.Model IR
2-std error bands around Estimated IR
Note: The ﬁrst column displays impulse responses to a US interest rate shock ( rus ).2 −0.5 0.5 −1 −1.1 0 0 5 10 15 20 0 0
Response of TB/GDP to εr
5
10
15
20
Response of Country Interest Rate to εrus 3 2 1 0 0 5 10 15 20 1 0.

yt−1 . the country interest rate displays a monotonic response to a country-spread shock.20). the country spread St = Rt − Rt moves in response to four types of variable: its own lagged value St−1 (the autoregressive component). Chapter 6 umn shows impulse responses to a US-interest-rate shock (
rus ). the exogenous country-spread shock
r t
(the sentiment component). Second. Third.1) is indeed successful in isolating country-spread shocks and US-interest-rate shocks from the data. and broken lines depict the associated two-standard-error bands. ˆt . and current and past values of a
ˆ ˆ set of domestic endogenous variables. t
147 and the
right column shows impulse responses to a country-spread shock ( r ).2 and 6. current
us us and past US interest rates Rt and Rt−1 ). ˆt−1 .6
The Endogeneity of Country Spreads
According to the estimated process for the country interest rate given in ˆ ˆ ˆ us equation (6. the trade balance improves in response to either shock. The model replicates three key qualitative features of the estimated impulse response functions: First. We therefore conclude that the scheme used to identify the parameters of the VAR system (6.
6. the country interest rate displays a hump-shaped response to an innovation in the US interest rate. Fourth. tbyt . output and investment contract in response to either a US-interest-rate shock or a country-spread shock.3. A natural ˆ ˆ ı ı question is to what extent the endogeneity of country spreads contributes
. Solid t lines display empirical impulse response functions. yt . tbyt−1 . Crossed lines depict theoretical impulse response functions.Lectures in Open Economy Macroeconomics. This information is reproduced from ﬁgures 6.

given by equation (6.63. it implies that.11ˆt − 0.12ˆt−1 y y ı (6. To this end.20) only in that the coeﬃcient on the contemporaneous US interest rate is unity and the coefﬁcient on the lagged US interest rate equals -0. We note that in conducting this and the next counterfactual exercises we do not reestimate the VAR system.
This process diﬀers from the one shown in equation (6. t
.61ˆt−1 + 0. Second.19tbyt−1 +
r t.79ˆt + 0.148 to exacerbating aggregate ﬂuctuations in emerging countries. St−1 = Rt−1 − Rt−1 . we assume that the process for the country interest rate is given by ˆ ˆ ˆ us ˆ us Rt = 0. The ﬁrst exercise aims at gauging the degree to which country spreads amplify the eﬀects of world-interest-rate shocks.24) ı + 0. which is the negative of the coeﬃcient on the lagged country interest rate. does not directly depend upon current or past values of the US interest rate. This parametrization has two properties of interest.
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We address this question by means of two counterfactual exercises.63Rt−1 + Rt − 0. the above speciﬁcation of the country-interest-rate process preserves the dynamics of the model in response to country-spread shocks. we calculate the volatility of endogenous macroeconomic variables due to US-interest-rate shocks in a world where the country spread does not directly depend on the US interest rate. Speciﬁcally. St . given the past value ˆ ˆ ˆ us of the country spread. The process for the US interest rate is assumed to be unchanged (i..e. The reason is that doing so would alter the estimated process of the country spread shock
r. the current country spread.29tbyt − 0. First.22)).63Rt−1 − 0.

The result is shown in table 6.784 0.429 3. ˆ The precise question we wish to answer is: what process for Rt induces higher volatility in macroeconomic variables in response to US-interest-rate shocks.Lectures in Open Economy Macroeconomics.429 3.819 0. or tby us ˆ. Dev.983 Note: The variable S denotes the country spread and is deﬁned as S = R/Rus .547 1.245 0. Namely.885 0..3: Endogeneity of Country Spreads and Aggregate Instability Std.
This would amount to introducing two changes at the same time.640 4.110 0.639 ˆ ı 2.429 4. A hat on a variable denotes log-deviation from its non-stochastic steady-state value.983 S 2.547 1.622 2. under the process for Rt given in equation (6.20) or the one given in equation (6.866 1.347 1.175 tby 1.20) and then with equation (6. when Rt follows
.663 0.420 0. changes in the endogenous and the sentiment components of the country spread process. due to rus Std.3. Dev.623 4. or tby Variable Model No R ı Model No R ı y ˆ 1.429 4.446 R 3.509 1.24)) the standard deviation of output and the trade balance-to-output ratio explained by US-interest-rate shocks is about two thirds smaller than in the baseline scenario (i.819 0. Chapter 6
149
Table 6.515 0.e.. due to r Baseline No yt ˆ Baseline No yt ˆ us ˆ.580 1.469 0.24) and in each case compute a variance decomposition of output and other endogenous variables of interest.e.24)? To answer this question. the one given in equation (6.319 0. we feed the theoretical model ﬁrst with equation (6.663 0. We ﬁnd that when the country spread is assumed not to respond directly to variations in the US interest rate (i.

and the trade balance-to-output ratio explained jointly by US-interest-rate shocks and country-spread shocks ( and
r) t rus t
falls by about one fourth when the feedback from endogenous do-
mestic variables to country spreads is shut oﬀ.50Rt + 0. This indicates that the aggregate eﬀects of US-interest-rate shocks are strongly ampliﬁed by the dependence of country spreads on US interest rates. A second counterfactual experiment we wish to conduct aims to assess the macroeconomic consequences of the fact that country spreads move in response to changes in domestic variables. we use our theoretical model to compute the volatility of endogenous domestic variables in an environment where country spreads do not respond to domestic variables.63Rt−1 + 0. To this end. t t
13
. We ﬁnd that the equilibrium volatility of output. such as output and the external accounts.150
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the process given in equation (6.
Ideally. this particular exercise should be conducted in an environment with a richer battery of shocks capable of explaining a larger fraction of observed business cycles than that accounted by rus and r alone.20)).25)
Table 6. we replace the process for Rt given in equation (6.3 displays the outcome of this exercise.20) with the process ˆ ˆ ˆ us ˆ us Rt = 0.
(6. Speciﬁcally. investment.13 We conclude that the fact that country spreads respond to the state of domestic business conditions signiﬁcantly exacerbates aggregate instability in emerging countries.35Rt−1 +
r t.

we do observe a signiﬁcant amount of borrowing and lending across nations. It follows that international borrowers must have reasons to repay their debts other than 151
. one reason why residents of a given country honor their debts with other residents of the same country is because creditors are protected by a government able and willing to apply force against delinquent debtors. If agents have no incentives to pay their international debts. A key distinction between international and domestic debts is that the latter are enforceable. Countries typically have in place domestic judicial systems capable of punishing defaulters. Defaulting on international ﬁnancial contracts appears to have no legal consequences. Thus.Chapter 7
Sovereign Debt
Why do countries pay their international debts? This is a fundamental question in open-economy macroeconomics. then lenders should have no reason to lend internationally to begin with. At the international level the situation is quite diﬀerent. For there is no such a thing as a supernational authority with the capacity to enforce ﬁnancial contracts between residents of diﬀerent countries. Yet.

import tariﬀs and quotas. trade embargoes. the smaller the incentives for debtor countries to default. as it precludes use of the current account to smooth out consumption in response to aggregate domestic income shocks.1
Empirical Regularities
Table 7.152 pure legal enforcement. Before plunging into theoretical models of country debt.
7. countries may choose to repay their debts simply to preserve their reputation and thereby maintain access to international ﬁnancing.
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Two main reasons are typically oﬀered for why countries honer their international debts: economic sanctions and reputation. etc. the stronger is the ability of creditor countries to impose economic sanctions. This chapter investigates whether the existing theories of sovereign debt are capable of explaining the observed levels of sovereign debt. As a result. Intuitively. Being isolated from international ﬁnancial markets is costly. we will present some stylized facts about international lending and default that will guide us in evaluating the existing theories. such as seizures of debtor country’s assets located abroad.1 displays average debt-to-GNP ratios over the period 1970-2000 for a number of emerging countries that defaulted upon or restructured their external debt at least once between 1824 and 1999. A reputational motive to pay international debts arises when creditor countries have the ability to exclude from international ﬁnancial markets countries with a reputation of being defaulters. Economic sanctions may take many forms. however. The table also
.

7 58. and Turkey. and expressed in basis points.4 50. 1999.5 41. tables 3 and 6. Country spreads are measured by EMBI country spreads. Rogoﬀ. Brazil. and are averages through 2002. produced by J. Mexico 1982. Colombia. Turkey 1978. Debt-to-GNP ratios at the beginning of a default episodes are averages over the following default dates in the interval 1970-2002: Argentina 1982 and 2001. and Savastano (2003).7 112. Mexico.6 21.
. Source: Own calculations based on Reinhart. with varying starting dates as follows: Argentina 1993. Philippines.6 70.1 30. Chile. Colombia did not register an external default or restructuring episode between 1970 and 2002.1 Debt-to-GNP Ratio at Year of Default 54. Egypt 2002. Venezuela 1982 and 1995. Philippines 1983. Morgan. Chile 1972 and 1983.1 Average Country Spread 1756 845 186 649 442 593 464 663 1021 638
Country Argentina Brazil Chile Colombia Egypt Mexico Philippines Turkey Venezuela Average
Notes: The sample includes only emerging countries with at least one external-debt default or restructuring episode between 1824 and 1999.0 46. Brazil 1983. and Venezuela.7 70.0 46. 1992. Egypt 1984.3 58. Debt-to-GNP ratios are averages over the period 1970-2000.4 33.2 55.Lectures in Open Economy Macroeconomics.1 63. 1997. Chapter 7
153
Table 7.1: Debt-to-GNP Ratios and Country Premiums Among Defaulters Average Debt-to-GNP Ratio 37.3 44.6 38.2 31.P.

1.154
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displays average debt-to-GNP ratios at the beginning of default or restructuring episodes. The data suggest that at the time of default debt-to-GNP ratios are signiﬁcantly above average. the debt-to-GNP ratio at the onset of a default or restructuring episode was on average 14 percentage points above normal times. they estimate ∂ log country spread = 1. column 4).1 also shows the country premium paid by the 9 emerging countries listed over a period starting on average in 1996 and ending in 2002. for the countries considered in the sample. Table 7. During this period. as documented in table 7. In eﬀect. the interest rate at which these 9 countries borrowed in the international ﬁnancial market was on average about 6 percentage points above the interest rate at which developed countries borrow from one another. about whether the higher debt-to-GDP ratios observed at the brink of default episodes obey to a contraction in aggregate activity or to a faster-than-average accumulation of debt in periods immediately preceding default. ∂debt-to-GNP ratio Thus.3. There is evidence that country spreads are higher the higher the debt-to-GNP ratio. however.3 (see their table 3. and the average country spread during normal times is about 640 basis points. That is. Akitoby and Stratmann (2006). it follows that at the beginning of a default
. the debt-to-GNP ratio is 14 percentage points higher at the beginning of a debt default or restructuring episode than during normal times. estimate a semielasticity of the spread with respect to the debt-to-GNP ratio of 1. if. The information provided in the table is silent.

For being in state of default with a set of lenders.Lectures in Open Economy Macroeconomics. countries defaulted on average once every 33 years. If one assumes that while in state of default countries have little access to fresh funds from international markets.16 percent. This increase in spreads might seem small for a country that is at the brink of default.14 = 116 basis points.2 displays empirical probabilities of default for 9 emerging countries over the period 1824-1999. Chapter 7
155
episode the country premium increases on average by 1. however. or 1. one would conclude that default causes countries to be in ﬁnancial autarky for about a decade. For instance. But the connection between state of default and ﬁnancial autarky should not be taken too far. doesn’t necessarily preclude the possibility of obtaining new loans (possibly from
.3 × 640 × 0. Table 7. We note. On average.2 also reports the average number of years countries are in state of default or restructuring after a default or restructuring episode. Akitoby and Stratmann (2006) and others have documented that spreads increase signiﬁcantly with the rate of inﬂation and decrease signiﬁcantly with the foreign reserve-to-GDP ratio. the probability of default is about 3 prevent per year. Country spreads are known to respond systematically to other variables that may take diﬀerent values during normal and default times. that this increase in the country premium is only the part of the total increase in country spreads that is attributable to changes in the debt-to-GNP ratio. After a debt crisis. That is. Table 7. countries are in state of default for about 11 years on average. these two factors contribute to higher country spreads in periods immediately preceding a default episode. Because around default periods inﬂation tends to be high and foreign reserves tend to be low.

Therefore.051 0.034 0.2: Probability of Default and Length of Default State 1824-1999 Probability of Default per year 0.156
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Table 7. table 1.030 Years in State of Default per Default Episode 11 6 14 10 11 6 32 5 7 11
Country Argentina Brazil Chile Colombia Egypt Mexico Philippines Turkey Venezuela Average
Note: The sample includes only emerging countries with at least one external-debt default or restructuring episode between 1824 and 1999.040 0. and Savastano (2003).023 0. Source: Own calculations based on Reinhart.046 0.040 0. the average probability is conditional on at least one default in the sample period.006 0.017 0.
.011 0. Rogoﬀ.

Default episodes are also associated with disruptions in international trade.
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7.2
The Cost of Default
Default and debt restructuring episodes are typically accompanied by signiﬁcant declines in aggregate activity. then maintaining access to international trade could represent a reason why countries tend to honor their international ﬁnancial obligations.Lectures in Open Economy Macroeconomics. The question of
whether default disrupts international trade is of interest because if for some reason trade between two countries is signiﬁcantly diminished as a result of one country defaulting on its ﬁnancial debts with other cuntries.
where Tijt is a measure of average bilateral trade between countries i and j in period t. the cumulative output loss associated with default and restructuring episodes in the 1980s was of about 4 percent over four yeas. The Paris Club is an informal association of creditor-country ﬁnance ministers and central bankers that meets to negotiate bilateral debt rescheduling agreements with debtor-
. Sturzenegger (2003) ﬁnds that after controlling for a number of factors that explain economic growth. Chapter 7 other lenders) or issuing new external debt. Rose estimates an equation of the form
M
Tijt = β0 +
m=0
φijtm Rijt−m + βij Xijt +
ijt . Rose identiﬁes default with dates in which a country enters a debt restructuring deal with the Paris Club. Rose (2005) investigates this issue empirically.

The variable Xijt is a vector of regressors including (current and possibly lagged) characteristics of the country pair ij at time t such as output. as measured by the debt restructuring variable Rijt has a significant and negative eﬀect on bilateral trade. a common border. The regressor Rijt proxies default and is a binary variable equal to unity if countries i and j renegotiated debt in period t in the context of the Paris Club and zero otherwise. Landlocked countries and islands trade less. area. respectively. one. and most of the colonial eﬀects are large and positive. Rose’s empirical model belongs to the family of gravity models. The sample contains 283 Paris-Club debt-restructuring deals. population. The vector Xijt also includes current and lagged values of a variable IM Fijt . 1. The data set used for the estimation of the model covers all bilateral trades between 217 countries between 1948 and 1997 at an annual frequency. whereas high-income country pairs trade more. etc. sharing of land borders. The inception of IMF programs is associated with an accumulated contraction in trade of about 10 percent over three years. distance. countries that are more distant geographically trade less. if neither. Rose estimates the parameter
. or 2. or membership in a regional free trade agreement trade more. country pair-speciﬁc dummies. Specifically. Default. The main focus of Rose’s work is the estimation of the coeﬃcients φijm . or both countries i and j engaged in an IMF program at time t. that takes the values 0. sharing of a common language. a common language.158
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country governments. membership to the same free trade agreement. Rose ﬁnds sensible estimates of the parameters pertaining to the gravity model. Countries that share a common currency.

countries pay their international debts to preserve their reputation and in that way maintain access to external ﬁnancing. As a result.Lectures in Open Economy Macroeconomics.07 and the lag length.
. Thus. Thus. Preferences are described by the utility function
∞
E0
t=0
β t u(ct ). This means that entering in a debt restructuring agreement with a member of the Paris Club leads to a decline in bilateral trade of about 7 percent per year for about 15 years.
7. to be about 15 years. Our version of the Eaton-Gersowitz model follows Arellano (2005). Based on this ﬁnding. countries that default are punished by having to operate in autarky.3
A Reputational Model of Sovereign Debt
Eaton and Gersowitz (1981) pioneered a literature that explains sovereign debt with a reputational argument. Consider a small open economy populated by a large number of identical individuals. Rose concludes that one reason why countries pay back their international ﬁnancial obligations is fear of trade disruptions in the case of default. Chapter 7
159
φijm to be on average about 0. The central assumption behind this theory is that somehow foreign lenders coordinate to exclude from international ﬁnancial markets countries with a reputation for being defaulters. Autarky is costly because it implies that countries cannot share systematic income risks with the rest of the world. the cumulative eﬀect of default on trade is about one year worth of trade in the long run. M .

When in autarky the household is forced to consume its endowment. Formally. y ]. it can choose to default on its debt obligations or to honor its debt. consumption of a household in bad ﬁnancial standing is given by c = y. If it chooses to honor its debt. then it immediately acquires a bad ﬁnancial status. the representative household is endowed with yt units of consumption goods.. d denotes the debt acquired in the current period and due in the next period. 1) is a parameter denoting the subjective discount factor. Households that are in good standing and choose not to default face the following budget constraint:
c + d = y + q(d )d . the household can be either in good ﬁnancial standing or in bad ﬁnancial standing If the household is in bad ﬁnancial standing. and i.i.
where d denotes the household’s debt due in the current period. We drop the time subscript in expressions where all variables are dated in the current period. then it is prevented from borrowing or lending in ﬁnancial markets. ¯ At the beginning of each period. then it maintains its good ﬁnancial standing until the beginning of the next period.d. and β ∈ (0. and
. Each period t ≥ 0. If the household is in good ﬁnancial standing. stochastic. This endowment is assumed to be exogenous. If it chooses to default. with a distribution featuring a bounded support Y = [y. u is a period utility function assumed to be strictly increasing and strictly concave.160
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where ct denotes consumption in period t.

nature of the endowment. This is because the default decision in the next period depends on the amount of debt due then. which implies that its current value conveys no information about future expected endowment levels. not defaulting) is denoted by v c (d.e. This means that once the household falls into bad standing. d . Chapter 7
161
q(d ) denotes the market price of the household’s debt. The value function associated with bad ﬁnancial standing is denoted v b (y) and is given by
v b (y) = u(y) + βEv b (y ).
d
.
Here. Notice also that q(·) is independent of the current level of output. If instead we had assumed that y were serially correlated. y) = max u(y + q(d )d − d) + βEv g (d .d. Note that the price of debt depends on the amount of debt acquired in the current period and due next period.
For an agent in good standing. This is because of the assumed i. The household enters in bad standing when it defaults on its ﬁnancial obligations. d. the value function associated with continuing to participate in capital markets (i. then bond prices would depend on the level of current endowment.Lectures in Open Economy Macroeconomics. it remains in that status forever. y ) . but not on the level of debt acquired in the previous period and due in the current period.
We assume that ‘bad ﬁnancial standing’ is an absorbent state. y) and is given by
v c (d.i.. y denotes next period’s endowment.

y) denotes the value function associated with being in good ﬁnancial standing.
Because it is never in the agent’s interest to default when its asset position is nonnegative (or d ≤ 0). In what follows. It is then reasonable to conjecture that default is more likely the larger the level of debt and the lower the current endowment. we demonstrate that this intuition is in fact correct. y) = max{v b (y). the default set is deﬁned by
D(d) = {y ∈ Y : v b (y) > v c (d. y)}. We denote the default set by D(d). In this economy. y)}. We do so in steps. and is given by
v g (d. it follows that D(d) is empty for all d ≤ 0.162 subject to ¯ d ≤ d. v c (d. Formally.
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where v g (d. ¯ The parameter d > 0 is a debt limit that prevents agents from engaging in Ponzi games. The following proposition shows that at debt levels for which the default
.
The Default Set The default set contains all endowment levels at which a household chooses to default given a particular level of debt. households choose to default when servicing the debt entails a cost in terms of forgone current consumption that is larger than the inconvenience of living in ﬁnancial autarky forever.

Then.
. if the default set is not empty then it is indeed an interval with lower bound given by the lowest endowment set level y. y )
¯ d <d
≥ u(y + q d d − d) + βEv g (d. ¯ Proof: Suppose that q d d − d ≥ 0 for some d ≤ d. q(d)d − d ≥ 0 and because. then if it is to continue to participate in the ﬁnancial market. it must devote part of its current endowment to servicing the debt.Lectures in Open Economy Macroeconomics. the economy must run trade surpluses. then y1 ∈ D(d).
163
v c (d.1 If D(d) = ∅. y ) ≥ u(y) + βEv b (y ) ≡ v b (y). It follows that if q(d)d − d ≥ 0 ¯ for some d ≤ d. we show that if a household with a certain level of debt and income chooses to default then it will also choose to default at the same level of debt and lower income. then D(d) = ∅. The second inequality holds because. y ) ≥ v b (y ). v g (d. We now establish that in this economy households tend to default in bad times. then q(d )d − d < 0 for all d ≤ d. y) ≡ max u(y + q(d )d − d) + βEv g (d . This proposition states that if the household has a level of debt that puts it in risk of default. ¯ Proposition 7. Chapter 7 set is not empty. The ﬁrst inequality follows from the fact that d was picked arbitrarily.
for all y. Speciﬁcally. by deﬁnition. by assumption. In other worlds.2 If y2 ∈ D(d) and y1 < y2 .
Proposition 7.

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Proof: Suppose D(d) = ∅. [y. It follows that y ∗ (d) is
given either by y or (implicitly) by v b (y ∗ (d)) = v c (d. Consider any y ∈ Y such that y ∈ D(d). if y2 ∈ D(d). b c dd vy (y ∗ (d)) − vy (d. y1 ) for y1 < y2 . y) = u (y + q(d )d − d). We have shown that vy (y ∗ (d))−vy (d. Proposition 7. y) ≡ ∂v c (d. then v b (y1 ) > v c (d. y) < 0 for all y ∈ D(d).
for all y ∈ D(d). By the envelope theorem. y)/∂d. y ∗ (d)]. That is. that u (y + q(d )d − d) > u (y). then D(d) is an interval. By deﬁnition. Put diﬀerently.3 If D(d) = ∅. ¯
Proof: We already proved that the default set D(d) is an interval. We now show that the default set D(d) is a larger interval the larger the stock of debt. By proposition 7. Let
b c vy (y) ≡ ∂v b (y)/∂y and vy (d. At the same time. y ∗ (d)) c b c where vd (d. y ∗ (d)) dy ∗ (d) . y) > 0. every y ∈ D(d) satisﬁes v b (y) − v c (d.
b c we showed that vy (y) − vy (d. y ∗ (d)) <
. y2 ) for y2 ∈ D(d). y ∗ (d)). y)/∂y. y) is a decreasing function of y for all y ∈ D(d). y) ≡ ∂v c (d. y) < 0. b c vy (y) = u (y) and vy (d. the larger the probability of default. by strict concavity
b c of u. We have shown that the default set is an interval with a lower bound given by the lowest endowment y. This implies. v b (y) − v c (d. This means that if v b (y2 ) > v c (d. where y ∗ (d) is increasing in d if y ∗ (d) < y . we
¯ have that q(d )d − d < 0 for all d ≤ d. It follows that vy (y) − vy (d. Diﬀerentiating ¯ this expression yields
c vd (d. the higher the debt. Equivalently. then y1 ∈ D(d) for any y1 < y2 .

foreign lenders receive 1/q(d ) units of goods per unit lent. Summarizing. given the stock of debt. the higher the probability of default. Let the world interest rate be constant and equal to r ∗ > 0. default is more likely the lower the level of output. We then conclude
that dy ∗ (d) > 0. Chapter 7
165
c 0. foreign lenders receive nothing. We assume that foreign lenders are risk neutral and perfectly competitive. y) and applying the envelope theorem. it folc lows that vd (d. y ∗ (d)) = −u (y ∗ (d) + q(d )d − d) < 0. equating the expected rate of return on the domestic debt to the risk-free world interest rate. If the country DOES default.1 shows that at the time of default countries tend to display above-average debt-to-GNP ratios. dd as stated in the proposition. q(d )
1 + r∗ =
. It follows that the expected rate of return on the debt must equal r ∗ . Therefore.
Default Risk and the Country Premium We now consider the behavior of the country interest-rate premium in this economy. Using the deﬁnition of vd (d. table7. If the country does not default. Second. we have obtained two important results: First. These two results are in line with the stylized facts presented earlier in this chapter. the larger the stock of debt. one obtains Prob {y ≥ y ∗ (d )} . In eﬀect.Lectures in Open Economy Macroeconomics.

7.166
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The numerator on the right side of this expression is the probability that the country will not default next period. 1 + r∗
q(d ) =
Taking derivative with respect to next period’s debt yields dq(d ) −F (y ∗ (d ))y ∗ (d ) = ≤ 0. At a ﬁrst glance. Bullow and
. given by 1/q(d ) − 1 − r ∗ is nondecreasing in the stock of debt. is nondecreasing in the stock of debt. by proposition7. y ∗ (d ) ≥ 0. Letting F (y) denote the cumulative density function of the endowment shock. dd 1 + r∗ The inequality follows because by deﬁnition F ≥ 0 and because. we can write 1 − F (y ∗ (d )) . it might seem that what is important is that defaulters be precluded from borrowing in international ﬁnancial markets.4 The country spread.3. It follows that the country spread.4
Saving and the Breakdown of Reputational Lending
A key assumption of the reputational model of sovereign debt is that when a country defaults foreign lenders coordinate to exclude this country from the possibility to borrow or lend in international ﬁnancial markets. given by the diﬀerence between 1/q(d ) and 1+r ∗ . We summarize this result in the following proposition: Proposition 7.

if the country is excluded from borrowing starting in period T − 1. Continuing with this logic. consider a deterministic economy.1 . As a result. no lending at all could be supported on reputational grounds alone. where dt denotes the level of external debt t=0 assumed in period t and due in period t + 1. dT −1 ≤ 0. no foreign investor will be willing to lend to the country in period T − 2. then it will have no incentives to honor any debts outstanding in that period. but that lending in these markets is allowed after default. To illustrate this insight in a simple setting. Chapter 7
167
Rogoﬀ (1989) have shown. since default would occur for sure one period later. dT −2 ≤ 0.Lectures in Open Economy Macroeconomics. That is. That is. notice that if the country defaults at some date T > 0. we arrive at the conclusion that default in period T implies no debt at any time. see Eaton and Fern´ndez (1995). This assumption and the fact that the economy operates under perfect foresight imply that any reputational equilibrium featuring positive debt at at least one date must be characterized by no default. however. In turn. It follows from this result that in an equilibrium with positive external
1 For an example of a deterministic model with sovereign debt supported by reputation. Thus.Assume that default is punished with perpetual exclusion from borrowing in international ﬁnancial markets. a
. then no foreign investor would want to lend to this country in period T − 1. that the prohibiting defaulters to lend (or save) to foreign agents is crucial for the reputational model to work. Suppose that a reputational equilibrium supports a path for external debt given by {dt }∞ . If delinquent countries were not allowed to borrow but could run current account surpluses. To see this. dt ≤ 0 for all t ≥ 0.

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debt the interest rate must equal the world interest rate r ∗ > 0. According to the economy’s no-default resource constraint. Let dT be the maximum level of external debt in this equilibrium sequence. dT ≥ dt for all t ≥ −1.
(7.
where tbT +1 is the trade balance prevailing in period T + 1 under the original debt sequence {dt }. Does it pay for the country to honor this debt? The answer is no. where tbt denotes the trade balance in period t. That is. we have that −tbT +1 = dT +1 − (1 + r ∗ )dT . the country can generate the no-default level of trade balance in
. That is. we have that dT +1 < 0.
for t ≥ 0. because the probability of default is nil. To see this. Let the debt position acquired in the period of default be ˜ dT +1 = −tbT +1 . let dt for t > T denote the post-default path of external debt.1)
˜ Because by assumption dT ≥ dT +1 and r ∗ > 0. The reason is that the country could default on this debt in T + 1—and therefore be excluded from borrowing internationally forever thereafter—and still be able to run trade balances no larger than the ones ˜ that would have obtained in the absence of default. The evolution of the equilibrium level of debt is then given by
dt = (1 + r ∗ )dt−1 − tbt . the country premium is nil. That is. which implies that ˜ dT +1 = dT +1 − (1 + r ∗ )dT .

1989).
for all j ≥ 1. But the result also holds in a stochastic environment (see Bullow and Rogoﬀ. Chapter 7
169
period T +1 without having to borrow internationally. tbT +j for j > 0. tbT +2 is the trade balance prevailing in period T + 2 under the original debt sequence {dt }.
.
where. we obtain ˜ dT +2 = dT +2 − (1 + r ∗ )2 dT < 0. It follows that no external debt can be supported in equilibrium on reputational grounds. we derived the breakdown of the reputation model under saving using a model without uncertainty.1) and the fact that tbT +2 = (1 + r ∗ )dT +1 − dT +2 . Using (7. one obtains that the no-default sequence of trade bal˜ ances. Continuing in this way. For simplicity. The inequality follows because by assumption dT +2 ≤ dT and r ∗ > 0. can be supported by a debt path dT +j satisfying ˜ dT +j = dT +j − (1 + r ∗ )j dT < 0. But we showed that default in this perfect foresight economy implies zero debt at all times. Let the external debt position in period T + 2 be ˜ ˜ dT +2 = (1 + r ∗ )dT +1 − tbT +2 .Lectures in Open Economy Macroeconomics. It follows that it pays for the country to default immediately after reaching the largest debt level dT . again.

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