Where δ represents consumer’s subjective discount rate, r the world interest

rate, and pt relative prices. Equations 3.11, 3.12, and 3.13 represent the current

account, the stochastic endowment process (𝑒𝑡∗ ),3 and the transversality condition to
∗
exclude Ponzi schemes, respectively. In the current account equation, if 𝑏𝑡+1 is

positive, then it denotes the amount of home stock bonds held by ROW, and the

opposite if negative. The F.O.C. are:

∗
𝑢𝑡𝑑 = 𝜆𝑡 . (3.14)
∗
𝑢𝑡𝐼 = 𝜆𝑡 𝑝𝑡 . (3.15)

𝜆𝑡 = (1 + 𝛿)−1 (1 + 𝑟)𝐸𝑡 𝜆𝑡+1 . (3.16)

Where 𝜆𝑡 is the Lagrange multiplier on equation 3.11, and ROW “consumer’s

marginal utility for domestic goods” on equation 3.14. Assuming that the utility

function is addilog:

𝑢(𝑑𝑡∗ , 𝐼𝑡∗ ) = 𝐴𝑡 (𝑑𝑡∗ )(1 − 𝛼)−1 + 𝐵𝑡 (𝐼𝑡∗ )(1 − 𝛽)−1 , α, β>0 (3.17)

𝐴𝑡 = 𝑒 𝑎0 +𝜖𝐴,𝑡 . (3.18)

𝐵𝑡 = 𝑒 𝑏0 +𝜖𝐵,𝑡 . (3.19)

Where A and B are random shocks to preferences. Equating 3.14 to the partial

derivative of 3.17’ [𝑢(𝑑𝑡∗ , 𝐼𝑡∗ )] w.r.t. 𝑑𝑡∗ , yields:

𝑑𝑡∗ = 𝐴𝑡 1/𝛼 𝜆𝑡 −1/𝛼 . (3.20)

Equating 3.14 to the partial derivative of 3.17’ [𝑢(𝑑𝑡∗ , 𝐼𝑡∗ )] w.r.t. 𝐼𝑡∗ , yields:

−1/𝛽
𝐼𝑡∗ = 𝜆𝑡 −1/𝛽 𝐵𝑡 1/𝛽 𝑃𝑡 . (3.21)

Substituting 3.18 – 3.20 into 3.21 equation (in log-log form), yields:
3
In this notation 𝑒𝑡∗ does not longer represent exchange rates as in the case of the imperfect
substitutes model.

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