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Mart´ Uribe2 ın This draft, December 31, 2010 Newer versions maintained at http://www.columbia.edu/~mu2166/lecture_notes.html

I would like to thank Javier Garc´ ıa-Cicco, Felix Hammermann, and Stephanie Schmitt-Groh´ for comments and suggestions. Comments welcome. e 2 Columbia University and NBER. E-mail: martin.uribe@columbia.edu.

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Contents

1 A First Look at the Data 1.1 Duration and Amplitude of Business Cycles in Emerging and Developed Countries . . . . . . . . . . . . . . . . . . . . . . . 2 An 2.1 2.2 2.3 2.4 Endowment Economy The Model Economy . . . . . . . . . . . . . The Economy’s Response to Output Shocks Nonstationary Income Shocks . . . . . . . Testing the Model . . . . . . . . . . . . . . 1 5 9 9 16 19 24 29 30 33 38 40 42 44 47 48 57 60 62 63 65 67 69 71 74

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3 An Economy with Capital 3.1 The Basic Framework . . . . . . . . . . . . . . . . . . 3.1.1 A Permanent Productivity Shock . . . . . . . . 3.1.2 Adjustment to Temporary Productivity shocks 3.2 Capital Adjustment Costs . . . . . . . . . . . . . . . . 3.2.1 Dynamics of the Capital Stock . . . . . . . . . 3.2.2 A Permanent Technology Shock . . . . . . . . . 4 The 4.1 4.2 4.3 4.4

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Small-Open-Economy Real-Business-Cycle Model The Model . . . . . . . . . . . . . . . . . . . . . . . . . . The Model’s Performance . . . . . . . . . . . . . . . . . . The Roles of Persistence and Capital Adjustment Costs . Alternative Ways to Induce Stationarity . . . . . . . . . . 4.4.1 External Discount Factor (EDF) . . . . . . . . . . 4.4.2 External Debt-Elastic Interest Rate (EDEIR) . . 4.4.3 Internal Debt-Elastic Interest Rate (IDEIR) . . . 4.4.4 Portfolio Adjustment Costs (PAC) . . . . . . . . . 4.4.5 Complete Asset Markets (CAM) . . . . . . . . . . 4.4.6 The Nonstationary Case (NC) . . . . . . . . . . . iii

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CONTENTS 4.4.7 Quantitative Results . . . . . . . . . . . . . . . . . . . 4.4.8 The Perpetual-Youth Model . . . . . . . . . . . . . . . Emerging-Country Business Cycles Through the Lens of the SOE RBC Model . . . . . . . . . . . . . . . . . . . . . . . . Appendix A: Log-Linearization . . . . . . . . . . . . . . . . . Appendix B: Solving Dynamic General Equilibrium Models . Local Existence and Uniqueness of Equilibrium . . . . . . . . Second Moments . . . . . . . . . . . . . . . . . . . . . . . . . Impulse Response Functions . . . . . . . . . . . . . . . . . . . Matlab Code For Linear Perturbation Methods . . . . . . . . Higher Order Approximations . . . . . . . . . . . . . . . . . . Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 76 91 100 101 112 113 117 117 118 119

4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13

5 Interest-Rate Shocks 129 5.1 An Empirical Model . . . . . . . . . . . . . . . . . . . . . . . 132 5.2 Impulse Response Functions . . . . . . . . . . . . . . . . . . . 134 5.3 Variance Decompositions . . . . . . . . . . . . . . . . . . . . . 140 5.4 A Theoretical Model . . . . . . . . . . . . . . . . . . . . . . . 145 5.4.1 Households . . . . . . . . . . . . . . . . . . . . . . . . 146 5.4.2 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 5.4.3 Driving Forces . . . . . . . . . . . . . . . . . . . . . . 155 5.4.4 Equilibrium, Functional Forms, and Parameter Values 156 5.5 Theoretical and Estimated Impulse Responses . . . . . . . . . 159 5.6 The Endogeneity of Country Spreads . . . . . . . . . . . . . . 161 6 The Terms of Trade 165 6.1 Deﬁning the Terms of Trade . . . . . . . . . . . . . . . . . . . 166 6.2 Empirical Regularities . . . . . . . . . . . . . . . . . . . . . . 166 6.2.1 TOT-TB Correlation: Two Early Explanations . . . . 168 6.3 Terms-of-Trade Shocks in an RBC Model . . . . . . . . . . . 177 6.3.1 Households . . . . . . . . . . . . . . . . . . . . . . . . 177 6.3.2 Production of Consumption Goods . . . . . . . . . . . 180 6.3.3 Production of Tradable Consumption Goods . . . . . 181 6.3.4 Production of Importable, Exportable, and Nontradable Goods . . . . . . . . . . . . . . . . . . . . . . . . 182 6.3.5 Market Clearing . . . . . . . . . . . . . . . . . . . . . 184 6.3.6 Driving Forces . . . . . . . . . . . . . . . . . . . . . . 184 6.3.7 Competitive Equilibrium . . . . . . . . . . . . . . . . 185 6.3.8 Calibration . . . . . . . . . . . . . . . . . . . . . . . . 185 6.3.9 Model Performance . . . . . . . . . . . . . . . . . . . . 189

CONTENTS 6.3.10 How Important Are the Terms of Trade?

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7 Overborrowing 7.1 Imperfect Policy Credibility . . . . . . . . . . . . . . 7.1.1 The Government . . . . . . . . . . . . . . . . . 7.1.2 Equilibrium Under A Permanent Trade Reform 7.1.3 Equilibrium Under A Temporary Tariﬀ Reform 7.2 Financial Externalities . . . . . . . . . . . . . . . . . . 7.2.1 The No Overborrowing Result . . . . . . . . . 7.2.2 The Case of Overborrowing . . . . . . . . . . . 7.2.3 The Case of Underborrowing . . . . . . . . . . 7.2.4 Discussion . . . . . . . . . . . . . . . . . . . . .

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8 Sovereign Debt 8.1 Empirical Regularities . . . . . . . . . . . . . . . . . . . . 8.2 The Cost of Default . . . . . . . . . . . . . . . . . . . . . 8.3 Default Incentives With State-Contingent Contracts . . . 8.3.1 Optimal Debt Contract With Commitment . . . . 8.3.2 Optimal Debt Contract Without Commitment . . 8.4 Default Incentives With Non-State-Contingent Contracts 8.5 Saving and the Breakdown of Reputational Lending . . .

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vi

CONTENTS

6 in Argentina and only 2. and examples of small open emerging economies are Argentina and Malaysia. Periods of 1 . The volatility of detrended output is 4. Examples of developed small open economies are Canada and Belgium. critically. Table 1.8 in Canada. and the group of emerging economies is composed of middle income countries.Chapter 1 A First Look at the Data The characterization of business cycles in small open economies requres.1 illustrates this contrast by displaying key business-cycle properties in Argentina and Canada. the distinction between developed and emerging economies. The group of developed economies is typically deﬁned by countries with high income per capita. 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. 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.

59 0.54 0.76 0.2 Mart´ Uribe ın Table 1.1: 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 4.79 0. Kydland and Zarazaga (1997). xt−1 ) 0.3 9.0 3.1 2.61 corr(xt .4 2.37 Source: Mendoza (1991). GDPt ) 1 1 0.9 4.6 2.96 0.84 -0. For Argentina.7 corr(xt .70 0.64 -0.3 1.8 5.66 0. Standard deviations are measured in percentage points from trend. data on hours and productivity are limited to the manufacturing sector.13 0.70 0.48 0.0 1.8 2. .94 0.31 0.80 0.5 13.

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

Philippines.02 1.94 3. Denmark.71 -0. Canada. Sweden. Israel.09 -0.26 0.23 1.58 0. Mexico. Finland. Malaysia. Developed Countries: Australia.09 0. Switzerland.96 2. Source: Aguiar and Gopinath (2004). Austria. South Africa.86 0.87 0.y ρc.y Emerging Countries 2. Spain.69 0. and Turkey.87 Developed Countries 1. Norway. Ecuador.9 0.42 0. Developed Economies Moment σy σ∆y ρy ρ∆y σc /σy σi /σy σtb/y ρtb/y.95 0. Netherlands. Peru. Thailand. New Zealand. Belgium.75 Note: Average values of moments for 13 small emerging countries and 13 small developed countries. . Korea. Data are detrended using a band-pass ﬁlter including frequencies between 6 and 32 quarters with 12 leads and lags. Portugal. Brazil.2: Business Cycles: Emerging Vs.y ρi.4 Mart´ Uribe ın Table 1. Emerging countries: Argentina.04 0.74 0.32 3. Slovak Republic.

They deﬁne a peak as an output observation that is larger than the two immediately preceeding and succeeding observations. . 1. Chapter 1 5 more volatile than output in emerging countries but less volatile than output in developed countries. 2. consisting in identifying peaks and troughs in the logarithm of real quarterly GDP. a peak takes place when yt > yt+j . The amplitude of an expansion is the percentage increase in output between a trough and the next peak. Calder´n and Fuentes (2010) adopt o a classical approach to characterizing business cycles in emerging and developed countries. −1. 1. And the duration of an expansion is the period of time that goes from a trough to the next peak. 2. Similarly. for j = −2.1 Duration and Amplitude of Business Cycles in Emerging and Developed Countries We have documented that emerging countries display signiﬁcantly more output volatility than developed countries. The duration of a contraction is the period of time that goes from a peak to the next trough. The amplitude of a contraction is the percentage fall in output between a peak and the next trough. −1. or a level of yt satistying yt < yt+j . We now decompose business cycles into contractions and expansions and estimate for each of these phases of the cycle its duration and magnitude. letting yt denote the logarithm of real GDP. for j = −2.Lecture in Open Economy Macroeconomics. 1. a trough is deﬁned as an output observation that is lower than its two immediately preceeding and succeeding observations. Formally. The duration of a cycle is the period of time that goes from one peak to the next.

2 21. and the United States. The table shows that contractions are on average quite short (about 11 months) and of about the same duration in the emerging and developed countries. Brazil. Colombia.8 Amplitude Contraction Expansion 6. Uruguay. Finally. Japan. expansions are much longer than contractions.2 20. Chile. The countries included in the OECD group are Australia. Costa Rica. 12 from Latin America and 12 from the pertaining to the OECD. Spain. The coutries included in the Latin America group are: Argentina. which results from adding the average durations of con- .5 16. emerging countries are more cyclical developed economies in the sense that in the former set of countries complete cycles are shorter (20 quarters versus 27 quarters. Italy. Germany. France. o Note: The data is quarterly real GDP from 1980:1 to 2006:4. Portugal. However.2 Source: Calder´n and Fuentes (2010). United Kingdom. Canada.2 percent of GDP). New Zealand.and Venezuela. However. Mexico.3 displays the average duration and amplitude of business cycles in two groups of countries.3: Duration and Amplitude of Business Cycles in Emerging and Developed Economies Group of Countries Latin America OECD Duration Contraction Expansion 3. Bolivia. We will identify the former group with emerging countries and the latter with developed countries.6 23.6 Mart´ Uribe ın Table 1. Paraguay. Peru.2 versus 2.0 3. Sweden. At the same time.3 2. contractions are much more pronounced in emerging countries than in developed countries (6. Ecuador. their amplitude is about the same in both groups of countries (about20 percent of GDP). Table 1. and are shorter in emerging countries than in developed countries (16 versus 23 quarters).

The general pattern that emerges is of emerging countries being more volatile. as they display more cycles per unit of time and more pronounced contractions on average.Lecture in Open Economy Macroeconomics. Chapter 1 7 tractions and expansions). .

8 Mart´ Uribe ın .

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. 2. 9 (2.1) . 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. The model developed in this chapter is simple enough to allow for a full characterization of its equilibrium dynamics using pen and paper.

and excess expenditure over income. Each period. ct − yt .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 in the long run. This endowment process represents the sole source of uncertainty in this economy.2) where dt denotes the debt position assumed in period t. This is because if the allocation {ct . (1 + r)j j→∞ lim Et (2. dt }∞ satisﬁes the no-Ponzi-game constraint with strict inequality. has two sources. rdt−1 . (2. which is assumed to be strictly increasing and strictly concave. households receive an exogenous and stochastic endowment and have the ability to borrow or lend in a risk-free real bond that pays a constant interest rate. and yt is an exogenous and stochastic endowment of goods. interest services on previously acquired debt. assumed to be constant. then t=0 . Households are subject to the following borrowing constraint that prevents them from engaging in Ponzi games: dt+j ≤ 0. dt − dt−1 . The optimal allocation of consumption and debt will always feature this constraint holding with strict equality. The evolution of the debt position of the representative household is given by dt = (1 + r)dt−1 + ct − yt . r denotes the interest rate.10 Mart´ Uribe ın where ct denotes consumption and U denotes the single-period utility function. The above constraint states that the change in the level of debt.

The optimality conditions associated with this problem are (2. the cost and beneﬁt of postponing consumption must equal each other in the margin.2) and the no-Ponzi-scheme constraint (2. so as to maximize (2. (2. We now derive an intertemporal resource constraint by combining the household’s sequential budget constraint (2. and the following Euler condition: U (ct ) = β(1 + r)Et U (ct+1 ). 1 + r.3) holding with equality. In period t + 1 the household receives the unit of goods invested plus interests. Get rid of dt by combining this expression with itself evaluated one period .2) and (2.Lecture in Open Economy Macroeconomics. At the optimal allocation. dt }∞ that also satisﬁes the not=0 Ponzi-game constraint and that satisﬁes ct ≥ ct . yielding β(1 + r)Et U (ct+1 ) utils.3) holding with equality—also known as the transversality condition.4) The interpretation of this expression is simple. its period-t utility falls by U (ct ). This alternative allocation is clearly strictly preferred to the original one because the single period utility function is strictly increasing. for all t ≥ 0. If the household sacriﬁces one unit of consumption in period t and invests it in ﬁnancial assets.3). The household chooses processes for ct and dt for t ≥ 0.2). Begin by expressing the sequential budget constraint in period t as (1 + r)dt−1 = yt − ct + dt . Chapter 2 11 one can choose an alternative allocation {ct . with ct > ct for at least one date t ≥ 0.1) subject to (2. (2.

First we require that the subjective and pecuniary rates of .. 1+r 1+r Mart´ Uribe ın (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 + . 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.3) holding with equality) to get the following intertemporal resource constraint: ∞ (1 + r)dt−1 = Et j=0 yt+j − ct+j . then it must run a trade surplus in at least one period. if the economy starts as a net external debtor.e. yt+j could in principle be larger than ct+j for all j ≥ 0. if dt−1 (1 + r) > 0.e. i. However. This yields: yt+1 − ct+1 dt+1 + . if dt−1 (1 + r) < 0.. that is. that is. yt+j must exceed ct+j for at least one j ≥ 0.12 forward. According to this intertemporal resource constraint. if the economy starts as a net creditor of the rest of the world. then it could in principle run a perpetual trade deﬁcit. i. (1 + r)j Intuitively. 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. At this point. we make two additional assumptions that greatly facilitates the analysis.

13 β(1 + r) = 1.6) which says that consumption follows a random walk: At each point in time. we can write ct = Et ct+2 . be equal to each other. β and 1/(1 + r). using again the Euler equation (2. Use this result to get rid of expected future consumption in the above intertemporal 1 After imposing this assumption. Under these assumptions. Take expectations conditional on information available at time t and use the law of iterated expectations to obtain Et ct+1 = Et ct+2 . ¯ 2 (2. (2. Repeating this procedure j times. we can deduce that ct = Et ct+j . Finally. the Euler condition (2.6) to replace Et ct+1 by ct .Lecture in Open Economy Macroeconomics. households expect to maintain a constant level of consumption over time. Chapter 2 discount.6) one period to obtain ct+1 = Et+1 ct+2 . . This assumption eliminates long-run growth in consumption when the economy features no stochastic shocks. that is.1 This particular functional form makes it possible to obtain ¯ a closed-form solution of the model. Second.5) with c < c. we assume that the period utility index is quadratic and given by 1 U (c) = − (c − c)2 . Now lead the Euler equation (2.4) collapses to ct = Et ct+1 . our model becomes essentially Hall’s (1978) permanent income model of consumption.

ct .d.i. where t denotes an i. rdt−1 .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. Using this expression to eliminate expectations of future income from equation (2.7). the more persistent is the endowment process. and to debt ser- vice. we obtain r = yt 1+r = ∞ rdt−1 + ct j=0 ρ 1+r j r yt . we assume that the endowment process follows an AR(1) process of the form yt = ρyt−1 + t . 1) deﬁnes the serial correlation of the endowment process. To be able to fully characterize the equilibrium in this economy. 1+r−ρ . Given this autoregressive structure of the endowment.14 Mart´ Uribe ın resource constraint to obtain (after slightly rearranging terms) r Et 1+r ∞ rdt−1 + ct = j=0 yt+j . innovation and the parameter ρ ∈ [0. The larger is ρ. (1 + r)j (2. the j-period-ahead forecast of output in period t is given by Et yt+j = ρj yt .

We can then write the equilibrium levels of the trade balance and the current account as: 1−ρ yt 1+r−ρ tbt = rdt−1 + and cat = 1−ρ yt . Formally.Lecture in Open Economy Macroeconomics.. Because the current account equals the change in the country’s net foreign asset position. letting tbt denote the trade balance in period t. the trade balance is given by the diﬀerence between output and consumption. In the present model. we have that a unit increase in the endowment leads to a less-than-unit increase in consumption. 1+r−ρ Note that the current account inherits the stochastic process of the underlying endowment shock. it follows .8) Because ρ is less than unity. i. letting cat denote the current account in period t.e. Formally. The current account is deﬁned as the sum of the trade balance and net investment income on the country’s net foreign asset position. Chapter 2 Solving for ct . cat = −(dt − dt−1 ). we have that cat ≡ −rdt−1 + tbt . we obtain r yt − rdt−1 . Two key variables in open economy macroeconomics are the trade balance and the current account. we have that tbt ≡ yt − ct . 1+r−ρ 15 ct = (2. The trade balance is given by the diﬀerence between exports and imports of goods and services.

the endowment shock is assumed to be purely transitory. 1+r−ρ dt = dt−1 − According to this expression. The intuition for this result is clear. ρ = 0.16 Mart´ Uribe ın that the equilibrium evolution of the stock of external debt is given by 1−ρ yt . Most of the endowment increase—a fraction 1/(1+r)—is saved.8). In this case. households smooth consumption by eating a tiny part of the current windfall and leaving the rest for future consumption. The longrun behavior of the trade balance is governed by the dynamics of external debt. A temporary increase in the endowment produces a gradual but permanent decline in the stock of foreign liabilities. the current account plays the role of a shock absorber. so that endowment shocks are positively serially correlated. external debt follows a random walk and is therefore nonstationary. Because income is expected to fall quickly to its long-run level. In the ﬁrst case. Two polar cases are of interest. an increase in the endowment leads to a permanent deterioration in the trade balance. Households borrow to ﬁnance negative income . According to equation (2. 2. Recall that we are assuming that 0 < ρ < 1.2 The Economy’s Response to Output Shocks Consider the response of our model economy to an unanticipated increase in output. Thus. 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.

More importantly. As a result. In response to the positive endowment shock. as documented in chapter 1. In the extreme case of purely transitory shocks. the current account is countercyclical in small open economies. the current account is nil and the stock of debt remains constant over time. the standard deviation of the current account is given by σy /(1 + r). the more volatile is the current account. the current account is procyclical. That is. an increase in income today is not accompanied by the expectation of a future decline in income. which is close to the volatility of the endowment shock itself for small values of r. ρ → 1. Note that the trade balance converges to . It follows that the more temporary are endowment shocks. when endowment shocks are permanent. In this case. the trade balance and the current account improve. 1). as a result. households allocate all innovations in their endowments to current consumption. which takes place when ρ ∈ (0.Lecture in Open Economy Macroeconomics. consumption experiences a once-and-for-all increase.1. Rather. The other polar case emerges when shocks are highly persistent. households are able to sustain an expendituren path consisting in consuming the totality of the current income shock. households expect the higher level of income to persist over time. This expansion in domestic absorption is smaller than the initial increase in income. is illustrated in ﬁgure 2. these two variables converge gradually to their respective long-run levels. The intermediate case of a gradually trend-reverting endowment process. This prediction represents a serious problem for this model. especially in developing countries. As a result. After the initial increase. Chapter 2 17 shocks and save in response to positive shocks. and. For. it improves during expansions and deteriorates during contractions. Intuitively.

18 Mart´ Uribe ın Endowment Consumption c t y t 0 t 0 t Trade Balance and Current Account External Debt 0 ca 0 t t t tbt dt Figure 2.1: Response to a Positive Endowment Shock .

which captures the essential elements of what has become known as the intertemporal approach to the current account. in this model.d. Summarizing. Suppose that ∆yt evolves according to the following autoregressive process: ∆yt = ρ∆yt−1 + t . is an i. the level of income is . Chapter 2 19 a level lower than the pre-shock level.Lecture in Open Economy Macroeconomics. shock with mean zero and variance σ 2 . a positive endowment shock produces a shortrun improvement in the trade balance but a long-run deterioration in this variable. displays mean reversion. 1) where t is a constant parameter.3 Nonstationary Income Shocks Suppose now that the rate of change of output. let ∆yt ≡ yt − yt−1 denote the change in endowment between periods t − 1 and t. According to this process. Fixing this problem is at the heart of what follows in this and the next two chapters. Thus.i.’ A central failure of the model is the prediction of a procyclical current account. 2. Speciﬁcally. whose service requiers a smaller trade surplus. and ρ ∈ [0. adjust to permanent shocks. rather than its level. This is because in the long-run the economy settles at a lower level of external debt. external borrowing is conducted under the principle: ‘ﬁnance temporary shocks.

Figure 2. The ﬁrst-order conditions associated with this problem are the sequential budget constraint.2: Stationary Versus Nonstationary Endowment Shocks nonstationary.20 Mart´ Uribe ın Stationary Endowment Nonstationary Endowment y c t t ct y t 0 t 0 t Figure 2. As before. consumption-smoothing households have an incentive to borrow against future income. This is the basic intuition why allowing for a nonstationary output process can help explain the observed countercyclicality of the trade balance and the current account at business-cycle frequencies. and the Euler equa- . Faced with such an income proﬁle. the model economy is inhabited by an inﬁnitely lived representative household that chooses contingent plans for consumption and debt to maximize the utility function (2.3). thereby producing a countercyclical tendency in the current account. the no-Ponzi-game constraint holding with equality. The following model formalizes this story.2) and the no-Ponzi-game constraint (2.2 provides a graphical expression of this intuition.5) subject to the sequential resource constraint (2. in the sense that a positive output shock ( t > 0) produces a permanent future expected increase in the level of output.

(1 + r)j This expression states that the current account equals the present discounted value of future expected income decreases. which we reproduce here for convenience r ct = −rdt−1 + Et 1+r ∞ j=0 yt+j . we have that Et ∆yt+j = ρj ∆yt . (1 + r)j Rearranging. we obtain ∞ cat = −Et j=1 ∆yt+j . we have not used the assumed stochastic properties of output. (1 + r)j Using this expression and recalling that the current account is deﬁned as cat = yt − ct − rdt−1 . Chapter 2 21 tion (2.6). the above expression is valid regardless of whether output follows a stationary or a nonstationary process. Using these optimality conditions yields the expression for consumption given in equation (2. Note that in deriving this expression. 1+r−ρ According to this formula. Using this result in the above expression. we can write r Et 1+r ∞ cat = yt − j=0 yt+j . This implication is an important improve- .7). the current account deteriorates in response to a positive innovation in output.Lecture in Open Economy Macroeconomics. Therefore. we can write the current account as: cat = −ρ ∆yt . Now using the assumed autorregressive structure for the change in the endowment.

the current account ceases to be countercyclical. or ρ > 0. The intuition behind this result is clear. letting σ∆c and σ∆y denote the standard deviations of ∆ct ≡ ct − ct−1 and ∆yt . respectively. this exercise is not comparable to the data displayed in chapter 1. Recall that when the endowment level is stationary. We note that the countercyclicality of the current account in the model with nonstationary shocks depends crucially on output changes being positively serially correlated. 2 . ∆ct /ct and ∆yt /yt ). which happens only if ∆yt is positively serially correlated. because here we are analyzing changes in the levels of consumption and output (i. In eﬀect.e.. whereas in chapter 1 we reported statistics pertaining to the growth rates of consumption and output (i. Are implied changes in consumption more or less volatile than changes in output? This question is important because.22 Mart´ Uribe ın ment relative to the model with stationary shocks. the current account increases in response to a positive endowment shock. developing countries are characterized by consumption growth being more volatile than output growth. as we saw in chapter 1. For an unexpected increase in income to induce an increase in consumption larger than the increase in income itself. Formally.2 We start with the deﬁnition of the current account cat = yt − ct − rdt−1 . ∆ct and ∆yt ). it is necessary that future income be expected to be higher than current income.. when ρ is zero or negative. Strictly speaking. we wish to ﬁnd 2 2 out conditions under which σ∆c can be higher than σ∆y in equilibrium.e.

so their changes are equally volatile.9) This expression implies that the standard deviation of consumpiton changes is given by σ∆c = 1+r σ. consumption and income move hand in hand. The right-hand side of this expression equals unity at ρ = 0. 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. It follows that there are values of ρ in the interval (0. namely. 1) for which the volatility of consumption changes is . we obtain 23 cat − cat−1 = ∆yt − ∆ct − r(dt−1 − dt−2 ). The right hand side of the above expression is increasing in ρ at ρ = 0. Noting that dt−1 − dt−2 = −cat−1 and solving for ∆ct . that when the level of income is a random walk. Then. Chapter 2 Taking diﬀerences.Lecture in Open Economy Macroeconomics. 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 The AR(1) speciﬁcaiton of ∆yt implies that σ∆y (1 − ρ2 ) = σ 2 . 1+r−ρ (2. This result conﬁrms the one obtained earlier in this chapter.

In the context of the open economy. whereas. Hall tested the prediction that consumption must follow a random walk.i. 1). 2. Here we review these restrictions and their empirical validity. Hall’s work motivated a large empirical literature devoted to testing the empirical relevance of the model described above. This property ceases to hold as ∆yt becomes highly persistent.d.4 Testing the Model Hall (1978) was the ﬁrst to explore the econometric implication of the simple model developed in this chapter. as expression (2. in particular. denoted cat .9) shows. Campbell’s restrictions are readily expressed in terms of the current account. the variance of ∆yt becomes inﬁnitely large as changes in income become a random walk. We start by deriving a representation of the current account that involves expected future changes in income. Speciﬁcally. deduced and tested a number of theoretical restrictions on the equilibrium behavior of national savings.7) as ∞ −(1 + r)cat = −yt + rEt j=1 (1 + r)−j yt+j . .24 Mart´ Uribe ın indeed higher than that of income changes. This is because as ρ → 1. is given by yt − ct − rdt−1 we can write equation (2. Noting that the current account in period t. Campbell (1987). process with ﬁnite variance for all values of ρ ∈ [0. ∆ct follows an i.

the country chooses to build its net foreign asset position (runs a current account surplus) when income is expected to decline in the future. Let Ht denote the information contained in the vector xt . Then. Similarly. cat Consider estimating a VAR system including xt : xt = Dxt−1 + t . Combining the above two expression we can write the current account as ∞ cat = − j=1 (1 + r)−j Et ∆yt+j . 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. it is simple to show that ∞ ∞ 25 −yt + rEt j=1 (1 + r)−j yt+j = (1 + r) j=1 (1 + r)−j Et ∆yt+j . In this case the country saves for a rainy day. we have that the forecast of xt+j given Ht is given by Et [xt+j |Ht ] = D j xt . Consider now an empirical representation of the time series ∆yt and cat .10) Intuitively. (2.Lecture in Open Economy Macroeconomics. Deﬁne ∆yt xt = . from the above VAR system. Chapter 2 Deﬁning ∆xt+1 = xt+1 − xt . .

In computing F . Since xt includes cat as one element.10) onto the vector xt . Consider now an additional testable cross-equation restriction on the .1. cat Let F ≡ − 1 0 [I − D/(1 + r)]−1 D/(1 + r). Nason and Rogers (2006) perform an econometric test of this restriction. then the Wald statistic. The regression coeﬃcients of the right-hand side regression is F . we obtain that the regression coefﬁcient for the left-hand side regression is the vector [0 1]. would take a value of 16. The VAR system that Nason and Rogers estimate includes 4 lags.04. The Wald statistic associated with null hypothesis that F = [0 1] is 16. with an asymptotic p-value of 0. which reﬂects the discrepancy of F from [0 1].26 It follows that ∞ Mart´ Uribe ın (1 + r)−j Et [∆yt+j |Ht ] = j=1 1 0 ∆yt [I − D/(1 + r)]−1 D/(1 + r) . This p-value means that if the null hypothesis was true. The estimation sample is 1963:Q1 to 1997:Q4. So the model implies the following restriction on the vector F : F = [0 1]. They estimate the VAR system using Canadian data on the current account and GDP net of investment and government spending.7 percent per year. they calibrate r at 3. Their data strongly rejects the above cross-equation restriction of the model. Now consider running a regression of the left and right hand side of equation (2.1 or higher only 4 out of 100 times.

for instance. From equation (2.5) by c + µt . Consider.and right-hand sides of this expression on the information set Ht .11) According to this expression. the variable cat+1 − (1 + r)cat − ∆yt+1 is unpredictable in period t. if one runs a regression of this variable on current and past values of xt .4 Both of the orthogonality conditions discussed here are strongly rejected by the data. 3 . because in general µt is correlated with cat .i. equation (2. and µt is an i. This projection yields the orthogonality restriction [0 1][D −(1+r)I]−[1 0]D = [0 0]. (2. Chapter 2 theoretical model. where c is still a constant. This yields the orthogonality condition [0 1][D − (1 + r)I]D − [1 0]D2 = [0 0]. replace c ¯ in equation (2. 4 In particular.Lecture in Open Economy Macroeconomics. Nason and Rogers (2006) ﬁnd that a test of the hypothesis that all coeﬃcients are zero in a regression of Consider projecting the left. Clearly. all coeﬃcients should be equal to zero. Speciﬁcally. 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. ¯ ¯ shock with mean zero. one can consider projecting the above expression onto ∆yt−1 and cat−1 .11) becomes Et cat+1 − (1 + r)cat − Et ∆yt+1 = µt .10) it follows that 27 Et cat+1 − (1 + r)cat − Et ∆yt+1 = 0. In this environment. the orthogonality condition stating that cat+1 − (1 + r)cat − ∆yt+1 be orthogonal to variables dated t or earlier. In particular.3 This restriction is not valid in a more general version of the model featuring private demand shocks. will not hold. a variation of the model economy where the bliss point is a random variable. Nevertheless.d.

The p-value associated with a regression featuring as regressors past values of xt is 0.28 Mart´ Uribe ın cat+1 − (1 + r)cat − ∆yt+1 onto current and past values of xt has a p-value of 0.06.01. .

an important result derived in the previous chapter is that the simple endowment economy model driven by stationary endowment shocks fails to predict the countercyclicality of the trade balance. Here. For output is perhaps the main variable any theory of the business cycle should aim to explain. First. Second. 29 . is unsatisfactory if the goal is to understand observed business cycles. the assumption that output is an exogenously given stochastic process. we introduce capital accumulation in the simple small open economy of chapter 2. which was maintained throughout the previous chapter. we show that allowing for capital accumulation can help resolve this problem. In this chapter we provide a partial remedy to this problem by assuming that output is produced with physical capital. The purpose of introducing physical capital in the model is twofold. in turn. which.Chapter 3 An Economy with Capital In this chapter. is an endogenous variable.

3) (3. 1) denotes the subjective discount factor. β ∈ (0. Households seek to maximize this utility function subject to the following three constraints: bt = (1 + r)bt−1 + yt − ct − it . and it denotes investment. we relax this . and to satisfy the Inada conditions. For the sake of simplicity.30 Mart´ Uribe ın 3. and bt+j ≥ 0. The function F describes the production technology and is assumed to be strictly increasing. strictly concave. strictly concave. t=0 (3.2) where bt denotes real bonds bought in period t yielding the constant interest rate r > 0. j→∞ (1 + r)j lim (3. we assume that the capital stock does not depreciate. kt denotes the stock of physical capital.1) where ct denotes consumption. kt+1 = kt + it . Later in these notes.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 ). The variable θt denotes an exogenous nonstochastic productivity factor. yt = θt F (kt ). assumed to be strictly increasing. and twice continuously diﬀerentiable. yt denotes output in period t. and U denotes the period utility function.

bt = (1 + r)bt−1 + θt F (kt ) − ct − kt+1 + kt . λt = β(1 + r)λt+1 . ct+1 = ct . and the transversality condition bt = 0.Lecture in Open Economy Macroeconomics. we assume that β(1 + r) = 1.4) . λt = βλt+1 [1 + θt+1 F (kt+1 )]. t→∞ (1 + r)t lim As in the endowment-economy model of chapter 2. 31 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 ]} . This assumption together with the ﬁrst two of the above optimality conditions implies that consumption is constant over time. Chapter 3 assumptions of a no depreciation and of deterministic productivity. (3. ∀t ≥ 0. The ﬁrst-order conditions corresponding to this problem are U (ct ) = λt . to avoid inessential long-run dynamics.

but also the present discounted value of the diﬀerences between output and investment. and a decreasing function of the opportunity cost of holding physical capital. θt+1 . (1 + r)j (3. kt+1 . κ1 > 0. given the initial stock of physical capital. Equilibrium condition (3. we follow the same steps as in the derivation of its counter- . the optimality conditions can be reduced to the following two expressions: r = θt+1 F (kt+1 ) (3. b−1 .6) says that consumption equals the interest ﬂow on a broad deﬁnition of wealth.6). is an increasing function of the future expected level productivity. j=0 (1+r)j To obtain equilibrium condition (3. bt . and the deterministic sequence of productivity shocks {θt }∞ . which includes not only initial ﬁnancial wealth. It follows from this equilibrium condition that next period’s level of physical capital. b−1 .6) for t ≥ 0. Formally.5) and ct = rbt−1 + r 1+r ∞ j=0 θt+j F (kt+j ) − kt+j+1 + kt+j . ∞ θt+j F (kt+j )−kt+j+1 +kt+j .4)-(3.5) states that households invest in physical capital until the marginal product of capital equals the rate of return on foreign bonds. A perfect foresight equilibrium is a set of sequences {ct . r). kt+1 = κ(θt+1 . k0 . the initial net external asset position. t=0 Equilibrium condition (3. r.32 Mart´ Uribe ın Using this expression. kt+1 }∞ t=0 satisfying (3.6). κ2 < 0.

equation (2. when households expected θ0 to ¯ ¯ be equal to θ. that is. That is. r). Suppose now that in period 0 there is a permanent. Chapter 3 part for the endowment economy. the trade balance is ¯ ¯ constant and large enough to serve the external debt.7). tb ≡ −r¯ b. Because in this steady state the capital stock is constant and because the depreciation rate of capital is assumed to be zero. Because the current account equals the change in the net international asset position (cat = bt+1 − bt ). ¯ i0 = k − k > 0.6) and evaluating that . In period 0. investment experiences a one-time increase that raises the level of capital available for production in ¯ ¯ period 1. ca = 0.1 A Permanent Productivity Shock Suppose that up until period -1 inclusive. 33 3. Plugging this path for the capital stock into the intertemporal resource constraint (3.6) then implies that consumption ¯ ¯ is constant and equal to c = r¯ + y. where y ≡ θF (k) denotes the steady¯ b ¯ state level of output. The intertemporal resource constraint (3. for t ≥ 1. Finally. respectively.1. the technology factor θt was con¯ stant and equal to θ. we have that k0 = k.Lecture in Open Economy Macroeconomics. k1 . θt = θ for t ≤ −1 and θt = θ for t ≥ 0. Thus. Because k0 was chosen in period −1. and it = 0. Suppose further that before period 0 the economy was in a steady state in which bond holdings and the capital stock were constant ¯ ¯ b and equal to ¯ and k ≡ κ(θ. from k to a level k ≡ κ(θ . kt = k for t ≥ 1. r) > k. unexpected increase ¯ ¯ ¯ in the technology factor from θ to θ > θ. we have that investment is constant and equal to zero. we have that in the steady state the current account equals zero.

2) to t t . given because θ > θ. This means that the expression within curly brackets is strictly possitive. t ¯ ¯ by c ≡ θF (k) + r¯ To show that the proposed allocation is feasible. 1+r 1+r (3. rewrite the above expression as ¯ ¯ c = r¯ + θ F (k) + b 1 ¯ ¯ θ F (k ) − F (k) − r k − k 1+r . we have that ¯ F (k )−F (k) ¯ k −k > F (k ). b b ¯ ¯ ¯ This establishes that consumption experiences a once-and-for-all increase in period 0. consumption experiences a permanent increase.34 equation at t = 0 we get Mart´ Uribe ın c0 = r¯ + b r 1 ¯ ¯ θ F (k) − k + k + θ F (k ). Clearly. consumption and investment paths cs and is into the sequential budget constraint (3.1 1 I thank Alberto Felettigh for providing this proof.7) This expression can be used to show that in response to the permanent technology shock. Therefore. I used to oﬀer the following alternative demostration: Consider the following suboptimal ¯ b paths for consumption and investment: cs = θ F (k) + r¯ and is = 0 for all tt ≥ 0.5) to replace r for θ F (k ) in the expression within curly brackets to obtain 1 ¯ ¯ θ F (k ) − F (k) − θ F (k ) k − k 1+r ¯ c = r¯ + θ F (k) + b . ct = c > c for all t ≥ 0. Because F is assumed to be strictly concave. That is. t t ¯ the consumption path cs is strictly preferred to the pre-shock path. let us plug the ¯ b. In previous versions of this book. we have that ¯ c > r¯ + θ F (k) > r¯ + θF (k) = c. To see this. Use equation (3.

We have established the existence of a feasible consumption path that is strictly preferred to the pre-shock consumption allocation. This is equivalent to assuming that households cannot invest in physical capital. the expression within square brackets on the right-hand side of equation (3. . in period zero households expect future output.Lecture in Open Economy Macroeconomics. is to set k = k on the right-hand side of equation (3. To better grasp the intuition behind this result. the optimal consumption path is constant starting in period 0. This result is signiﬁcantly diﬀerent from the one obtained in the endowment economy. which. a permanent positive technology shock causes the trade balance to deteriorate in period zero for two reasons: First. implies that consumption must experience a permanent. The above expression therefore implies that the trade balance falls in period 0. ¯ ¯ before the shock. essentially. Recalling ¯ ¯ that i0 = k − k > 0 and that c > θ F (k) + r¯ we deduce that tb0 < b. amounts to ¯ assuming that output is given by the exogenous amount θt F (k).8) vanishes. obtain the sequence of asset positions bs = ¯ for all t ≥ 0. tb. Obviously. To this end. limt→∞ ¯ b t so the proposed suboptimal allocation satisﬁes the no-Ponzi-game condition (3.7) to write ¯ tb0 = tb − 1 ¯ ¯ [θ F (k ) − θ F (k) + (k − k)].8). This means that the b. from equilibrium condition (3. implying that tb0 = tb.4).3). ¯ −r¯ − (k − k) < −r¯ Recalling also that the trade balance prevailing b b. It follows that the optimal consumption path must also be strictly preferred to the pre-shock consumption path. equals −r¯ we have that tb0 < tb. θ F (k ). 2 A quick way to refresh the eﬀect of a permanent output shock in the endowment ¯ economy. it is of use to decompose the change in the trade balance into an eﬀect due to the investment surge and an eﬀect stemming from changes in future expected output. to be higher than b/(1+r)t = 0. in which a permanent endowment shock leaves the trade balance unchanged. use equation (3. Chapter 3 35 ¯ The trade balance in period 0 is given by tb0 = θ F (k)−c −i0 .8) The expression within square brackets is unambiguously positive. once-and-for-all increase in period 0.2 In the present economy. trade balance deteriorates on impact. Note that in this case. 1+r (3. This result together with the fact that.

36 Mart´ Uribe ın ¯ current output. write tb1 = y1 −c1 − ¯ i1 and note that between periods 0 and 1 output increases (from θ F (k) to ¯ θ F (k )). To see this. Finally. This eﬀect is reﬂected in the ﬁrst term of the expression within square brackets in equation (3. The trade balance improves in period 1. This means that the current account. the current account returns b permanently to zero. θ F (k). consumption smoothing households borrow from future income to consume in the present. To establish this. We started with the simple small open economy of chapter 2 and introduced a single modiﬁcation. capital accumulation. The current account deteriorates in period 0 by the same magnitude as the trade balance. Thtis expression states that net foreign asset holdings are constant from t = 0 onward. as already explained. Let’s take stock of the results obtained thus far. the identity b0 = ¯ + ca0 and the fact that the current account deteriorates in b period 0 imply that net foreign asset holdings fall in period 0. In period 1. it is useful to characterize the behavior of net foreign asset holdings from period 1 onward.8). and investment falls (from k − k > 0 to k − k = 0. equals zero for periods t ≥ 1. note that ca0 = r¯ + tb0 and that b ¯ is predetermined in period 0. Evaluating the intertemporal budget constraint (3. namely.) The trade balance remains constant after period 1.6) at any period t ≥ 1. Second. consumption is unchanged.8). the positive productivity shock generates an investment surge in period 0. given by bt − bt−1 . We then showed that the modiﬁed model produces very diﬀerent predictions regarding the initial behavior of . This second source of trade deﬁcit appears in the second term of the expression within square brackets in equation (3. As a result. To show this. we readily ﬁnd that bt = (c − θ F (k )) for t ≥ 0.

households expect the productivity of capital to be high in the future. Consequently. To highlight the importance of these two factors in generating a deterioration of the trade balance in response to a positive productivity shock. Chapter 3 37 the trade balance in response to a positive shock. In turn. dampening the increase in domestic absorption in the date the shock occurs. the entire adjustment in investment occurs in period zero. in the next two sections we analyze separately an economy with purely temporary productivity shocks and an economy with capital adjustment costs. This channel is closed in the endowment economy of the previous chapter. Note that in response to the increase in future expected productivity. In the presence of costs of adjusting the stock of capital. whereas in the endowment economy a permanent output shock leaves the trade balance unchanged. In our model economy.Lecture in Open Economy Macroeconomics. . A second 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. they expand investment in the present period. investment spending is spread over a number of periods. In the present economy. investment falls to zero in period 1 and remains nil thereafter. What is behind the novel predictions of the present model? One factor that contributes to causing an initial deterioration of the trade balance is the combination of a demand for goods for investment purposes and a persistent productivity shock. a permanent increase in productivity causes the trade balance to initially deteriorate. To this end. the positive productivity shock in period 0 is expected to last over time. and thus have an incentive to raise the future stock of physical capital. Indeed. this increase in the demand for goods tends to deteriorate the trade balance.

¯ where k is the level of capital inherited in period 0. In this case. θ0 = θ > θ. Furthermore. That is. households would like to have more capital in that period. As a result. That is ¯ ¯ y0 = y−1 + (θ − θ)F (k).5) implies that the capital stock. everybody expects θt = θ for all t > 0. from θF (k) to θ F (k). ¯ ¯ where y−1 ≡ θF (k) is the pre-shock level of output. it is worth analyzing the eﬀect of a purely temporary shock.2 Adjustment to Temporary Productivity shocks To stress the importance of persistence in productivity movements in inducing a deterioration of the trade balance in response to a positive output shock. But k0 is ﬁxed in period zero. suppose that up until period -1 inclusive the productivity factor θt ¯ was constant and equal to θ. But agents have no incentives to have a higher capital stock in the future. equation (3. and therefore also invest¯ ment. That is. This output increase . This is intuitive. a zero probability event happens. kt = k for all t ≥ 0. because its productivity is expected to go back down to its historic ¯ level θ right after period 0.1. The productivity of capital unexpectedly increases in period zero. In period ¯ 0. suppose that everybody correctly expects the productivity shock to ¯ be purely temporary.38 Mart´ Uribe ın 3. Investment in period zero can only increase the future stock of capital. Specifically. namely. Suppose also that in period -1 people assigned ¯ a zero probability to the event that θ0 would be diﬀerent from θ. The positive productivity shock in period zero does produce an increase ¯ ¯ ¯ in output in that period. however. are unaﬀected by the productivity shock.

as the increase in the productivity of capital is short lived. we get that the trade balance in period 0 is given by 1 ¯ ¯ (θ − θ)F (k) > 0. At the same time. Chapter 3 induces higher consumption: Using equation (3. Combining the above two expressions and recalling that investment is unaﬀected by the temporary shock. The reason for this counterfactual response is simple: Firms have no incentive to invest. As a consequence. Comparing the results obtained under the two polar cases of permanent and purely temporary productivity shocks. we can derive the following principle: Principle I: The more persistent are productivity shocks.Lecture in Open Economy Macroeconomics. 1+r 39 c0 = c−1 + ¯ ¯ where c−1 ≡ rb−1 + θF (θ) is the pre-shock level of consumption. Basically. the more likely is the trade balance to experience an initial deterioration. domestic absorption increases but by less than the increase in output. . consumers save most of the purely temporary increase in income in order to smooth consumption over time. households invest the entire increase in output in the international ﬁnancial market and increase consumption by the interest ﬂow associated with that ﬁnancial investment. 1+r tb0 − tb−1 = (y0 − y−1 ) − (c0 − c−1 ) − (i0 − i−1 ) = This expression shows that the trade balance improves on impact.6) we have that r ¯ ¯ (θ − θ)F (k).

. Suppose that the sequential budget constraint is of the form 1 i2 t . As will be cler shortly. also vanishes in the steady state.40 Mart´ Uribe ın We will analyze this principle in more detail later. so that the law of motion of the capital stock is given by kt+1 = kt + it . 2 kt bt = (1 + r)bt−1 + θt F (kt ) − ct − it − Here. capital adjustment costs are given by i2 /(2kt ) and are a strictly cont vex function of investment. Note further that the slope of the adjustment-cost function. among many e others). we assume that physical capital does not depreciate. except that now changes in the stock of capital come at a cost. 3. in the context of a model featuring a more ﬂexible notion of persistence. this feature implies that in the steady state the relative price of capital goods in terms of consumption goods is unity. 1998. 1991. it = 0. given by it /kt . and Schmitt-Groh´. As in the economy without adjustment costs. Note that the level of this function vanishes at the steady-state value of investment.2 Capital Adjustment Costs Consider now an economy identical to the one analyzed thus far. e. This means that capital adjustment costs are nil in the steady state. Capital adjustment costs—in a variety of forms—are a regular feature of small open economy models because they help dampen the volatility of investment over the business cycle (see. Mendoza. .g.

ct = rbt−1 + and ct+1 = ct .3). r 1+r ∞ (3.9) 1 (1 + r)qt = θt+1 F (kt+1 ) + (it+1 /kt+1 )2 + qt+1 .1) subject to the above two restrictions and the no-Ponzi-game constraint (3. respectively. The variables λt and qt denote Lagrange multipliers on the sequential budget constraint and the law of motion of the capital stock. Chapter 3 41 Households seek to maximize the utility function given in (3. 2 kt+1 = kt + it . (1 + r)j In deriving these optimality conditions.10) j=0 θt+j F (kt+j ) − it+j − 1 (i2 /kt+j ) 2 t+j . 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 . kt 1+ (3.Lecture in Open Economy Macroeconomics. we combined the sequential budget constraint with the transversality condition to obtain a single intertemporal budget constraint and made use of the fact that the Lagrange multiplier λt is constant for t ≥ 0. We continue to assume that β(1 + r) = 1. The Lagrange multiplier qt represents the shadow relative price of capital . The ﬁrst-order conditions associated with the household problem are: it = qt .

Equation (3. Finally. This unit yields θt+1 F (kt+1 ) units of output next period.9) equates the marginal cost of producing a unit of capital. In addition.10).11) . Optimality condition (3. and is known as Tobin’s q. nonlinear diﬀerence equations in kt and qt : kt+1 = qt kt (3.10) compares the rate of return on bonds (left-hand side) to the rate of return on physical capital (right-hand side). instead of using qt units of goods to buy one unit of capital. Consider ﬁrst the rate of return of investing in physical capital. an extra unit of capital reduces tomorrow’s adjustment costs by (it+1 /kt+1 )2 /2. 3. the agent can engage in a ﬁnancial investment by purchasing qt units of bonds in period t which yields a gross return of (1+r)qt in period t+1. As qt increases.10). The sum of these three sources of income form the right hand side of (3. to the marginal revenue of selling a unit of capital.2. on the left-hand side. the unit of capital can be sold next period at the price qt+1 . Adding one unit of capital to the existing stock costs qt . which tends to restore the equality between the marginal cost and marginal revenue of capital goods. qt . agents have incentives to devote more resources to the production of physical capital. the increase in investment raises the marginal adjustment cost. Alternatively. it /kt . At the optimum both strategies must yield the same return. This is the left-hand side of equation (3. we obtain the following two ﬁrst-order. 1 + it /kt .1 Dynamics of the Capital Stock Eliminating it from the optimality conditions. on the right-hand side.42 Mart´ Uribe ın in terms of consumption goods. In turn.

The locus QQ corresponds to the .Lecture in Open Economy Macroeconomics.1.11). the capital stock grows over time.13) Above the locus KK . 1+r (3. q = 1. The horizontal line KK corresponds to the pairs (kt . (3.12) The perfect-foresight solution to these equations is depicted in ﬁgure 3. That is. qt ) for which kt+1 = kt in equation (3. and below the locus KK the capital stock declines over time.1: The Dynamics of the Capital Stock q Q S a • 1 K • K′ S′ Q′ k0 k* k qt = θt+1 F (qt kt ) + (qt+1 − 1)2 /2 + qt+1 . Chapter 3 43 Figure 3.

13) and (3. The value of k ∗ is implicitly determined by the expression r = θF (k ∗ ). Above and to the right of QQ . Mart´ Uribe ın (3. on the other hand. q decreases over time. . adjustment costs vanish in the steady state.44 pairs (kt . Equation (3.14) determine the steady-state value of the capital stock.13) that the locus KK is not aﬀected by the productivity shock. qt ) for which qt+1 = qt in equation (3.2 A Permanent Technology Shock Suppose now that in period 0 the technology factor θt increases permanently ¯ ¯ from θ to θ > θ. the long-run level of capital experiences a permanent increase. the locus QQ is downward sloping. If the initial capital stock is diﬀerent from its long-run level. That is. It follows that in response to a permanent increase in productivity.14) Jointly.14)shows that the locus QQ shifts up and to the right. because.2. It is clear from equation (3. For qt near unity. both q and k converge monotonically to their steady states along the saddle path. and the steady-state value of Tobin’s q. 1. q increases over time and below and to the left of QQ .12). is not aﬀected in the long run. This is the same value obtained in the economy without adjustment costs.12) is saddle-path stable. The locus SS represents the converging saddle path. The price of capital. rq = θF (qk) + (q − 1)2 /2. equations (3. qt . The system (3. 3. which we denote by k ∗ . as noted earlier. This is not surprising.11)-(3.

the capital stock does not move. as the capital stock adjusts gradually to its long-run level. qt . In particular. point a in the ﬁgure. Chapter 3 45 Consider now the transition to the new steady state. Then the new steady-state values of k and q are given by k ∗ and 1. Under capital adjustment costs. In eﬀect. investment experiences a one-time jump equal to k ∗ −k0 in period zero. capital and investment display a mute response. which in turn makes capital grow over time. the less It is straightforward to see that the response of the model to a purely temporary productivity shock is identical to that of the model without adjustment costs. because investment is part of domestic absorption. The price of installed capital. After the initial impact. Suppose that the steady-state value of capital prior to the innovation in productivity is k0 in ﬁgure 3.Lecture in Open Economy Macroeconomics. This increase in the price of installed capital induces an increase in investment. Along this transition. qt decreases toward 1. the initial increase in investment is smaller. In the period of the shock. The equilibrium dynamics of investment in the presence of adjustment costs are quite diﬀerent from those arising in the absence thereof. and because investment tends to be less responsive to productivity shocks in the presence of adjustment costs.1. In the frictionless environment. it follows that the trade balance is less likely to deteriorate in response to a positive innovation in productivity in the environment with frictions. the capital stock increases monotonically towards its new steady-state k ∗ . 3 . The following principle therefore emerges: Principle II: The more pronounced are capital adjustment costs. jumps to the new saddle path.3 The diﬀerent behavior of investment with and without adjustment costs has consequences for the equilibrium dynamics of the trade balance.

. We address this issue in the next chapter. In light of principles I and II derived in this chapter it is natural to ask what the model would predict for the behavior of the trade balance in response to productivity shocks when one introduces realistic degrees of capital adjustment costs and persistence in the productivity-shock process.46 Mart´ Uribe ın likely is the trade balance to experience an initial deterioration in response to a positive productivity shock.

or. we arrived at the conclusion that a model driven by productivity shocks can explain the observed countercyclicality of the current account. The resulting theoretical framework is known as the Small-Open-Economy Real-Business-Cycle model. First. Second. 47 . uncertainty in the technology shock process.Chapter 4 The Small-Open-Economy Real-Business-Cycle Model In the previous two chapters. capital adjustment costs must not be too strong. productivity shocks must be suﬃciently persistent. and capital depreciation. In this chapter. the SOE-RBC model. We also established that two features of the model are important for making this prediction possible. succinctly. we extend the model of the previous chapter by allowing for three features that add realism to the model’s implied dynamics: endogenous labor supply and demand.

θt+1 = β(ct . (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. (4.3) where βc < 0. βh > 0. ct denotes consumption.48 Mart´ Uribe ın 4. it makes it possible to rely on linear approximations to characterize equilibrium dynamics. it denotes gross in- . This property is desirable for a purely technical reason. yt denotes domestic output.2) (4. 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 ). 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. Namely. This preference speciﬁcation was conceived by Uzawa (1968) and introduced in the small-open-economy literature by Mendoza (1991). (4.4) where dt denotes the household’s debt position at the end of period t.1) θ0 = 1. rt denotes the interest rate at which domestic residents can borrow in period t. under these preferences the steady state is independent of the initial net foreign asset position of the economy. ht ).

1) subject to (4. θt+1 }∞ so as to maxt=0 imize the utility function (4. Chapter 4 49 vestment. small open economy models typically include capital adjustment costs to avoid excessive investment volatility in response to variations in the productivity of domestic capital or in the foreign interest rate.2)-(4. (4.6) to eliminate. dt . yt = At F (kt . yt and it .6) where δ ∈ (0.7) Use equations (4. it .Lecture in Open Economy Macroeconomics. Households choose processes {ct . As pointed out earlier.5) and (4. ht ). or Tobin’s q. kt+1 .5) where At is an exogenous and stochastic productivity shock. respectively.6) and a no-Ponzi constraint of the form j→∞ lim Et dt+j j s=0 (1 + rs ) ≤ 0. (4. (4. ht . Output is produced by means of a linearly homogeneous production function that takes capital and labor services as inputs. and kt denotes physical capital. The stock of capital evolves according to kt+1 = it + (1 − δ)kt . yt . The restrictions imposed on Φ ensure that in the steady state adjustment costs are nil and the relative price of capital goods in terms of consumption goods. from the . 1) denotes the rate of depreciation of physical capital. The function Φ(·) is meant to capture capital adjustment costs and is assumed to satisfy Φ(0) = Φ (0) = 0. is unity. This shock represents the single source of aggregate ﬂuctuations in the present model.

ht+1 ) + Et ηt+1 β(ct+1 .3)-(4. ht ) − ηt βc (ct . except for the fact that the marginal utility of consumption is not given simply by Uc (ct . ht ) + ct + kt+1 − (1 − δ)kt + Φ(kt+1 − kt ). In turn.50 sequential budget constraint (4.3). ηt equals the expected present discounted value of utility from period t + 1 onward. a unit decline in the discount factor reduces utility in period t by ηt .4). ht+1 ) (4. Let θt λt denote the Lagrange multiplier associated with this sequential budget constraint and θt ηt be the Lagrange multiplier associated with (4. Then.10) (4.9) (4. ht )Et λt+1 At+1 Fk (kt+1 . This operation yields Mart´ Uribe ın dt = (1 + rt−1 )dt−1 − At F (kt . the ﬁrst-order conditions associated with the household’s maximization problem are (4. Similarly. ht ) = λt At Fh (kt . ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) (4. ht+j ).12) These ﬁrst-order conditions are fairly standard.11) forward to obtain ηt = −Et ∞ j=1 θt+j θt+1 U (ct+j . Intuitively.11) λt [1+Φ (kt+1 −kt )] = β(ct . ht ) + ηt βh (ct . iterate the ﬁrst-order condition (4. ht )−βc (ct . ht ) ηt = −Et U (ct+1 . ht ) but rather by Uc (ct . To see this. ht ) = λt − Uh (ct . ht )(1 + rt )Et λt+1 (4.8) Uc (ct . ht )ηt .7) holding with equality and: λt = β(ct . The second term in this expression reﬂects the fact that an increase in current consumption lowers the discount factor (βc < 0). the marginal .

13) The law of motion of the productivity shock is given by the following ﬁrstorder autoregressive process: ln At+1 = ρ ln At + t+1 . given the initial conditions A0 . d−1 . white noise −1 β(c. σ 2 ). Chapter 4 51 disutility of labor is not simply Uh (ct . −ψ1 . rt .14) where the parameter ρ ∈ (−1. ht . it . The world interest rate is assumed to be constant and equal to r. h) = k α h1−α Φ(x) = φ 2 x .i. A competitive equilibrium is a set of processes {dt . ηt . ct .14). who uses the following functional forms for preferences and technology: c − ω −1 hω U (c. yt . 2 φ > 0. kt+1 .Lecture in Open Economy Macroeconomics. h) = 1 + c − ω −1 hω F (k. h) = 1−γ 1−γ t is assumed to be an i.4)-(4. Equating the domestic and world interest rates. ht )−βh (ct . We assume free capital mobility. yields rt = r. (4. and k0 and the exogenous process { t }. ht ) but instead Uh (ct . ht )ηt . At } satisfying (4. λt . 1) measures the serial correlation of the technology shock and the innovation distributed N (0. We parameterize the model following Mendoza (1991).d. (4.

0129 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. ω. δ.455 implies. It represents the supply of labor. because it indicates the real wage at which households are willing to supply an extra unit of labor to the market. in particular.1.9) and (4. combining equations (4. Mendoza calibrates the model to the Canadian economy.32 φ 0. The parameter values are shown in table 4. by equation (4. It follows that under the assumed functional forms for preferences. coincides with the demand for labor. as it indicates the real wage at which ﬁrms are willing to hire an extra unit of labor.52 Mart´ Uribe ın Table 4. a relatively high labor supply elasticity .42 σ 0. The left-hand side is the marginal rate of substitution of leisure for consumption. In eﬀect.028 r 0.04 δ 0. t (4.1: Calibration of the Small Open RBC Economy γ 2 ω 1. The value of ω of 1. the labor supply depends only upon the wage rate and.1 ρ 0.455 ψ1 0 . We also follow Mendoza (1991) in assigning values to the structural parameters of the model. The time unit is meant to be a year.11 α 0.15) The right-hand side of this expression is the marginal product of labor. and r are quite standard in the real-business-cycle literature.10) yields hω−1 = At Fh (kt .. The values assigned to the parameters γ. α.15). which. is independent of the level of consumption. ht ). in in a decentralized setting.

and output (y = k α h1−α ).Lecture in Open Economy Macroeconomics. investment (i = δk). equilibrium condition (4.2. Given the steady-state values of hours and the capital-labor ratio. To see how in steady state this ratio is linked to the value of ψ1 .12) in steady state to get k = h α r+δ 1 1−α . It is of interest to explain in more detail the calibration of the parameter ψ1 deﬁning the elasticity of the discount factor with respect to the composite c − hω /ω.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) . The calibrated value of r of 4 percent is in line with the average real rate of return of broad measures of the stock market in developed countries over the postwar period. This parameter determines the stationarity of the model and the speed of convergence of the net external debt position to the steady state. Use the resource constriant . Given the capital-labor ratio. use equation (4. we can ﬁnd directly the steady-state values of capital. independently of ψ1 . The value assigned to ψ1 is picked to match the average Canadian tradebalance-to-GDP ratio of about 2 percent. The assumed value of α implies a share of labor income in GDP of 68 percent. The calibrated value of δ implies that capital goods depreciate at a rate of 10 percent per year. Chapter 4 53 of 1/(ω − 1) = 2. It follows from this expression that the steady-state capital-labor ratio is independent of the parameter ψ1 .

it follows that this expression can be solved for ψ1 given tb/y. the larger is the assumed steady-state trade-balance-to-output ratio. just ¯ to ensure stationarity. ht ) = β[1 + (ct − c) − ω −1 (hω − hω )]−ψ1 . such as β(ct . and set the parameter β to match the observed trade- . Clearly.54 Mart´ Uribe ın c = y − i − tb to eliminate c from the steady-state version of equilibrium condition (4. matching the observed average trade-balance-to-output ratio might require a value of ψ1 that does aﬀect the behavior of the model at business-cycle frequency. With this speciﬁcation. r. δ. Recalling that y. h. For this reason. nd i are all independent of ψ1 . the parameter ψ1 governs both the steady-state trade-balance-to-output ratio and the stationarity of the equilibrium dynamics.8) to obtain the following relation between the steady-state level of the trade balance and the parameter ψ1 : [1+y−i−tb−hω /ω]−ψ1 (1+r) = 1. On the other hand. α. it might be useful to consider a two-parameter speciﬁcations of the discount ¯ factor. On the one hand. This dual role may create a conﬂict. Note that in our assumed speciﬁcation of the endogenous discount factor. and ω. where c and t ¯ h denote the steady-state values of ct and ht . one may want to set ψ1 at a small level so as to ensure stationarity without aﬀecting the predictions of the model at business-cycle frequency. This expression uses the speciﬁc functional form assumed for the discount factor and can be solved for the trade balance-to-output ratio to obtain: (1 + r)1/ψ1 + i tb =1− − y y y hω ω −1 . the larger is ψ1 . and β > 0 is a parameter. one can ﬁx the parameter ψ1 at a small value.

ct . This expression describes a system of nonlinear stochastic diﬀerence equations. ht . λt .4)-(4.e. xt ) = 0. There are a number of techniques that have been devised to solve dynamic systems like the one we are studying. kt .14) of ten equations in ten variables given by the elements of the vector xt . we have that the transversality condition limj→∞ Et dt+j /(1 + r)j = 0 is always satisﬁed.8)-(4. and ρ are calibrated to match the standard deviation of investment. σ . the parameters φ. The technique we will employ here consists in applying a ﬁrst-order Taylor expansion (i. The resulting linear system can be readily solved using well-established techniques. Before linearizing the equilibrium conditions.4)-(4. we introduce a convenient . ηt . Closed form solutions to this type of system are not typically available. Chapter 4 balance-to-output ratio. it . In any such solution the stock of debt is bounded.14) where the vector xt ≡ {dt−1 . We can therefore focus on bounded solutions to the system (4. rt . We therefore must resort to an approximate solution. Approximating Equilibrium Dynamics We look for solutions to the equilibrium conditions (4. linearizing) the system of equations around the nonstochastic steady state. and the serial correlation of output in Canada as shown in table 1. At } ﬂuctuates in a small neighborhood around its nonstochastic steady-state level. yt .6) and (4. the standard deviation of output.1. 55 Finally. The system can be written as Et f (xt+1 .Lecture in Open Economy Macroeconomics..

with net interest rates or variables that can take negative values. and At is an exogenous state variable. we deﬁne wt ≡ wt − w. are ˆ ˆ ˆ ˆ ˆ co-state variables. ηt . Note ˆ that for small deviations of wt from w it is the case that wt ≈ (wt − w)/w. It is useful to express some variables in terms of percent deviations from their steady-state values. such as the trade balance.e. which we denote generically by wt . Of these 10 variables. The remaining 7 elements of xt . where w denotes the steady-state value of wt . and At . dt−1 . Appendix A displays the linearized equilibrium conditions of the RBC model studied here. wt × 100 is approximately equal to the percent deviation of wt from its steady-state level.. rt . ˆ The linearized version of the equilibrium system can then be written as Axt+1 = Bxt . that . for instance. This is the case. In our model. where A and B are square matrices conformable with xt . we deﬁne its log deviation from steady state. Some other variables are more naturally expressed in levels. ht .56 Mart´ Uribe ın variable transformation. For any such variable. λt . kt . wt ≡ log(wt /w). 3 are state ˆ variables. That is. determined before ˆ t) or determined in t but in an exogenous fashion. For this type of variable. and yt . The vector xt contains 10 variables. Co-states are endogenous variables whose values are not predetermined in period t. ct . kt and ˆ ˆ dt−1 are endogenous state variables. All the coeﬃcients of the linear system. namely. State variables are variables whose values in any period t ≥ 0 are either predetermined (i. that is. it .

are known functions of the deep structural parameters of the model to which we assigned values when we calibrated the model. we impose a terminal condition requiring that at any point in time the system be expected to converge to the nonstochastic steady state.2 The Model’s Performance Table 4.htm. and ρ to match these three moments. φ. it correctly implies a volatility . d−1 . It should not come as a surprise that the model does very well at replicating the volatility of output. Matlab code to compute second moments and impulse response functions implied by the model studied here is available online at http://www. Formally. and A0 .Lecture in Open Economy Macroeconomics. That appendix also shows how to compute second moments and impulse response functions.edu/~mu2166/closing. For we picked values for the parameters σ . Chapter 4 57 is. Appendix B shows in some detail how to solve linear stochastic systems like the one describing the dynamics of our linearized equilibrium conditions. The linearized system has three known initial conditions k0 .2 displays some unconditional second moments of interest implied by our model. the terminal condition takes the form j→∞ lim |Et xt+j | = 0. the volatility of investment. But the model performs relatively well along other dimensions.columbia. To determine the initial value of the remaining seven variables. 4. For instance. and the serial correlation of output. the elements of A and B.

07 0. Also in line with the data is the model’s prediction of a countercyclical trade balance-to-output ratio. Empirical moments are taken from Mendoza (1991). as we established in the previous chapter.5 9. Note in particular that the implied correlation between hours and output is exactly unity.8 2.5 1.xt−1 0.7 0. equilibrium condition (4.1 2.3 ρxt .59 0.xt−1 0.3 9. which. were set independently of the cyclical properties of the trade balance.64 0.15). are the key determinants of the cyclicality of the trade-balance-to-output ratio. Standard deviations are measured in percentage points.7 0.66 ρxt .GDPt 1 0.54 0.5 2.61 0. In eﬀect.33 0.026 Note.58 Mart´ Uribe ın Table 4.94 0. which equates the marginal product of labor to the marginal .1 1.8 -0.61 0.13 σx t 3. On the downside.2: Empirical and Theoretical Second Moments Variable σx t y c i h tb y ca y Canadian Data ρxt .31 0. This prediction is due to the assumed functional form for the period utility index.66 1 -0.8 2 1. This prediction is of interest because the parameters φ and ρ governing the degree of capital adjustment costs and the persistence of the productivity shock.61 0. ranking featuring investment volatility above output volatility and output volatility above consumption volatility.1 2. the model predicts too little countercyclicality in the trade balance and overestimates the correlations of both hours and consumption with output.GDPt 1 0.9 Model ρxt .012 0.

. This stark prediction is a consequence of the particular functional form assumed for the period utility function.5 0 −0. Figure 4. can be written as hω = (1 − α)yt . investment.5 1 0.5 1 Consumption 0 2 4 Hours 6 8 10 Investment 10 5 0 −5 1. displays the impulse response functions of a number of variables of interest to a technology shock of size 1 in period 0.1. the increase in ct +it ) that takes place following the expansionary technology . the increase in domestic absorption (i. consumption. Chapter 4 59 Figure 4. In response to this innovation.5 0 0 2 4 6 8 10 0.5 1 0.5 0 1. the model predicts an expansion in output. The log-linearized version of this condition is ω ht = yt .5 −1 0 2 Current Account / GDP 4 6 8 10 rate of substitution between consumption and leisure.5 0 −0. Interestingly.e.5 0 0 2 4 6 8 10 0 2 4 6 8 10 Trade Balance / GDP 1 0.Lecture in Open Economy Macroeconomics.5 −1 0 2 4 6 8 10 1 0. t which implies that ht and yt are perfectly correlated. and hours.1: Responses to a One-Percent Productivity Shock Output 2 1.

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shock is larger than the increase in output, resulting in a deterioration of the trade balance.

4.3

The Roles of Persistence and Capital Adjustment Costs

In the previous chapter, we deduced that the negative response of the trade balance to a positive technology shock was not a general implication of the neoclassical model. In particular, Principles I and II of the previous chapter state that 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. First, capital adjustment costs must not be too stringent. Second, the productivity shock must be suﬃciently persistent. To illustrate this conclusion, ﬁgure 4.2 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 speciﬁcations. The solid line reproduces the benchmark case from ﬁgure 4.1. The broken line depicts an economy where the persistence of the productivity shock is half as large as in the benchmark economy (ρ = 0.21). In this case, because the productivity shock is expected to die out quickly, the response of investment is relatively weak. In addition, the temporariness of the shock induces households to save most of the increase in income to smooth consumption over time. As a result, the expansion in aggregate domestic absorption is modest. At the same time, because the size of the productivity shock is the same as in the benchmark economy, the initial responses of output and hours are identical

Lecture in Open Economy Macroeconomics, Chapter 4

61

**Figure 4.2: Response of the Trade-Balance-To-Output Ratio to a Positive Technology Shock
**

0.6 benchmark high φ low ρ 0.4

0.2

0

−0.2

−0.4

−0.6

−0.8

0

1

2

3

4

5

6

7

8

9

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in both economies (recall that, by equation (4.15), ht depends only on kt and At , and that kt is predetermined in period t). The combination of a weak response in domestic absorption and an initial response in output that is independent of the value of ρ, results in an improvement in the trade balance when productivity shocks are not too persistent. The crossed line depicts the case of high capital adjustment costs. Here the parameter φ equals 0.084, a value three times as large as in the benchmark case. In this environment, high adjustment costs discourage ﬁrms from increasing investment spending by as much as in the benchmark economy. As a result, the response of aggregate domestic demand is weaker, leading to an improvement in the trade balance-to-output ratio.

4.4

Alternative Ways to Induce Stationarity

The small open economy RBC model analyzed thus far features households with endogenous subjective discount factors. We will refer to that model as the ‘internal discount factor model,’ or IDF model. As mentioned earlier in this chapter, the inclusion of an endogenous discount factor responds to the need to obtain stationary dynamics up to ﬁrst order. Had we assumed a constant discount factor, the log-linearized equilibrium dynamics would have contained a random walk component. Two problems emerge when the linear approximation possesses a unit root. First, 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. Second, when the variables of interest contain

Lecture in Open Economy Macroeconomics, Chapter 4

63

random walk elements, it is impossible to compute unconditional second moments, such as standard deviations, serial correlations, correlations with output, etc., which are the most common descriptive statistics of the business cycle. In this section, we analyze and compare alternative ways of inducing stationarity in small open economy models. Our analysis follows closely Schmitt-Groh´ and Uribe (2003), but expands their analysis by including e two additional approaches to inducing stationarity: a model with an internal interest-rate premium, and a model with perpetually-young consumers.

4.4.1

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. Speciﬁcally, suppose that the discount factor depends not upon the agent’s own consumption and eﬀort, but rather on the average per capita levels of these variables. Formally, preferences are described by (4.1), (4.2), and

θt+1 = β(˜t , ht )θt c ˜

t ≥ 0,

(4.16)

where ct and ˜ t denote average per capita consumption and hours, which ˜ h the individual household takes as given. The ﬁrst-order conditions associated with the household’s maximization

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problem are (4.2), (4.4)-(4.7), (4.16) holding with equality, and:

λt = β(˜t , ht )(1 + rt )Et λt+1 c ˜

(4.17)

λt = Uc (ct , ht ) − Uh (ct , ht ) = λt At Fh (kt , ht )

(4.18) (4.19)

λt [1+Φ (kt+1 −kt )] = β(˜t , ht )Et λt+1 At+1 Fk (kt+1 , ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) c ˜ (4.20) In equilibrium, individual and average per capita levels of consumption and eﬀort are identical. That is, ct = ct ˜ and ht = ˜ t . h (4.22) (4.21)

A competitive equilibrium is a set of processes {dt , ct , ht , ct , ht , yt , it , ˜ ˜ kt+1 , λt , rt , At } satisfying (4.4)-(4.7), (4.13), (4.14), (4.17)-(4.22) all holding with equality, given A0 , d−1 , and k0 and the stochastic process { t }. Note that the equilibrium conditions include one fewer Euler equation (equation (4.11)), and one fewer variable, ηt , than the internal discount-factor model of subsection 4.1. The smaller size of the external-discount-factor model slightly speeds up the computation of equilibrium dynamics using perturbation techniques. Remarkably, the reverse is true if the model is solved using value-function iterations over a discretized state space. The reason is that in the value-function formulation, the aggregate variables ct ˜

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65

˜ and ht add two state variables. And each of these state variables comes at a cost in terms of computational speed.1 We evaluate the model using the same functional forms and parameter values as in the IDF model.

4.4.2

External Debt-Elastic Interest Rate (EDEIR)

Under an external debt-elastic interest rate, stationarity is induced by assuming that the interest rate faced by domestic agents, rt , is increasing in ˜ the aggregate level of foreign debt, which we denote by dt . Speciﬁcally, rt is given by ˜ rt = r + p(dt ), (4.23)

where r denotes the world interest rate and p(·) is a country-speciﬁc interest rate premium. The function p(·) is assumed to be strictly increasing. Preferences are given by equation (4.1). Unlike in the IDF or EDF model,s however, preferences are assumed to display a constant subjective rate of discount. Formally, we assume that

θt = β t ,

where β ∈ (0, 1) is a constant parameter. The representative agent’s ﬁrst-order conditions are (4.4)-(4.7) holding with equality and λt = β(1 + rt )Et λt+1

1

(4.24)

A similar comment applies to the computation of equilibrium in a model with an interest-rate premium that depends on the aggregate per capita level of external al debt to be discussed in the next subsection.

r.1.25) (4. ht ) = λt At Fh (kt .23)-(4. β= 1 .26) λt [1+Φ (kt+1 −kt )] = βEt λt+1 At+1 Fk (kt+1 . d−1 . this. and the process { t }. yt . equilibrium conditions (4. We use the following functional form for the risk premium: p(d) = ψ2 ed−d − 1 .1.28) all holding with equality. and k0 . (4. − Uh (ct . We set the subjective discount factor equal to the world interest rate. ρ. rt . F . 1+r To see ¯ ¯ The parameter d equals the steady-state level of foreign debt.27) Because agents are assumed to be identical. kt+1 . ˜ given A0 .4)-(4. and Φ as in the IDF model of subsection 4. ht+1 ) + 1 − δ + Φ (kt+2 − kt+1 ) . that is. and (4. δ.14).24) .28) ˜ A competitive equilibrium is a set of processes {dt .66 Uc (ct . ¯ where ψ2 and d are constant parameters. α. in equilibrium aggregate per capita debt equals individual debt. We adopt the same forms for the functions U . (4. ht . At } satisfying (4. (4. ct . it . We calibrate the parameters γ. ht ).7). ω. φ. d−1 = d−1 .23) and (4. that is. Mart´ Uribe ın (4. λt . note that in steady state. ht ) = λt . and σ using the values shown in table 4. ˜ dt = dt . dt .

Chapter 4 67 Table 4. Formally. d. (4.7442 ψ2 0.000742 together with the assumed form of the interest-rate premium imply that 1 = β 1 + r + ψ2 ed−d − 1 ¯ .3. ¯ We set d so that the steady-state level of foreign debt equals the one implied by the calibrated version of the IDF model of section 4.4. as before. and ψ2 are given in Table 4. The resulting values of β. Finally. In all other aspects. Note that the argument of the interest-rate premium function is the household’s own net debt position. the household . It follows that in the steady state the interest rate premium is nil. 4.96 ¯ d 0. The fact that β(1 + r) = 1 then implies that ¯ d = d. dt .1 generate the same volatility of the current-account-to-GDP ¯ ratio.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: Calibration of the Model with an External Debt Elastic Interest Rate β 0. we set the parameter ψ2 to ensure that the model analyzed here and the IDF model of section 4. This means that in deciding its optimal expenditure and savings plan. r denotes the world interest rate. in the IDEIR model the interest rate is given by rt = r + p(dt ).Lecture in Open Economy Macroeconomics.29) where.1. and p(·) is a householdspeciﬁc interest-rate premium. the model is identical to the EDEIR model.

The only optimality condition that changes relative to the EDEIR model is the Euler equation for debt accumulation. We assume the same functional forms and parameter values as in the EDEIR model of section 4. which now takes the form λt = β[1 + r + p(dt ) + p (dt )dt ]Et λt+1 .30) This expression features the derivative of the premium with respect to debt because households internalize the fact that as their net debt increases. and k0 . A competitive equilibrium is a set of processes {dt .4045212.7442.14). ¯ (1 + d)ed−d = 1. (4. ht .30) imposes the following restriction on d.4.7). given A0 . ¯ which does not admit the solution d = d. ct .25)-(4. d−1 . The fact that the steady-state debt is lower than d implies .2. recall that β(1 + r) = 1 and note that the steady-state version of equation (4.4)-(4.27). At } satisfying (4. (4. it .2. rt . λt . so does the interest rate they face in ﬁnancial markets. and (4. (4.4. which is the value imposed in the EDEIR model of section 4. We note that in the model analyzed here ¯ the steady-state level of debt is no longer equal to d. To see this. and the exogenous process { t }. We set d = 0.29).30). kt+1 . yt .68 Mart´ Uribe ın will take into account the fact that a change in his debt position alters the marginal cost of funds. (4. all holding with equality. The implied steady-state level of debt is then given by ¯ d = 0. except in the special case in which ¯ ¯ d = 0.

Preferences and technology are as in the EDEIR model of section 4. An alternative calibration ¯ strategy is to impose d = d. but the marginal premium is positive and equal to ψ2 d. 2 dt = (1 + rt−1 )dt−1 − yt + ct + it + Φ(kt+1 − kt ) + (4.31) ¯ where ψ3 and d are constant parameters deﬁning the portfolio adjustment cost function.25)-(4. Chapter 4 69 that the country premium is negative in the steady state.13) is assumed to hold. That is.2.27).5)-(4.31) holding with equality and ¯ λt [1 − ψ3 (dt − d)] = β(1 + rt )Et λt+1 (4.4.4 Portfolio Adjustment Costs (PAC) In this model. 4.4. is nil in the steady state. here the interest rate at which domestic households can borrow from the rest of the world is assumed to be constant and equal to the world interest rate. (4. The sequential budget constraint of the household is given by ψ3 ¯ (dt − d)2 . in contrast to what is assumed in the EDEIR model.2. as it is in the EDEIR economy of section 4.4. In this case. the country premium vanishes in the ¯ steady state. and adjust β to ensure that equation (4. given by ∂[ρ(dt )dt ]/∂dt .30) holds in steady state. However. The ﬁrst-order conditions associated with the household’s maximization problem are (4. the marginal country premium.32) . However. (4. equation (4.7).Lecture in Open Economy Macroeconomics. stationarity is induced by assuming that agents face convex costs of holding assets in quantities diﬀerent from some long-run level.

the household must repay the additional unit of debt plus interest.00074 to ψ3 . (4. we assign the value 0. and the exogenous process { t }. At } satisfying (4. the subjective discount factor is assumed to satisfy β(1 + r) = 1.7).32) all holding with equality. and k0 . λt . α. (4. Next period.25)-(4.2.4) and (4.3).14). The value of this increase in consumption in terms of utility is given by the left-hand side of the above equation. At the optimum. kt+1 . ρ.1 generate the same volatility in the current-account-to-GDP ratio. ht . (4. We calibrate d so that the steady-state level of foreign debt equals the one implied by models IDF.5)-(4. and EDEIR (see table 4. (4. ω. EDF. the marginal beneﬁt of a unit debt increase must equal its marginal cost.4. it .1. As in the EDEIR model of section 4. which ensures that this model and the IDF model of section 4. the models share all equilibrium conditions but the resource constraint (compare equations (4. Preferences and technology are parameterized as in the EDEIR model of section 4.32) imply that the parameter d determines the steady-state level ¯ ¯ of foreign debt (d = d). the Euler equations associated with the optimal choice of foreign .70 Mart´ Uribe ın This optimality condition states that if the household chooses to borrow an additional unit. A competitive equilibrium is a set of processes {dt . d−1 . rt . The parameters γ. φ. and (4. Finally. given A0 . r.2.31). δ. yt . and σ take the values displayed in table 4.4. ct .13). This assumption and ¯ equation (4. The value of this repayment in terms of today’s utility is given by the right-hand side of the above optimality condition. This parameter value is almost identical to that assigned to ψ2 in the EDEIR model. Indeed.31)). then current consumption increases by one unit minus the ¯ marginal portfolio adjustment cost ψ3 (dt − d).27). This is because the log-linearized versions of models 2 and 3 are almost identical.

In those models. agents have access to a complete array of state-contingent claims. (4.13) and (4.23)). However.4.t+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. In the model studied in this subsection. As we will see.2.4. Using these results. Preferences and technology are as in the EDEIR model of section 4. The period-by-period budget constraint of the household is given by Et rt. this assumption per se induces stationarity in the equilibrium dynamics.t+1 bt+1 . The log-linear approximation to the domestic interest rate is given by 1 + rt = ψ2 d(1 + r)−1 dt in the EDEIR model and by 1 + rt = 0 in the PAC model.33) where rt. agents have access to a single ﬁnancial asset that pays a non-state-contingent rate of return.t+1 bt+1 = bt + yt − ct − it − Φ(kt+1 − kt ). It follows that for small values of ψ2 and ψ3 . satisfying ψ2 = (1 + r)ψ3 . the log-linearized versions of the Euler equation for debt can be written as λt = ψ2 d(1 + r)−1 dt + Et λt+1 in the EDEIR model and as λt = ψ3 ddt + Et λt+1 in the PAC model. deﬁne the current state .5 Complete Asset Markets (CAM) All model economies considered thus far feature incomplete asset markets. Chapter 4 71 bonds (compare equations (4.2 Note that 2 To clarify the nature of the stochastic discount factor rt.t+1 . the EDEIR and PAC models imply similar dynamics. 4. and the interest rate faced by domestic households (compare equations (4. the log-linearized versions of the resource constraints are the same in both models.Lecture in Open Economy Macroeconomics.24) and (4.32)).

5).34) at all dates and under all contingencies.72 Mart´ Uribe ın because Et rt. Now let π(S t+1 |S t ) denote the probability of occurrence of state S t+1 .t+1 rt+1.27). (4.6). let bt+1 ≡ b(S t+1 |S t ). Also. Households are assumed to be subject to a no-Ponzi-game constraint of the form j→∞ lim Et rt. The variable rt. (4.t+2 · · · rt+j−1.25)-(4. (4.t+1 bt+1 .t+1 bt+1 π(S Et rt.t+j bt+j is the periodt price of a stochastic payment bt+j in period t + j. (4. Then.t+1 ≡ p(S t+1 |S t )/π(S t+1 |S t ) be the price of a contingent claim that pays in state S t+1 |S t scaled by the inverse of the probability of occurrence of the state in which the claim pays. Now |S ) let rt.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. whereas under incomplete markets of nature as S t . Let p(S t+1 |S t ) denote the price of a contingent claim that pays one unit of consumption in a particular state S t+1 following the current state S t .t+1 = βλt+1 . it follows that 1/[Et rt. But this expression is simply the conditional expectation S t+1 |S t rt. (4. given information available at the current state S t .t+1 is the price in period t of an asset that pays 1 unit of good in every state of period t + 1.33).t+1 ] denotes the risk-free real interest rate in period t. Then the current price of a portfolio composed of b(S t+1 |S t ) units of contingent claims paying in states S t+1 following S t is given by S t+1 |S t p(S t+1 |S t )b(S t+1 |S t ).t+j bt+j ≥ 0. Multiplying and dividing the expression inside the summation sign by π(S t+1 |S t ) p(S t+1 t we can write the price of the portfolio as S t+1 |S t π(S t+1 |S t ) π(S t+1|S t) b(S t+1 |S t ). . we can write the price of the portfolio as t+1 |S t ).34) holding with equality and λt rt. The ﬁrst-order conditions associated with the household’s maximization problem are (4. and (4.t+j ≡ rt.t+j represents the stochastic discount factor such that Et rt.

one ﬁrst-order condition of the foreign household is an equation similar to (4. Note t that we are assuming that domestic and foreign households share the same subjective discount factor.35). Formally. This means that λ∗ is exogenously determined.Lecture in Open Economy Macroeconomics. t t+1 (4. t Because we are interested only in the eﬀects of domestic productivity shocks. Combining the domestic and foreign Euler equations— equations (4.36) where λ∗ denotes the foreign household’s marginal utility of wealth. λt = ξλ∗ . Consequently. This means that the domestic marginal utility of consumption is indeed proportional to its foreign counterpart. t where ξ is a constant parameter determining diﬀerences in wealth across countries. λt λ∗ t This expression holds at all dates and under all contingencies. λ∗ rt.35) and (4. We assume that the domestic economy is small. where λ∗ is a parat . 73 Foreign households are assumed to have access to the same array of ﬁnancial assets as do domestic households. we assume that λ∗ is constant and equal to λ∗ . Chapter 4 the above Euler equation holds only in expectations.36)—yields λ∗ λt+1 = t+1 .t+1 = βλ∗ .

up to ﬁrst order.5).6). The above equilibrium condition then becomes Mart´ Uribe ın λ t = ψ4 . we consider a version of the small open economy model that displays no stationarity. and Φ are parameterized as in the previous models. (4.27). and (4. (c) agents face no frictions in adjusting the size of their portfolios. (4. Also. 4. 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. ω. where ψ4 ≡ ξλ∗ is a constant parameter. The functions U .1 and 4. EDEIR.14).6 The Nonstationary Case (NC) For comparison with the models considered thus far. In this model (a) the discount factor is constant. α. it . Under this speciﬁcation. yt . and the exogenous process { t }. At } satisfying (4.37) A competitive equilibrium is a set of processes {ct . ρ. and k0 . F . (4. ht . (4. λt . φ. EDF.4. β. The parameters γ.74 meter. the deterministic steady state of the model depends on the assumed initial level net foreign debt.3. given A0 . and PAC models.37). the equilibrium dynamics contain a random wal component in variables such . and (d) markets are incomplete. and σ take the values displayed in tables 4. kt+1 .25)-(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). in the sense that domestic households have only access to a single risk-free international bond. δ.

3 The NC model is nonstationary up to ﬁrst order. . This result is evident from table 4.edu/~mu2166. PAC. which.Lecture in Open Economy Macroeconomics. as might be expected.27) all holding with equality. the model’s predictions regarding second moments are virtually identical.24)-(4. We calibrate the model using the parameter values displayed in tables 4.14).7 Quantitative Results Table 4. it . and net external debt. ct . yt . The appendix shows the log-linear version of the IDF model of subsection 4. 75 A competitive equilibrium in the nonstationary model is a set of processes {dt . and k0 . and the exogenous process { t }. At } satisfying (4. ht . predicts less volatile consumption.4)-(4. EDF. 4. λt . rt . Chapter 4 as consumption.1 and 4. the complete markets case.3 For all models. The only noticeable diﬀerence arises in the CAM model. IDEIR. EDEIR. (4.4. EDF. kt+1 .columbia.4.3. and (4.13). The Matlab computer code used to compute the unconditional second moments and impulse response functions for all models presented in this section is available at www. (4. given d−1 . The main result of this section is that regardless of how stationarity is induced. the trade balance.1. we compute the equilibrium dynamics by solving a log-linear approximation to the set of equilibrium conditions. and CAM models. and therefore does not have well deﬁned unconditional second moments.7). The low volatility of consumption in the complete markets model introduces an additional diﬀerence between the predictions of this model and those of the IDF.4 displays a number of unconditional second moments of interest implied by the IDF. EDEIR.

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. As a result. the CAM model predicts that the correlation between output and the trade balance is positive. small-openeconomy version of the perpetual-youth model due to Blanchard (1985). Each panel shows the impulse response of a particular variable in the six models.8 The Perpetual-Youth Model In this subsection. consumption increases less when markets are complete than when markets are incomplete. the impulse response functions are so similar that to the naked eye the graph appears to show just a single line. We treat this case separately because exact aggregation in the presence of aggregate uncertainty requires the adoption of a particular functional form for the period utility index. For all variables. whereas the models featuring incomplete asset markets all imply that it is negative. Again. Figure 4. and PAC models: Because consumption is smoother in the CAM model.4. the only small but noticeable diﬀerence is given by the responses of consumption and the trade-balance-to-GDP ratio in the complete markets model. I present an additional way to induce stationarity in the small open economy RBC model. In response to a positive technology shock. 4. Cardia (1991) represents an early adoption of the perpetual-youth model in the context of a small open economy.76 Mart´ Uribe ın IDEIR.3 demonstrates that all of the models being compared imply virtually identical impulse response functions to a technology shock. As . It is a discrete-time. This in turn.

051 CAM 3.84 0.62 0.1 2.1 2.5 9 2.3 0.62 0.51 0.Lecture in Open Economy Macroeconomics. it−1 ) corr(ht .43 0.9 9.61 0.1 1. CAM = Complete Asset Markets.041 EDEIR 3.1 2.026 Serial Correlations: 0.62 0.66 1 -0.33 0.32 0. IDF = Internal Discount Factor.61 0.7 9 2.62 0. yt ) y corr( catt .66 1 -0.013 0.5 0.1 1.044 0.5 0.62 0.62 0.6 3.05 PAC 3.1 1.61 0.61 0.94 0.94 0.069 0.89 0.1 2. NC = Nonstationary Case.1 1. tbt−1 ) y y t−1 corr( catt . PAC = Portfolio Adjustment Costs.025 IDEIR 3.67 1 -0.7 0.036 0. yt−1 ) corr(ct .5 1. IDEIR = Internal Debt-Elastic Interest Rate.32 0.1 2.8 1.32 0.8 1.068 0.78 0.67 1 -0.07 0. EDEIR = External Debt-Elastic Interest Rate.39 Correlations with Output: corr(ct .5 0.6 1.3 0.1 2.61 0.5 0. . ct−1 ) corr(it . ht−1 ) t−1 corr( tbtt .012 0.7 9 2. yt ) y 1 0. Chapter 4 77 Table 4.1 1. yt ) corr(ht .4: Implied Second Moments IDF Volatilities: std(yt ) std(ct ) std(it ) std(ht ) std( tbtt ) y std( catt ) y corr(yt .76 0.5 0.85 0.31 0.07 0.66 1 0.4 0.13 Note.07 0.1 2.1 1.3 9.1 1.043 0.68 1 -0.61 0.1 2.069 0.7 0. yt ) corr(it . EDF = External Discount Factor. cat−1 ) y y EDF 3.3 9. Standard deviations are measured in percent per year.5 1.61 0.78 0. yt ) corr( tbtt .

Dotted line: complete asset markets model.5 0 10 5 0 −5 1 0. Squares: Endogenous discount factor model without internalization.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 0.5 0 −0. Dash-dotted line: Portfolio adjustment cost model.5 1 0.5 1 0.5 −1 0 2 4 6 8 10 0 2 4 6 Investment 8 10 0. Dashed line: Debt-elastic interest rate model.3: Impulse Response to a Unit Technology Shock in Models 1 .5 Output 2 1.5 −1 0 2 4 6 8 10 1.78 Mart´ Uribe ın Figure 4. Solid line: Endogenous discount factor model. . Circles: Model without stationarity inducing elements.5 0 1.5 0 −0.

and µt is a white noise common to all agents. 1) of dying.Lecture in Open Economy Macroeconomics.t = ds.and right-hand sides of the law of motion for debt over all agents alive in period t—i. the aggregate dynamics of the model are very much in line with those obtained from the other models studied earlier in this section. where dt denotes the aggregate debt position in period t.e. we assume that 1 − θ agents are born each period. In performing the aggregation. however. Each period. Here. Consider an economy in which debt holdings of individual agents follow a pure random walk of the form ds.. Adding the left. individual agents face a probability 1 − θ ∈ (0. In addition. ds.t−1 + µt —yields dt = θdt−1 + µt .t denotes the net debt position in period t of an agent born in period s. applying the operator (1 − θ) −∞ t−s s=t θ on both sides of the expression ds.t−1 + µt . Assume that those agents who die leave their outstanding debts unpaid and that newborns inherit no debts. We now depart from the representative-agent assumption by introducing a constant and ageindependent probability of death at the individual level.t = ds. recall that dt. assume that the population is constant over time and normalized to unity. because agents are born free of debts. . Chapter 4 79 we will see.t−1 = 0. representative-agent economy of chapter 2. This was exactly the equilibrium evolution of debt we obtained in the quadraticpreference. Speciﬁcally. The Basic Intuition The basic intuition behind why the assumption of ﬁnite lives by itself helps to eliminate the unit root in the aggregate net foreign asset position can be seen from the following simple example. to keep the size of the population constant over time.

in the world ﬁnancial market.38) ∞ (βθ)t (xs. we embed this basic stationarity result in the smallopen-economy real-business-cycle model. 1) represents a subjective discount factor.80 Mart´ Uribe ın Clearly.t = cs.t − x)2 ¯ t=0 where cs. Agents can borrow from foreign lenders by means of a bond paying a constant real interest rate. But we depart from the preference speciﬁcations used earlier in this chapter by assuming a quadratic period utility index. The key diﬀerence with the representative agent model is that here each period a fraction 1 − θ of the stock of debt simply disappears. Households Each agent maximizes the utility function 1 − E0 2 with xs. Following ¯ the preference speciﬁcation used in all of the models studied in this chapter. this assumption is essential to achieve aggregation in the presence of aggregate uncertainty. the risk-free inter- .t . the resulting law of motion for the aggregate level of debt is mean reverting at the survival rate θ.t denote consumption and hours worked in period t by an agent born in period s. ω (4. and x is a parameter denoting a satiation point.t and hs. The parameter β ∈ (0. we assume that agents derive utility from a quasi-diﬀerence between consumption and leisure. As will become clear shortly.t − hω s. In what follows.

t−1 + cs. they have access to an actuarily fair insurance market. Domestic agents can also lend at the rate r.40) The ﬁrst-order conditions associated with the agent’s maximization prob- . Agents are assumed to be subject to the following no-Madoﬀgame constraint j→∞ lim Et θ 1+r j ds.t = ds. share holdings are identical across agents. Chapter 4 81 est rate is given by r. The agent’s sequential budget constraint can be written as 1+r θ ds.Lecture in Open Economy Macroeconomics. we assume that agents do not trade shares and that the shares of the dead are passed to the newborn in an egalitarian fashion. domestic agents therefore pay a constant premium over the world interest rate. The debts of deceased domestic agents are assumed to go unpaid.39) where πt and wt denote. Thus.t . respectively. In addition. the insurance contract in this market speciﬁes that lenders receive a constant premium over the interest rate r while alive and must leave their assets to the insurance company in case of death. (4. proﬁts received from the ownership of stock shares and the real wage rate. Foreign agents are assumed to lend to a large number of domestic agents so that the fraction of unpaid loans due to death is deterministic. To compensate foreign lenders for these losses.t+j ≤ 0 (4.t − πt − wt hs. It follows that the gross interest rate on the domestic agent’s asset position (whether this position is positive or negative) is given by (1 + r)/θ. To facilitate aggregation.

t − x) = λs.t−1 − πt − 1 − ¯ ¯ wt hs.38) and (5.t = ds. 1+r θ 1 ω ds. t (4.39). This means that we can drop the subscript s from hs. (4. and Mart´ Uribe ın − (xs.t+1 (4.38).39).44) Use equations (4.t and λs.t is independent of s (i.t + x + (xs.t − x) To facilitate notation. (4.e.40) holding with equality. This yields. it is independent of the agent’s birth date). Then the sequential budget con- .82 lem are (4.t from the sequential budget constraint (4.t = β(1 + r)Et .42) (4. ¯ hω−1 = wt . s. we introduce the following auxiliary variable: 1 ω yt ≡ πt + 1 − ¯ wt ht − x.9) to eliminate cs. (4.t .45) which is the same for all generations s because both proﬁts and hours worked are independent of the age of the cohort.41) (4..λs.t and write hω−1 = wt .43) Note that hs.

t − x) Now iterate this expression forward and use the transversality condition (i.Lecture in Open Economy Macroeconomics.t to obtain β(1 + r)2 − θ (˜t − ds. to obtain 1+r θ ∞ ds.t+j yields 1+r θ ∞ ds. Speciﬁcally.t = x + ¯ (4.t−1 = Et j=0 θ 1+r j [yt+j − (xs. y βθ(1 + r) xs.47) We now aggregate individual variables by summing over generations born . Chapter 4 straint becomes: 1+r θ 83 ds. yt is deﬁned as ˜ θ yt ≡ ˜ Et 1+r ∞ j=0 θ 1+r j yt+j ..43) to replace Et xs.46) where yt denotes a weighted average of current and future expected values ˜ of yt . equation (4.41) and (4.t−1 ).t−1 − yt + (xs.t+j − x)] ¯ Using equations (4.e.40) holding with equality). and can be expressed recursively as θ θ ˜ yt + Et yt+1 1+r 1+r yt = ˜ (4.t−1 = Et j=0 θ 1+r j yt+j − β(1 + r)2 ¯ (xs.t = ¯ ds.t − x) β(1 + r)2 − θ Solve for xs.

50) (4.46): β(1 + r)2 − θ (˜t − θdt−1 ). keep in mind that dt.84 Mart´ Uribe ın at time s ≤ t.41) and the budget constraint(4. agents inherit no debts at birth.t denote the aggregate levels of xs. That is.39) to obtain − (xt − x) = λt ¯ and dt = (1 + r)dt−1 − yt + xt − x ¯ (4.t . respectively.t−1 = 0. Let −∞ xt ≡ (1 − θ) s=t θ t−s xs.t and −∞ dt ≡ (1 − θ) s=t θ t−s ds.49) We now turn to the economic units producing consumption and capital goods. and. (1 − θ)θ s people born in period t − s. aggregate the ﬁrst-order condition (4. Finally. .t and bs.48) In performing this step. Now multiply (4.46) by (1 − θ)θ t−s and then sum for s = t to s = −∞ to obtain the following expression for the aggregate version of equation (4. y βθ(1 + r) xt = x + ¯ (4. in general. Notice that at time t there are alive 1 − θ people born in t. (1 − θ)θ people born in t − 1.

which we reproduce here for convenience kt+1 = (1 − δ)kt + it (4.54) . ht ) − wt ht − ut kt . (4. Chapter 4 Firms Producing Consumption Goods 85 We assume the existence of competitive ﬁrms that hire capital and labor services to produce consumption goods.52) Firms Producing Capital Goods We assume that there exist ﬁrms that buy consumption goods to transform them into investment goods. πt .Lecture in Open Economy Macroeconomics. where the productivity factor At and the production function F are as described earlier in this section.53) The evolution of capital follows the law of motion given earlier in this chapter. and pay dividends. which are given by: At F (kt . these ﬁrms maximize proﬁts. rent out capital. ht ) = ut (4. ht ) = wt . Formally. The ﬁrst-order conditions associated with the ﬁrm’s proﬁt-maximization problem are At Fk (kt . dividends in period t are given by πt = ut kt − it − Φ(kt+1 − kt ) (4.51) and At Fh (kt .

That is. we will assume that the ﬁrm uses the discount factor β j λt+j /λt to discount quantities of goods delivered in a particular state of period t + j into period t. respectively. For there is no market for such claims. Recall that the shares of the dead are distributed in equal parts among the newborn. One must therefore introduce assumptions regarding the ﬁrm’s discounting behavior. It follows that the optimization problem of the capitalproducing ﬁrm is inherently dynamic. the owners of the ﬁrm change over time. the ﬁrm operates in a ﬁnancial environment characterized by incomplete asset markets.86 Mart´ Uribe ın Because investment goods take one period to become productive capital and because of the presence of adjustment costs. Note that this discount factor uses the average marginal utility of consumption of agents alive in period t and t+j.’ For the representative household does not exist. It follows that the ﬁrm cannot use as its discount factor the intertemporal marginal rate of substitution of the ‘representative household. The ﬁrm must maximize some present discounted value of current and future expected proﬁts. current investment decisions of the ﬁrm have consequences not only for current proﬁts but also for future proﬁts. Note also that we use as the subjective discount factor . at any given time. With this in mind. the ﬁrm converts goods into utils by multiplying the amount of goods by the average marginal utility of consumption of the shareholders alive at that time. Second. This issue does not have a clear answer for two reasons: ﬁrst. A problem that emerges at this point is what discount factor should the ﬁrm use. given by λt and λt+j . For this reason. it cannot use the price of state-contingent claims to discount future proﬁts. These assumptions will in general not be inocuous with respect to the dynamics of capital accumulation.

which declines at the mortality rate 1 − θ. Chapter 4 87 the parameter β and not βθ. yt . πt . θ θ ˜ yt + Et yt+1 . Below.55) form a system of eleven equations in eleven unknowns: xt . ut . The Lagrangean associated with the capital-producing optimization problem is then given by ∞ L = Et j=0 βj λt+j [ut+j kt+j − kt+j+1 + (1 − δ)kt+j − Φ(kt+j+1 − kt+j )] λt The ﬁrst-order condition with respect to kt+1 is λt [1 + Φ (kt+1 − kt )] = βEt λt+1 ut+1 + 1 − δ + Φ (kt+2 − kt+1 ) (4. we reproduce ˜ the system of equilibrium conditions for convenience: hω−1 = wt . ¯ .55) Equilibrium Equations (4. 1+r 1+r β(1 + r)2 − θ (˜t − θdt−1 ). dt . yt . kt . it . (4.44). This is because the number of shareholders is constant over time (and equal to unity). (4. unlike the size of a cohort born at a particular date. t 1 ω yt ≡ πt + 1 − yt = ˜ xt = x + ¯ ¯ wt ht − x. wt .Lecture in Open Economy Macroeconomics.45). λt . ht . y βθ(1 + r) −(xt − x) = λt .47)-(4.

88 dt = (1 + r)dt−1 − yt + xt − x. kt+1 = (1 − δ)kt + it . In eﬀect. the (autoregressive) coeﬃcient on past external debt is θ ∈ (0. (This intuition also goes through when β(1 + r) = 1. The mean reverting property of aggregate external debt obtains in spite of the fact that individual debt positions follow a random walk. This expression shows that the stock of debt per capital y does not follows a random walk as was the case in the representative-agent economy with constant subjective discount factor and world interest rate. At Fh (kt . ht ) = ut . 1) of the agents die and are replaced by newborns holding no ﬁnancial assets. As a result. ht ) = wt . The reason why the aggregate level of external debt is trend reverting in equilibrium is the fact that each period a fraction 1 − θ ∈ (0.) The forcing term yt − (1 + r − θ)/θ˜t represents the diﬀerence y between current and permanent income. It is of interest to consider the special case in which β(1 + r) = 1. πt = ut kt − it − Φ(kt+1 − kt ). 1). In equilibrium. In this case. on average. Mart´ Uribe ın λt [1 + Φ (kt+1 − kt )] = βEt λt+1 ut+1 + 1 − δ + Φ (kt+2 − kt+1 ) . the current account . the evolution of per capita external debt is given by dt = θdt−1 + (1 + r − θ)/θ˜t − yt . the current aggregate level of debt is only a fraction θ of the previous period’s level of debt. although in this case individual levels of debt display a trend in the deterministic equilibrium. ¯ At Fk (kt .

ω = 1.4 depicts impulse responses to a one-percent increase in total factor productivity.32. x = 0.028. Note that the calibration makes agents relatively impatient. 89 In the deterministic steady state. wish to hold constant debt levels over time. That is. Chapter 4 absorbs these income deviations. Implied Business Cycles As in the previous subsections.1. h) = k α h1−α and Φ(x) = φ x2 .9933. Table 4. and a positive steady-state trade-balance-to-output ratio of about 2 percent. in the sense that β(1 + r) < 1. The model dynamics are quite similar to those obtained under the alternative ways of inducing stationarity discussed in this section. This is because in this case agents. and ¯ β = 0. α = 0. φ = 0. the model generates the same ranking of volatilities and quite . as in the calibration of the models discussed earlier in this section.4550. we use the functional forms F (k.51.Lecture in Open Economy Macroeconomics.5 displays unconditional second moments implied by the model and ﬁgure 4. r = 0. And we calibrate the model as follows: δ = 0. in the steady state both the aggregate and the individual levels of debt are zero in this case. In particular. The reason for imposing tis parameterization is that it allows for a positive aggregate level of external debt in the steady state.9596. θ = 0. the steady-state aggregate stock of debt is nil.04. 2 ρ = 0. the aggregate level of debt is given by 1 r − 1 d= β(1+r)2 −θ rβ(1+r)(1+r−θ) 2 − β(1+r) −θ rβ(1+r) y In the special case in which β(1 + r) equals unity. all of whom are born with no debts.42.

059 Note.89 0.5 0 0 2 4 6 8 10 0 2 4 6 8 10 Trade Balance / GDP 1 0.69 1 -0.4 ρxt .GDPt 1 0.9 2.5 1 0.099 0.5 1 Consumption 0 2 4 Hours 6 8 10 Investment 10 5 0 −5 1.46 0.5 0 0 2 4 6 8 10 0.5: Perpetual Youth Model: Implied Second Moments Variable Output Consumption Investment Hours Trade-Balance-To-Output Ratio Current-Account-To-Output Ratio σx t 3.90 Mart´ Uribe ın Table 4.8 0.5 −1 0 2 4 6 8 10 1 0.2 1.63 0.6 1.3 ρxt .5 0 1.5 −1 0 2 Current Account / GDP 4 6 8 10 .xt−1 0.065 0.4: Perpetual Youth Model: Impulse Response to a One-Percent Productivity Shock Output 2 1.5 1 0.63 0.2 2. Figure 4.5 0 −0.5 0 −0. Standard deviations are measured in percentage points.8 8.

5 Emerging-Country Business Cycles Through the Lens of the SOE RBC Model Can the SOE RBC model explain business cycles in emerging economies? One problem with the SOE-RBC model studied thus far is that it predicts consumption to be smoother than output (see table 4.2).2). consumption. we suggested that a possible solution to this problem is to introduce nonstationary income shocks. investment. Chapter 4 91 similar patterns of autocorrelations and correlations with output. Aguiar and Gopinath (2007) pursue this strategy and argue that the SOE-RBC model is an adequate framework for understanding aggregate ﬂuctuations in developing countrires provided it is augmented to allow for nonstationary productivity shocks. the perpetual-youth model implies expansions in output. Contrary to this prediction. as in the other models discussed in this section. they consider a small open economy populated by a large number of identical households seeking to maximize the utility function ∞ max E0 t=0 βt [Ctγ (1 − ht )1−γ ]1−σ − 1 1−σ . in response to a positive innovation in total factor productivity. Speciﬁcally. and hours and a deterioration in the trade balance and the current account. emerging countries are characterized by consumption being more volatile than output (see table1. 4. In addition.Lecture in Open Economy Macroeconomics. In section 2.3.

Λt = βRt Et Λt+1 . . ˜ where Dt denotes the cross-sectional average level of external debt per capita in period t. Dt denotes net external debt. In equilibrium. This economy is driven by a stationary productivity shock At and a nonstationary productivity shock Xt . In the above expressions.2. as in section 4. which. we have that ˜ D t = Dt . and to some no-Ponzi-game constraint of the type presented earlier in this chapter.92 subject to Dt+1 φ = Dt + Ct + Kt+1 − (1 − δ)Kt + Rt 2 Kt+1 −g Kt 2 Mart´ Uribe ın Kt − At Ktα (Xt ht )1−α . Ct denotes consumption. (1 − ht )(1−γ)(1−σ) = Λt . is assumed to be debt elastic: ˜ ¯ Rt = R∗ + ψ eDt+1 /Xt −d − 1 .4. The optimality conditions associated with the household’s problem are 1 − γ Ct = (1 − α)At Xt γ 1 − ht Ct γ(1−σ)−1 Kt X t ht α . ht denotes hours worked. because all households are identical. and Rt denotes the gross interest rate charged by the rest of the world. Kt denotes the stock of physical capital.

Note that the productivity factor Xt is nonstationary in the sense that it displays both secular growth. The parameter g > 1 denotes the gross growth rate of productivity in a nonstochastic equilibrium path. Chapter 4 and Kt+1 −g Kt Kt+1 Xt+1 ht+1 φ 2 α−1 93 Λt 1 + φ = βEt Λt+1 1 − δ + αAt+1 +φ Kt+2 Kt+1 Kt+2 −g Kt+1 − Kt+2 −g Kt+1 2 . where Λt denotes the Lagrange multiplier associated with the sequential budget constraint of the household. at an average rate g. The variables and g t are assumed to be exogenous.Lecture in Open Economy Macroeconomics. Assume that Xt and At are mutually independent random variables with laws of motion given by ln At = ρa ln At−1 + σa a t and ln(gt /g) = ρa ln(gt−1 /g) + σg g . The main diﬀerence between the present model and the one studied earlier in this chapter is the introduction of the nonstationary productivity shock Xt . This last characteristic is reﬂected . t where gt ≡ Xt Xt−1 a t denotes the gross growth rate of Xt . 1). mutually independent white noises distributed N (0. and a random walk cmponent.

investment. including consumption.94 Mart´ Uribe ın in the fact that an innovation in gt has a permenent eﬀect on the level of Xt . there exists a simple stationary transformation of the variables of the model whose equilibirum behavior is described by a system of equations very similar to the one that governs the joint determination of the original variables. the marginal utility of wealth. however. Clearly. and λt ≡ Xt−1 1+(σ−1)γ Λt . Then we have that under the present technology speciﬁcation SRt = At Xt1−α . Let SRt denote total factor productivity. the Solow residual inherits the nonstationarity of Xt . Then. which in this case coincides with the Solow residual. Speciﬁcally. one can write the system of equilibrium conditions in stationary form as gt dt+1 φ = dt + ct + gt kt+1 − (1 − δ)kt + Rt 2 gt kt+1 −g kt ¯ 2 α kt − At kt (ht )1−α . Rt = R∗ + ψ edt+1 −d − 1 . it is impossible to linearize the model around such point. Because non of thise variables exhibits a deterministic steady sate. kt ≡ Kt /Xt−1 . dt ≡ Dt /Xt−1 . And this properties will be transmitted in equilibrium to other variables of the model. because At is a stationary random variable independent of Xt . and the stock of external debt. 1 − γ ct = (1 − α)At gt γ 1 − ht ct γ(1−σ)−1 kt gt ht α (1 − ht )(1−γ)(1−σ) = λt . the capital stock. let ct ≡ Ct /Xt−1 . Fortunately.

Recalling that the variable transformations involve dividing by the productivity factor Xt . the capital stock. together with the laws of motion of gt and At . σg . First. investment.8 and the observed average growth rate of GDP. capital. and g to match the empirical second moments displayed in table 4. The data are from Mexico and the sample is 1980:Q1 to 2003:Q1. This property of the model is known as the balancegrowth property.Lecture in Open Economy Macroeconomics. the rational expectations dynamics are. In other words. Chapter 4 λt = βRt gt γ(1−σ)−1 95 Et λt+1 λt 1 + φ gt kt+1 −g kt = βgt γ(1−σ)−1 Et λt+1 1 − δ + αAt+1 gt+1 kt+2 −g kt+1 − φ 2 kt+1 gt+1 ht+1 α−1 +φ gt+1 kt+2 kt+1 gt+1 kt+2 −g kt+1 2 This system. output. in equilibrium. possesses two properties. and net external debt all share the same stochastic trend Xt . ρg . All other parameters of the model are calibrate using standard values in business-cycle analysis. investment. Aguiar and Gopinath (2007) econometrically estimate the parameters deﬁning the laws of motion of the two productivity shocks as well as the parameter governing the strength of capital adjustment costs. as shown in table 4. it follows that in this model consumption. φ.6. Because the number of estimated parameters (six) is smaller than the number of mo- . Second. and external debt in GDP are all stationary variables. up to ﬁrst order. The econometric estimation consists in picking values for σa . mean reverting. the shares of consumption. ρa . it has a deterministic steady state that is independent of initial conditions.

68 σ 2 δ 0. consider the growth rate of the Solow residual.36 b 0.05 Table 4.37 ments matched (eleven). g . we can ask what fraction of the variance of ∆ ln SRt is explaind by gt .98 γ 0.0213 σa 0. it is of interest to calculate the importance of the nonstationary component of productivity in driving movements in the Solow residual implied by the econometrically estimated parameters. Before studying how the model ﬁts the data.7: Estimated Parameters σg 0. It is straightforward to deduce that the variance of ∆ ln At is given by 2 2 2σa /(1 + ρa ). Because the two terms on the right-hand side of this expression are mutually independent.6: Calibrated Parameters β 0.96 Mart´ Uribe ın Table 4. the estimation procedure uses a weighting matrix following the GMM technique.95 g 1.001 α 0.0066 φ 1.10 ψ 0.0053 ρg 0. the variance of gt is given by σg /(1 − ρ2 ). At the same time. To this end.00 ρa 0. which can be written as ∆ ln SRt = ∆ ln At + (1 − α)gt .

consumption is more volatile than output.8793. Aguiar and Gopinath (2007) also perform this exercise using Canadian data and ﬁnd that the nonstationary component explains only 40 percent of movements in total factor productivity.00532 /(1 + 0.56) (1 − 0. we have that var((1 − α)gt ) var(∆ ln SRt ) 2 (1 − α)2 σg /(1 − ρ2 ) g 2 2 2σa /(1 + ρa ) + (1 − α)2 σg /(1 − ρ2 ) g 97 = = (4. as in most other emerging countries. the presence of nonstationary productivity shocks plays a key role in making this prediction possible.3.Lecture in Open Economy Macroeconomics.95) + (1 − 0.32)2 × 0. Of particular relevance is the ability of the model to match the fact that in Mexico.32)2 × 0. The estimated model does a very good job at matching all of the moments shown in the table. As explained in detail in section 2. That is. the estimated parameters imply that the nonstationary component of productivity explains 88 percent of the variance of the growth rate of the Solow residual.02132 /(1 − 0. How should we interpret these results? There are three aspects of the .8 displays ten empirical and theoretical second moments.02132 /(1 − 0. This is an indication that the data favor the hypothesis that nonstationary technology shocks play a signiﬁcant role in moving total factor productivity at business-cycle frequency in emerging economies. Table 4.002 ) 2 × 0. Chapter 4 Therefore. These ﬁndings suggest that nonstationary productivity shocks to be more relevant in emerging economies than in developed ones.002 ) = 0.

or unitroot. nx) ρ(y.8: Model Fit Statistic σ(y) σ(∆y) σ(c)/σ(y) σ(i)/σ(y) σ(nx)/σ(y) ρ(y) ρ(∆y) ρ(y.95 0. The second diﬃculty with the econometric strategy pursued in this section is that it allows room only for productivity shocks.75 0.80 Note. One is that the data sample. This would not be a big problem if no other candidate shocks had been identiﬁed as potentially important in driving business cycles in emerging economies. and conclude that it is not possible to determine reliably whether the nonstationary component is more important in Mexico or in Canada (see their ﬁgure 2). It is well known that the only reliable way to disentangle the stationary and nonstationary components of a time series is to use long samples.18 -0.15 0.83 0.82 0.13 1.91 Model 2.98 Mart´ Uribe ın Table 4.40 1.82 0.52 1. is relatively short.42 1.10 3.80 0. Short samples can lead to misleading results. c) ρ(y. Source: Aguiar and Gopinath (2007).600.50 0. 1980:Q1 to 2003:Q1.26 4. But . Aguiar and Gopinath (2007) analyze direct evidence on Solow residuals for Mexico and Canada over the period 1980-2000. Variables in levels were HP ﬁltered using a parameter of 1. i) Data 2.91 0.27 -0. component in total factor productivity. Growth rates are unﬁltered. Recall that the main purpose of the estimation procedure is to identify the random-walk. In fact.83 0. econometric estimation that deserve special comments.

Lecture in Open Economy Macroeconomics, Chapter 4

99

this is not the case. For example, a growing number of studies show that world interest-rate shocks and country-spread shocks play an important role in driving business cycles in emerging countries. Omitting these and other relevant shocks in the econometric estimation may induce a bias in favor of the shocks that are included. Finally, the present model limits attention to a frictionless neoclassical framework. This might also be an oversimpliﬁcation. For instance, a large body of worked points at ﬁnancial frictions, including default risk, balance-sheet eﬀects, etc., as important ampliﬁers of business cycles in emerging economies. Omitting these sources of friction might cause a spurious increase in the estimated variance and persistence of the exogenous driving processes. In the next chapter, we attempt to address these concerns by ﬁrst studying the importance of interest-rate and country-spread shocks as drivers of business cycles in developing countries. Then, we estimate a business cycle model with ﬁnancial frictions in which stationary and nonstationary productivity shocks compete with interest-rate and country-spread shocks in explaining business cycles. As an attempt to obtain a reliable measure of the nonstationary component of productivity, we will estimate the model using long data samples.

100

Mart´ Uribe ın

4.6

Appendix A: Log-Linearization

**The log-linear version of the system (4.4)-(4.6) and (4.8)-(4.14) is given by 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 [ηt +

βc βc ct βcc ct

+

ch ht ]

−

β (1 − β)

βc c

−β

+

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 , where cUc /U ,
**

βc cc

≡ cβc /β,

βh

≡ hβh /β,

ch

βcc

≡ cβcc /βc ,

βch

≡ hβch /βc ,

c

≡

= cUcc /Uc ,

= hUch /Uc , stb ≡ tb/y, sc ≡ c/y, si = i/y.

In the log-linearization we are using the particular forms assumed for the production function and the capital adjustment cost function.

Lecture in Open Economy Macroeconomics, Chapter 4

101

4.7

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. Reduced forms of this sort are common in Macroeconomics. A problem that one must face is that, in general, it is impossible to solve such systems. But fortunately one can obtain good approximations to the true solution in relatively easy ways. In the previous chapter, we introduced one particular strategy, consisting in linearizing the equilibrium conditions around the nonstochastic steady state. Here we explain in detail how to solve the resulting system of linear stochastic diﬀerence equations. In addition, we show how to use the solution to compute second moments and impulse response functions. 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 , yt , xt+1 , xt ) = 0,

(4.57)

where Et denotes the mathematical expectations operator conditional on information available at time t. The vector xt denotes predetermined (or state) variables and the vector yt denotes nonpredetermined (or control) variables. The initial value of the state vector x0 is an initial condition for the economy. (Beyond the initial condition, the complete set of equi-

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librium conditions also includes a terminal condition, like a no-Ponzi game constraint. We omit such a constraint here because we focus on approximating stationary solutions.) The state vector xt can be partitioned as xt = [x1 ; x2 ] . The vector x1 consists of endogenous predetermined state t t t variables and the vector x2 of exogenous state variables. Speciﬁcally, we t assume that x2 follows the exogenous stochastic process given by t ˜ x2 = h(x2 , σ) + η σ ˜ t+1 t where both the vector x2 and the innovation t vector

t

t+1 ,

t

are of order n × 1.4 The

is assumed to have a bounded support and to be independently

and identically distributed, with mean zero and variance/covariance matrix ˜ I. 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. The solution to models belonging to the class given in equation (4.57) is of the form: yt = g (xt ) ˆ and ˆ xt+1 = h(xt ) + ησ

t+1 .

(4.58)

(4.59)

The vector xt of predetermined variables is of size nx × 1 and the vector yt of nonpredetermined variables is of size ny × 1. We deﬁne n = nx + ny . The function f then maps Rny × Rny × Rnx × Rnx into Rn .

4 It is straightforward to accommodate the case in which the size of the innovations vector t is diﬀerent from that of x2 . t

Lecture in Open Economy Macroeconomics, Chapter 4 The matrix η is of order nx × n and is given by ∅ η = . η ˜

103

ˆ The shape of the functions h and g will in general depend on the amount ˆ of uncertainty in the economy. 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, that is,

yt = g(xt , σ) and xt+1 = h(xt , σ) + ησ

t+1 ,

(4.60)

(4.61)

where the function g maps Rnx × R+ into Rny and the function h maps Rnx × R+ into Rnx .

Given this interpretation, a perturbation methods ﬁnds a local approximation of the functions g and h. By a local approximation, we mean an approximation that is valid in the neighborhood of a particular point (¯, σ ). x ¯

Taking a Taylor series approximation of the functions g and h around the point (x, σ) = (¯, σ ) we have (for the moment to keep the notation simple, x ¯

104 let’s assume that nx=ny=1)

Mart´ Uribe ın

g(x, σ) = g(¯, σ ) + gx (¯, σ )(x − x) + gσ (¯, σ )(σ − σ ) x ¯ x ¯ ¯ x ¯ ¯ 1 + gxx (¯, σ )(x − x)2 + gxσ (¯, σ )(x − x)(σ − σ ) x ¯ ¯ x ¯ ¯ ¯ 2 1 + gσσ (¯, σ )(σ − σ )2 + . . . x ¯ ¯ 2 h(x, σ) = h(¯, σ ) + hx (¯, σ )(x − x) + hσ (¯, σ )(σ − σ ) x ¯ x ¯ ¯ x ¯ ¯ 1 + hxx (¯, σ )(x − x)2 x ¯ ¯ 2 +hxσ (¯, σ )(x − x)(σ − σ ) x ¯ ¯ ¯ 1 + hσσ (¯, σ )(σ − σ )2 + . . . , 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 (¯, σ ). x ¯ To identify these derivatives, substitute the proposed solution given by equations (4.60) and (4.61) into equation (4.57), and deﬁne

F (x, σ) ≡ Et f (g(h(x, σ) + ησ , σ), g(x, σ), h(x, σ) + ησ , x) (4.62) = 0.

Here we are dropping time subscripts. We use a prime to indicate variables dated in period t + 1. Because F (x, σ) must be equal to zero for any possible values of x and σ, it must be the case that the derivatives of any order of F must also be equal to zero. Formally,

Fxk σj (x, σ) = 0

∀x, σ, j, k,

(4.63)

σ) = h(¯. x ¯ The remaining unknown coeﬃcients of the ﬁrst-order approximation to g . We are looking for approximations to g and h around the point (x. ¯ x ¯ x then Et f = f . x. 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. xt = x ¯ and σ = 0. 0)σ x x ¯ x As explained earlier. one can then ﬁnd the derivatives of the function F . y . 0) of the form x g(x. With the steady state values in hand. 0)σ x x ¯ x h(x. 0)(x − x) + gσ (¯. We deﬁne the non-stochastic steady state as vectors (¯. 0) + gx (¯. 0) = x.Lecture in Open Economy Macroeconomics. Chapter 4 105 where Fxk σj (x. 0) and x = h(¯. 0) = y x ¯ and h(¯. 0)(x − x) + hσ (¯. y ¯ ¯ ¯ It is clear that y = g(¯. σ) = g(¯. note that if σ = 0. σ) denotes the derivative of F with respect to x taken k times and with respect to σ taken j times. To see this. 0) + hx (¯. y ) such x ¯ that f (¯. As will become clear below. σ) = (¯. a particularly convenient point to approximate the functions g and h around is the non-stochastic steady state. g(¯. x) = 0. 0).

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.63). Taking derivative with respect to the scalar σ we ﬁnd: Fσ (¯. x) = 0. σ) + ησ . h(x. σ). σ) + ησ . x one can identify gσ and hσ : hσ fy + f y =0 gσ fy gx + fx . by equation (4.62) F (x. σ) ≡ Et f (g(h(x. σ).106 Mart´ Uribe ın and h are identiﬁed by using the fact that. Then imposing Fσ (¯. x and x Fx (¯. 0) = 0. it must be the case that: Fσ (¯. 0) = 0 To ﬁnd those derivatives let’s repeat equation (4. g(x. 0) = 0.

ﬁrst-order approximation techniques cannot be used to study risk premia. Another important question that can in general not be addressed with ﬁrst-order perturbation techniques is how uncertainty aﬀects welfare. They show that in general. This is an important limitation of ﬁrst-order perturbation techniques. if a unique solution exists. . 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. Thus. Thus. Chapter 4 107 This equation is linear and homogeneous in gσ and hσ . we can say that in a ﬁrst-order approximation the certainty ¯ equivalence principle holds. This question is at the heart of the recent literature on optimal ﬁscal and monetary stabilization policy. any two policies that give rise to the same steady state yield. For example. one need not correct the constant term of the approximation to the policy function for the size of the variance of the shocks. In this sense. up to ﬁrst-order the mean of the rate of return of all all assets must be same. Because in a ﬁrst-order accurate solution the unconditional expectation of a variable is equal to the non-stochastic steady state. and gσ = 0. These two expressions represent an important theoretical result. Because in many economic applications we are interested in ﬁnding the eﬀect of uncertainty on the economy. up to ﬁrst order.Lecture in Open Economy Macroeconomics. that is. we have that hσ = 0.

In this case. Mart´ Uribe ın To ﬁnd gx and hx diﬀerentiate (4. Imposing Fx (¯.108 up to ﬁrst-order the same level of welfare. x) are y ¯ ¯ ¯ known.62) with respect to x to obtain the following system Fx (¯. a perfect foresight equilibrium. y . Note that both A and B are known. 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 ]. hx xt = xt+1 . x. The above expression represents a system of n × nx quadratic equations in the n × nx unknowns given by the elements of gx and hx . 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. 0) = fy gx hx + fy gx + fx hx + fx x Note that the derivatives of f evaluated at (y . x . x) = (¯. Let xt ≡ xt − x. ˆ ˆ I I A ˆ ˆ xt+1 = B xt gx gx . y.

z = . 2 0 a22 0 b22 z21 z22 st More formal descriptions of the method can be found in Sims (1996) and Klein (2000). In particular. b. Recall that a matrix a is said to be upper triangular if elements aij = 0 for i > j. b = . we will use the Schur decomposition method. st = . 6 5 s1 t .Lecture in Open Economy Macroeconomics. x Then we have that ast+1 = bst Now partition a. A matrix z is orthonormal if z z = zz = I. Let st ≡ z [I. Chapter 4 We are interested in solutions in which 109 t→∞ lim |ˆt | < ∞ x We will use this limiting conditions to ﬁnd the matrix gx . gx ]ˆt .5 The generalized Schur decomposition of A and B is given by upper triangular matrices a and b and orthonormal matrices q and z satisfying:6 qAz = a and qBz = b. z. To solve the above system. we use the generalized Schur decomposition of the matrices A and B. and st as a11 a12 b11 b12 z11 z12 a= .

by t t+j the deﬁnition of s2 . t+1 t 22 Assume. it ˆ follows that it must be the case that z12 + z22 gx = 0. the eigenvalues of b−1 a22 are all less than unity in modulus. Namely. z12 is of order nx × ny . and s2 is of t order ny × 1. that the ratios abs(aii /bii ) are decreasing in i. ny . Here we are applying a number of properties of upper triangular matrices. without loss of generality. xt . (b) the product of two upper triangular matrices is upper triangular. (a) The inverse of a nonsingular upper triangular matrix is upper triangular. and that the number of ratios greater than one is equal to the number of state variables. x Because this condition has to hold for any value of the state vector. In turn. Suppose further that the number of ratios less than unity is exactly equal to the number of control variables. Then we have that a22 s2 = b22 s2 . 22 the requirement limj→∞ |s2 | < ∞ is satisﬁed only if s2 = 0. this restriction implies that t (z12 + z22 gx )ˆt = 0.110 Mart´ Uribe ın where a22 and b22 are of order ny × ny . (c) The eigenvalues of an upper triangular matrix are the elements of its main diagonal.7 Thus. nx . t+1 t or b−1 a22 s2 = s2 . 7 . By construction.

. x t Replacing gx .Lecture in Open Economy Macroeconomics. The fact that s2 = 0 also implies that t a11 s1 = b11 s1 . Chapter 4 Solving this expression for gx yields −1 111 gx = −z22 z12 . t+1 t or s1 = a11 −1 b11 s1 t+1 t Now s1 = (z11 + z21 gx)ˆt . x so that −1 −1 hx = [z11 − z21 z22 z12 ]−1 a11 −1 b11 [z11 − z21 z22 z12 ]. 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 Combining this expression with the equation describing the evolution of st shown two lines above.

But not for every economy this is the case. Now use element (1. which is simply z11 . 1) of z z to write z21 z21 = I − z11 z11 . nx . we get [z11 + (I − z11 z11 )z11 −1 ]. Then the requirement that we wish to study equilibria in which limj→∞ Et |ˆt+j | < ∞ will only yield m restrictions. It follows that one can choose arbitrary initial values for ny − m elements of y0 and the resulting ﬁrst order solution will still be 8 To obtain this simple expression for hx . use element (2. which is less than the number of control variables. we assumed that the number of eigenvalues of D with modulus less than unity is exactly equal to the number of control variables. and that the number of eigenvalues of D with modulus greater than one is equal to the number of state variables. Then this square bracket becomes [z11 + z21 z21 z11 −1 ]. . In this case there is a unique local equilibrium.8 Local Existence and Uniqueness of Equilibrium In the above discussion. ny . −1 Use this expression to eliminate z22 z12 From the square bracket in the expression for hx . Using this equation to eliminate z21 z21 from the expression −1 in square brackets. Premultiply by z22 and post multiply by z11 to get z22 z12 = −z21 z11 −1 . Let’s ﬁrst consider the case that the number of eigenvalues of D with modulus greater than unity is equal to m < ny. rather than x ny restrictions. 11 4. 1) of z z to get z12 z11 = −1 −1 −1 −z22 z21 .112 Mart´ Uribe ın 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:8 −1 hx = z11 a−1 b11 z11 .

4.Lecture in Open Economy Macroeconomics. because x0 is a vector of predetermined or exogenous variables and therefore its elements can take arbitrary values. Let again m denote the number of eigenvalues of D greater than unity in modulus and assume that m > ny . x This implies that m − ny elements of x0 must be functions of the remaining nx − (m − ny ) elements. On the other hand. In this case.64) 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 . .9 Second Moments Start with the equilibrium law of motion of the deviation of the state vector with respect to its steady-state value. ny . we say no local equilibrium exists. (4. But this can never be the case. Chapter 4 113 expected to converge back to the steady state. In this case the equilibrium is indeterminate. which is given by xt+1 = hx xt + ση ˆ ˆ t+1 . Then in order to ensure that lim Et |ˆt+j | < ∞ we must set m elements of [x0 y0 ] equal to zero. if the number of eigenvalues of D with modulus greater than unity is greater than the number of control variables. then no local equilibrium exists.

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

t hx.0 = I hx. Σx.t+1 . The eigenvalues of F are products of the eigenvalues of the matrix hx .0 = hx Σ .t Σ .0 . may be faster than the one described above in cases in which the number of state variables (nx ) is large. x x Method 2 The following iterative procedure.t + Σ hx. it follows that all eigenvalues of F are less than one in modulus. called doubling algorithm.t hx. Chapter 4 Solving the above expression for vec(Σx ) we obtain vec(Σx ) = (I − F)−1 vec(Σ ) 115 provided that the inverse of (I −F) exists.t+1 = hx. This implies that (I − F) is nonsingular and we can indeed solve for Σx .t Σ .t hx.t =Σ .t + Σ Σx.t Σx. Because all eigenvalues of the matrix hx have by construction modulus less than one.t = hx.Lecture in Open Economy Macroeconomics.t+1 = hx. One possible drawback of this method is that one has to invert a matrix that has dimension n2 × n2 .

more generally. . x for j ≥ 0. or control vector yt is given by yt = y + gx (xt − x). xt has been computed. 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.116 Other second moments Mart´ Uribe ın Once the covariance matrix of the state vector. consider the variance covariance matrix of linear combinations of the state vector xt . Let µt = ση t . Then ¯ ¯ ˆ ˆ E yt yt = Egx xt xt gx ˆˆ ˆ ˆ = gx [E xt xt ]gx ˆ ˆ = gx Σx gx and. which we can write as: yt = gx xt . For instance. the co-state. E yt yt−j = gx [E xt xt−j ]gx ˆˆ ˆ ˆ = gx hj Σx gx . it is easy to ﬁnd other second moments of interest. Consider for instance the covariance matrix E xt xt−j for j > 0.

letting x denote the innovation to the state vector in period 0. htm.m computes the matrices gx and hx using the Schur . Chapter 4 117 4.Lecture in Open Economy Macroeconomics. x ˆ ˆ x x x t ≥ 0.10 Impulse Response Functions The impulse response to a variable.edu/~mu2166/2nd_order. 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. 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. relative to what was expected at time t − 1. y x 4. The response of the vector of controls yt is given by ˆ IR(ˆt ) = gx ht x. The program gx_hx. that is. x = ησ 0 .11 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.columbia. Using the law of motion Et xt+1 = hx xt for the ˆ ˆ state vector.

Namely.m computes second moments. obtaining a higherorder approximation to the solution of the non-linear system is a sequential procedure. there is a sense in which higher order approximations are simpler than the ﬁrst order approximation. 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. 4..12 Higher Order Approximations In this chapter. for j > 1 and i < j.m computes impulse response functions. More importantly. .118 Mart´ Uribe ın decomposition method. since the coeﬃcients of the linear terms are those of the ﬁrst order approximation. But higher order approximations are relatively easy to obtain. So if the ﬁrst-order approximation to the solution is available. 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 . 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. xt ) = 0. Indeed. obtaining the coeﬃcients of the ith order terms of the approximate solution given all lower-order coeﬃcients involves solving a linear system of equations. Speciﬁcally. The program mom. The program ir. then obtaining the second order approximation requires only to compute the coeﬃcients of the quadratic terms.

13 Exercises 1. The Eﬀect of Nonstationary Productivity Shocks on the Trade Balance in the Preence of Nontraded Goods The purpose of this assignment is to explore whether nonstationary productivity shocks are useful to understand business cycles in emerging markets when the one-sector SOE RBC model studied in class is augmented to include a nontraded sector. 1−σ where Ct denotes consumption and ht denotes hours worked. Assume that At is a composite of tradable and nontradable goods produced via the following aggregator function: 1/(1−1/µ) At = η(AT )1−1/µ + (1 − η)(AN )1−1/µ t t . Output of tradable and nontradable . where It denotes gross domestic investment. domestic absorptions of tradt t able and nontradable goods. That is. At satisﬁes the identity At = Ct + It . respectively.Lecture in Open Economy Macroeconomics. Let At denote domestic absorption. Consider an economy populated by a large number of identical households with preferences described by the utility function ∞ E0 t=0 βt [Ctγ (1 − ht )1−γ ]1−σ − 1 . where AT and AN denote. Chapter 4 119 4.

where Iti denotes investment in sector i = T. t where Kti and hi denote. are produced under constant returns to scale using capital and labor as inputs: YtT = zt (KtT )1−αT (Xt hT )αT t and YtN = zt (KtN )1−αN (Xt hN )αN .120 Mart´ Uribe ın goods. The variable zt represents an exogenous. The capital stocks evolve according to the following laws of motion: φ − 2 T Kt+1 −g KtT 2 T Kt+1 = (1 − δ)KtT + ItT KtT and N Kt+1 = (1 − δ)KtN + ItN φ − 2 N Kt+1 −g KtN 2 KtN . Market clearing in the nontraded sector requires that domestic absorption equals production: YtN = AN . denoted. capital and labor services emt ployed in sector i. stationary. N and satisﬁes It = ItT + ItN . nonstationary productivity shock. stochastic productivity shock and Xt represents an exogenous. for i = T. respectively. N . respectively. stochastic. t . YtT and YtN .

Chapter 4 Also. The evolution of the household’s net foreign debt position. Because households are homogeneous. is given by Dt+1 = Dt + AT − YtT . t t Assume that the country has access to a single. t And the nonstationary productivity shock evolves according to ln(gt /g) = ρa ln(gt−1 /g) + σg g . t .Lecture in Open Economy Macroeconomics. assume that the stationary productivity shock zt follows an AR(1) process of the form ˜ ¯ ln zt = ρz ln zt−1 + σz z . one-period. we have that in equilibrium the following condition must hold: ˜ Dt = Dt . ˜ where Dt denotes average external debt per capita in period t. Dt . t Rt with Rt = R∗ + ψ eDt+1 /Xt −d − 1 . market clearing in the labor market requires that 121 h t = hT + hN . internationally traded bond that pays the debt-elastic interest rate Rt when held between periods t and t + 1. Finally.

05 σg 0.65 in the steady state.98 γ 0.0213 σz 0. Set η to ensure that the share of nontraded output in total output. σz . write your answers to 4 decimal places. Compute the steady state of the model. Count the number of variables and equations. 1).44 Guidelines for calibrating the parameter η are given below.80 σ 2 δ 0. (b) Let pN and pt be the (shadow) relative prices of the nontradable t good and the composite good in terms of tradable goods.36 d 0. Are pN and pt stationary variables? Why? t t (c) Write down the complete set of equilibrium conditions in stationary form along a balanced-growth path.40 αN 0.0066 φ 1.0053 z t Mart´ Uribe ın Xt . In addressing the numerical portions of the following questions.00 ρz 0. σg > 0.95 g 1.37 µ 0. respectively. Report the t t . Xt−1 and g t are independent white noises ρg 0.122 where gt ≡ ρz . Use the following table to calibrate the model: β 0. 1). and distributed N (0.10 ψ 0. Write down expressions for pN and pt in terms of AT and t t AN . (a) Write down the complete set of equilibrium conditions. deﬁned as pN YtN /(pN YtN + YtT ) equals 0. ρg ∈ (−1.001 αT 0. (d) Derive a restriction on R∗ that guarantees that the steady-state value of dt+1 ≡ Dt+1 /Xt along the balanced-growth path equals d.

Chapter 4 123 numerical value of η and the steady-sate values of all endogenous variables of the model. (e) Report the numerical values of the eigenvalues of the matrix hx deﬁning the linearized equilibrium law of motion of the state vector. Provide intuition making sure to emphasize the diﬀerences you can identify between the dynamics implied by the one-good SOE RBC model and the present two-good SOE RBC model. .Lecture in Open Economy Macroeconomics. respectively. Deﬁne the trade balance as the variable T Bt that satisﬁes T Bt = Yt − Ct − It . Compute the unconditional standard deviations of the growth rates of consumption and output. evaluate the ability of the present traded-nontraded model to explain key stylized facts in emerging countries. Answer the previous two questions under your proposed parameterization. (g) Compute other second moments of your choice and discuss whether they are in line with empirical regularities in emerging economies. (h) Explain how you would reparameterize the model to make it coincide with the one-sector model studied in Aguiar and Gopinath (2007). Compute the correlation between ∆Yt and the trade-balance-to-output ratio. (f) Deﬁne GDP as Yt = (YtT + pt YtN )/pt . as ∆Ct ≡ log(Ct /Ct−1 ) and ∆Yt ≡ log(Yt /Yt−1 ). deﬁned. deﬁned as tbyt ≡ T Bt /Yt . (i) Based on your answers to the previous three questions.

04.012. and the current-accountto-output ratio implied by the IDF model driven by interest-rate shocks. ¯ Calibrate all other parameters of the model at the values given in table 4. This exercise aims to establish whether that result is robust to assuming that business cycles are driven by world-interest-rate shocks. Replace the interest-rate speciﬁcation rt = r with the process rt − r = ξ(rt−1 − r ) + µt . (b) Now consider the EDEIR model. σµ ). consumption. (a) Consider the IDF economy studied in chapter 4. This result. Again.8. and σµ = 0. Using this version of the IDF model. set σ = 0. Inducing Stationarity and Interest-Rate Shocks Mart´ Uribe ın One result derived in chapter 4 of the lecture notes is that the business cycle implied by the SOE RBC model is not aﬀected by the method used to induce stationarity. ξ = 0. Provide intuition for these results.1. investment. compute the statistics considered in table 4. Make a ﬁgure showing impulse responses of output. hours. however. was derived in the context of a model driven by technology shocks. ¯ ¯ 2 where µt ∼ N (0. the trade-balance-to-output ratio. Replace the ˜ formulation rt = r + p(dt ) with ∗ ˜ rt = rt + p(dt ) . Shut down the productivity shock by setting σ = 0.124 2. Set r = 0.4 and make a table.

Provide intuition for your results. Calibrate ¯ all other parameters of this model mimicking the calibration of the EDEIR model studied in the lecture notes. which can be interpreted as an external shock. ¯ ¯ 125 Calibrate r. Suppose that the productivity factor At is constant and normalized to 1. Does the stationarity-inducing mechanism make any diﬀerence for the business-cycles implied by the SOE model driven by interest-rate shocks? 3. Use the resulting calibrated model to compute unconditional second moments and impulse responses. place the information generated here in the same table and ﬁgure produced in the previous question. where xt is an exogenous and stochastic random variable. Business Cycles in a Small Open Economy with Complete Asset Markets and External Shocks Consider the small open economy model with complete asset markets (CAM) studied in chapter 4 of the lecture notes. Assume that the external shock . ξ. To facilitate comparison. Chapter 4 and ∗ ∗ rt − r = ξ(rt−1 − r ) + µt . (c) Compare the predictions of the IDF and EDEIR models driven by interest rate socks. and σµ as in the previous question. Replace the equilibrium condition λt = ψ4 with the expression λt = x t .Lecture in Open Economy Macroeconomics.

serial correlation.b using these new parameter values. and . ct . set the steady state value of xt in such a way that the steady-state level of consumption equals the level of steady-state consumption in the version of the CAM modelstudied in the lecture notes. (c) Now replace the values of ρ and σ given above with values such that the volatility and serial correlation of output implied by the model are the same as those reported for the Canadian economy in table 4. ct . it .9 and σ = 0. ˆ x t ∼ N (0.a and 2. it . ht .2 of the lecture notes. evaluate the ability of external shocks (as deﬁned here) to explain business cycles t) of yt . (d) Based on your answer to the previous question. (a) Produce a table displaying the unconditional standard deviation. Calibrate all other parameters of the model following the calibration of the CAM model of chaper 4 of the lecture notes. and tbt /yt . Answer questions 2.126 follows a process of the form Mart´ Uribe ın xt = ρˆt−1 + t . Finally. σ 2 ). (b) Produce a ﬁgure with 5 plots depicting the impulse responses to an external shock (a unit innovation in tbt /yt . Let ρ = 0. and correlation with output of yt .02. where xt ≡ ln(xt /x) and x denotes the non-stochastic steady-state ˆ level of xt . ht .

Lecture in Open Economy Macroeconomics. Chapter 4 in Canada. 127 .

128 Mart´ Uribe ın .

Chapter 5 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 5. This question is complicated by the fact that the country interest rate is unlikely to be completely exogenous to the country’s domestic conditions. Peru -0.67 (0.07 (0.71).2 To clarify ideas.51 (0.58 (0.00). 2 There is a large literature arguing that domestic variables aﬀect the interest rate at which emerging markets borrow externally.37 (0.80 (0. Brazil -0. Mexico -0. for example. the Philippines -0. Cline 1 129 . Ecuador -0.12). let Rt denote the gross The estimated correlations (p-values) are: Argentina -0. 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.00). See.1 have motivated researches to ask what fraction of observed business cycle ﬂuctuations in emerging markets is due to movements in country interest rate. South Africa -0.00).00). which depicts detrended output and the country interest rate for seven developing economies between 1994 and 2001.95).1.02 (0. Edwards (1984).1 Data like those shown in ﬁgure 5.

1 0.130 Mart´ Uribe ın Figure 5. interest rates.15 Brazil Ecuador 0.1: Country Interest Rates and Output in Seven Emerging Countries Argentina 0.1 94 95 96 97 98 99 00 01 94 95 96 97 98 Mexico 0.05 94 95 96 97 98 99 00 01 99 00 01 0.04 0.4 Philippines 0.06 0.05 94 95 96 97 98 99 00 01 South Africa 0. Country interest rates are real yields on dollar-denominated bonds of emerging countries issued in international ﬁnancial markets.05 0.1 0. Source: Uribe and Yue (2006).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. .1 0. Data source: output.2 0.05 0 −0. IFS.1 0 0 94 95 96 97 98 Peru 0.3 0.15 0.15 0.05 0 −0.05 0 0.1 0.05 −0.05 94 95 96 97 98 99 00 01 0 0. EMBI+.1 99 00 01 −0.

i. We can’t say the same. Suppose now that a domestic productivity shock induces an expansion in output. borrow and lend from one another. however. If the country in question is a small player in international ﬁnancial markets. however. Thus. To see why. furthermore. like the U. about the country spread St . a Colombian spread. is completely exogenous to the emerging country’s domestic conditions. erroneously attributes (1995). and St denotes the gross country interest-rate spread. or country interest-rate premium. Suppose that the interest rate Rt is purely endogenous. in the data we ﬁnd an Argentine spread. The researcher. may induce foreign lenders to lower spreads on believes that the country’s ability to repay its debts has improved. . Rus denotes the world interest rate. consider the following example. or the us country interest rate. who believes Rt is exogenous. or the interest rate at which developed countries. for instance.S. foreign lenders reduce the country spread in response to expansions in aggregate activity. Here. and Cline and Barnes (1997). This interest rate can be expressed as Rt = Rt St . In response to this output increase. it is reasonable to assume that the world interest rate Rt .Lecture in Open Economy Macroeconomics. as many emerging us economies are. 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. Chapter 5 131 interest rate at which the country borrows in international markets.e.. the interest rate falls. wrongly assumes that the interest rate is purely exogenous. that Rt is countercyclical. its contribution to generating business cycles is nil. An increase in output.. Assume. The researcher. etc. Because the interest-rate premium is country speciﬁc.

It follows that in order to quantify the macroeconomic eﬀects of interest rate shocks. of course. it denotes real gross domestic us investment. the ﬁrst step is to identify the exogenous components of country spreads and world interest rate shocks. 5. tbyt denotes the trade balance to output ratio. is that all of the movement in output is due to the productivity shock. The particular combination adopted in this chapter draws heavily from Uribe and Yue (2006). The right conclusion. Rt denotes the gross real US interest rate.132 Mart´ Uribe ın part of the increase in output to the decline in Rt . A hat on yt and it denotes log deviations from a log-linear us us trend. and Rt denotes the gross real (emerging) country interest rate. Necessarily. We measure Rt as the 3-month gross Treasury bill rate divided by the average gross US inﬂation .1) where yt denotes real gross domestic output. the identiﬁcation process must combine statistical methods and economic theory.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 + (5. A hat on Rt and Rt denotes simply the log.

Lecture in Open Economy Macroeconomics. conceivably. it seems reasonable to assume that ﬁnancial markets are able to react quickly to news about the state of the business cycle. 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. 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. 3 r.3 We measure Rt as the sum of J. . Output. This identiﬁcation strategy is a natural one. for. 4 Uribe and Yue (2006). 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. Morgan’s EMBI+ stripped spread and the US real interest rate. decisions such as employment and spending on durable consumption goods and investment goods take time to plan and implement. Because Rt and Rt appear at the bottom of the system. is that the world us interest rate Rt follows a simple univariate AR(1) process (i.4 An additional restriction imposed on the VAR system. t and tby t ) aﬀect ﬁnancial markets contemporaneously. To identify the shocks in the empirical model. investment. discuss an alternative identiﬁcation strategy consisting in placing ﬁnancial variables ‘above’ real variables ﬁrst in the VAR system.e. t i. Chapter 5 133 over the past four quarters. for all i = 4). Also. the identiﬁcation scheme implies that real domestic shocks ( y . P. Uribe and Yue (2006) impose the restriction that the matrix A be lower triangular with unit diagus onal elements. and the trade balance are seasonally adjusted.. A4i = B4i = 0.

After estimating the VAR system (5. call it s. St ≡ Rt −Rt . t are identical to those associated r t Therefore. how do US-interest-rate shocks and country-spread shocks aﬀect real domestic variables such as output. t Moreover. 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. because Rt appears as a regressor in the bottom equation of the VAR system. the estimated residual of the newly deﬁned bottom equation. how important are US-interest-rate shocks and country-spread shocks in explaining movements in aggregate activity in emerging countries? Fifth. investment. t is identical to r.2 Impulse Response Functions Figure 5. consider substituting in equation (5.1) the ˆ ˆ ˆ ˆ us country interest rate Rt using the deﬁnition of country spread. ˆt . 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 and by how much do country spreads move in response to innovations in emerging-country fundamentals? Fourth. us Clearly. 5.2 displays with solid lines the impulse response function implied . throughout the paper we indistinctly refer to as a country interest rate shock or as a country spread shock. it is obvious that the impulse response s t functions of yt .1). and the trade balance? Second. how do country spreads respond to innovations in US interest rates? Third. To see this. and tbyt associated with ˆ ı with r.134 Mart´ Uribe ın country spread shock.

1 0 5 10 15 20 −1 5 0 World Interest Rate −0.2 −0.2 0 5 10 15 20 1 0.4 0.4 −0. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends. .5 10 15 20 Country Interest Rate 1 0.2 5 10 15 20 Investment Trade Balance−to−GDP Ratio 1 0.5 0.3 5 10 15 20 0 −0.05 −0.3 0. the country interest rate.8 0. and the country spread are expressed in percentage points.1 −0.2: Impulse Response To Country-Spread Shock Output 0 −0.6 0.15 −0.Lecture in Open Economy Macroeconomics.8 −1 −1.6 0.2 0.4 0.4 0.8 0. Chapter 5 135 Figure 5. The two-standard-error bands are computed using the delta method.25 −0.2 −0.6 −0. and broken lines depict two-standard-deviation error bands. The responses of the Trade Balance-to-GDP ratio. the US interest rate.2 0 5 Country Spread 10 15 20 Notes: (1) Solid lines depict point estimates of impulse responses.

They are unchanged in the period of impact. and subsequently recover gradually until they reach their pre-shock level.3 displays the response of the variables included in the VAR system (5. That is. t The eﬀects of US interest-rate shocks on domestic variables and coun- try spreads are measured with signiﬁcant uncertainty. For 5 These bands are computed using the delta method.1) to a unit innovation in the country spread shock. the country spread itself increases and then quickly falls toward its steady-state level. r. t Broken lines depict two-standard-deviation bands. rus . output and investment fall. However. The adverse spread shock produces a larger contraction in aggregate domestic absorption than in aggregate output. investment. however. and the trade balance. investment. This is reﬂected in the fact that the trade balance improves in the two periods following the shock. aggregate activity and gross domestic investment contract. Output.5 In response to an unanticipated country-spread shock.136 Mart´ Uribe ın by the VAR system (5. while net exports improve.1) to a one percentage point increase in the US interest rate shock. . The half life of the country spread response is about one year. as indicated by the width of the 2-standard-deviation error bands. 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. are qualitatively similar to those associated with an innovation in the country spread. Figure 5. The point estimates of the impulse response functions of output. because of our maintained assumption that external ﬁnancial shocks take one quarter to aﬀect production and absorption. In the two periods following the country-spread shock. and the trade balance-to-output ratio respond as one would expect.

4 0.Lecture in Open Economy Macroeconomics.5 2 1.5 −1 5 Country Spread 10 15 20 Notes: (1) Solid lines depict point estimates of impulse responses.5 0 −0.5 0 −0.8 World Interest Rate 10 15 20 Country Interest Rate 3 2.5 0. The responses of the Trade Balance-to-GDP ratio.3: Impulse Response To A US-Interest-Rate Shock Output 1 0 0 −1 −0.5 0.5 2 1. . and the US interest rate are expressed in percentage points. and broken lines depict two-standard-deviation error bands.2 0 0 5 10 15 20 5 1 0.5 5 10 15 20 2.5 5 10 15 20 −6 5 10 15 20 Investment Trade Balance−to−GDP Ratio 2 1.6 1 0.5 −2 −3 −1 −4 −5 −1. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends. Chapter 5 137 Figure 5.5 1 0. the country interest rate.5 1 0.

the trough in the output response is twice as large under a USinterest-rate shock than under a country-spread shock.138 Mart´ Uribe ın instance. The response of investment is about three times as large as that . In eﬀect. the country spread initially falls. the terms-oftrade. The response of output. As a result. impinge upon the variables of our empirical model. country spreads increase signiﬁcantly in response to innovations in the US interest rate but with a short delay. however. that because the models estimated by these authors are static in nature. Figure 5. It is remarkable that the impulse response function of the country spread to a US-interest-rate shock displays a delayed overshooting. 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. Thus. However. y t. The overshooting of country spreads is responsible for the much larger response of domestic variables to an innovation in the US interest rate than to an innovation in the country spread of equal magnitude. The model is vague about the precise nature of output shocks. by construction. in the period of impact the country interest rate increases but by less than the jump in the US interest rate. they are unable to capture the rich dynamic relation linking these two variables. the country spread recovers quickly and after a couple of quarters it is more than one percentage point above its pre-shock level. They can reﬂect variations in total factor productivity.4 depicts the impulse response function to a one-percent increase in the output shock. investment. The negative impact eﬀect is in line with the ﬁndings of Eichengreen and Mody (1998) and Kamin and Kleist (1999). etc. We now ask how innovations in output.1). We note.

the country interest rate. and the US interest rate are expressed in percentage points. (2) The responses of Output and Investment are expressed in percent deviations from their respective log-linear trends.5 World Interest Rate −0. The responses of the Trade Balance-to-GDP ratio.5 0 5 10 15 20 2.5 Investment Trade Balance−to−GDP Ratio 1 0 −0.5 10 15 20 Country Interest Rate 0 −0.2 −0.1 −0.3 −0.5 2 1.4 1 0.4: Impulse Response To An Output Shock Output 1 3 0.6 −0.Lecture in Open Economy Macroeconomics.2 0 5 10 15 20 0.4 −0.6 0. .6 −0.2 −0.5 5 10 15 20 −1 5 0 0.2 −0. and broken lines depict two-standard-deviation error bands.8 5 Country Spread 10 15 20 Notes: (1) Solid lines depict point estimates of impulse response functions.4 −0. Chapter 5 139 Figure 5.8 0.4 −0.8 5 10 15 20 0 −0.

t Broken lines depict the fraction of the variance of the forecasting error explained by US-interestrate shocks ( rus ). the trade balance deteriorates signiﬁcantly by about 0.140 Mart´ Uribe ın of output. 5. the increase in output produces a signiﬁcant reduction in the country spread of about 0.4 percent and after two quarters starts to improve.5 displays the variance decomposition of the variables contained in the VAR system (5. 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. converging gradually to its steady-state level. 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- .3 Variance Decompositions Figure 5. 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 ).1) at diﬀerent horizons. The half life of the country spread response is about ﬁve quarters. More interestingly. At the same time.6 percent.

05 5 10 15 quarters 20 0 5 10 15 quarters World Interest Rate 2 0.25 0.7 0.5: Variance Decomposition at Diﬀerent Horizons Output 0.2 0.8 0.4 0.6 0.1 0.2 0.1 5 10 15 quarters 20 0. Chapter 5 141 Figure 5.5 0.4 1.4 0.25 0.2 0.3 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.5 0.8 0.5 0.6 0.15 0.7 0. Broken lines depict the fraction of the variance of the forecasting error explained by rus at diﬀerent t horizons. .1 0.3 0.5 0 5 10 15 quarters Country Interest Rate 20 0 5 10 15 quarters Country Spread 20 0.2 0.3 0.2 0.15 0.3 1 20 Investment Trade Balances−to−GDP Ratio 0.Lecture in Open Economy Macroeconomics.05 0 0.1 0.

t explain about 20 percent of move- ments in aggregate activity in emerging countries at business cycle frequency. we have that ˆ i rus the estimates of t will in general not be orthogonal to the estimates of y . 1999). which takes the value one. 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. or tby . t t t However. Our choice of horizon falls in the middle of this window. The error in forecasting xt+h at time t j=0 for h > 0..e. innovations in the US interest rate. t account for about 12 percent of 6 ˆ us ˆ These forecasting errors are computed as follows.h of the matrix Σ for diﬀerent values of h.5 are given by rus . 7 We observe that the estimates of y .1).h ≡ j=0 Cj Σ Cj . In turn.h . to the diagonal elements x.7 Note that as the forecasting horizon approaches inﬁnity. second. where Σ is the (diagonal) variance/covariance matrix of t .4). But because yt . that is. At the same time. and ﬁfth equations of the VAR system) are orthogonal to each us other. the decomposition of the variance of the forecasting error coincides with the decomposition of the unconditional variance of the series in question. Researchers typically deﬁne business cycles as movements in time series of frequencies ranging from 6 quarters to 32 quarters (Stock and Watson.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 . . 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. ≡ t h (Cj Λ4 )Σ (Cj Λ4 ) . third. The diﬀerence between the solid lines and the broken lines (i. country-spread shocks. Thus.. one can write the MA(∞) representation of xt as xt = ∞ Cj t−j . According to our estimate of the VAR system given in equation (5. xt+h − Et xt+h . the sample residuals of t t t t the ﬁrst.h a particular shock. where Λ4 is a 5×5 matrix with all elements equal to zero except j=0 element (4. is given by h Cj t+h−j . For the purpose of the present discussion. rus . the variance of the h-stepahead forecasting error of xt is simply the vector containing the diagonal elements of Σx. i .142 Mart´ Uribe ın ferent horizons. Then. is given by the diagonal elements of the matrix Σx. r. ˆt . i . this lack of orthogonality should disappear as the sample size increases. we associate business-cycle ﬂuctuations with the variance of the forecasting error at a horizon of about ﬁve years. the broken lines in ﬁgure 5.6. The variance/covariance j=0 h matrix of this h-step-ahead forecasting error is given by Σx. say rus . and tbyt are excluded from the Rt equation. tby . and r (i. the variance of the error of the h-step-ahead forecasting error of xt due to rus .h the element-by-element ratio of the diagonal elements of Σx. Then. where Cj ≡ (A−1 B)j A−1 .

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. and tbyt−i for i = 0. is attributed to country-spread shocks. At the same time. Variations in country spreads are largely explained by innovations in US interest rates and innovations in country-spreads themselves. This last result concurs with Eichengreen and Mody (1998). we modify the Rt equation of the VAR system by setting to zero the coeﬃcients on yt−i . Here we make a ﬁrst step at answering this question. ˆt−i . Chapter 5 143 aggregate ﬂuctuations in these countries. In eﬀect.4 establish empirically that country spreads respond signiﬁcantly and systematically to domestic macroeconomic variables. around one third of business cycles in emerging economies is explained by disturbances in external ﬁnancial variables. ˆ Speciﬁcally.Lecture in Open Economy Macroeconomics. 1. Thus. Jointly. The impulse response functions shown in ﬁgure 5. These disturbances play an even stronger role in explaining movements in international transactions. We then compute ˆ i . these two sources of uncertainty account for about 85 percent of ﬂuctuations in country spreads. who interpret this ﬁnding as suggesting that arbitrary revisions in investors sentiments play a signiﬁcant role in explaining the behavior of country spreads. 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. Most of this fraction. A natural question raised by these ﬁndings is whether the feedback from endogenous domestic variables to country spreads exacerbates domestic volatility. about 60 percentage points.

We follow this route next. Of course. when we shut oﬀ the endogenous feedback. In eﬀect. . Std.144 Mart´ Uribe ın Table 5. The eﬀect of feedback on the cyclical behavior of the country spread itself is even stronger.1 serve solely as a way to motivate a more adequate approach to the question they aim to address. this counterfactual exercise is subject to Lucas’ (1976) celebrated critique.6450 3. 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. 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.1: Aggregate Volatility With and Without Feedback of Spreads from Domestic Variables Model Variable Feedback No Feedback Std.3846 3.7696 ˆ the implied volatility of yt . Table 5.0674 ˆ ı 14. the volatility of the country interest rate falls by about one third.5198 tby R 6. tbyt and Rt in the modiﬁed VAR system ˆ i at business-cycle frequency (20 quarters). when feedback is negated. As such. In particular. 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.9260 4. ˆt . Dev. the results of table 5.1 shows that the presence of feedback from domestic variables to country spreads signiﬁcantly increases domestic volatility.4955 4.1060 11. y ˆ 3. We compare these volatilities to those emerging from the original VAR model. Dev.

Second. preferences are as- . innovations in the world interest rate or the country spread are assumed to have allocative eﬀects with a one-period lag. we conclude that according to the proposed theory. we estimate the deep structural parameters of the model. we feed into the model the estimated version of the fourth and ﬁfth equations of the VAR system (5. First. we develop a standard model of the business cycle in small open economies. we assume that in each period. Chapter 5 145 5.g. Third. production and absorption decisions are made prior to the realization of that period’s world-interest-rate shock and country-spread shock.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 (5.Lecture in Open Economy Macroeconomics. The basis of the theoretical model presented here is the standard neoclassical growth model of the small open economy (e. Thus. Second.e. To assess the plausibility of these restrictions.1). describing the stochastic laws of motion of the US interest rate and the country spread.. as in the empirical model. If the estimated shocks imply similar business cycle ﬂuctuations in the empirical as in theoretical models.2 and 5. Mendoza. we will assess the plausibility of our estimated shocks in four steps: First.3) with those implied by the proposed theoretical framework. those shown in ﬁgures 5. it is necessary to use the predictions of some theory of the business cycle as a metric. we compare estimated impulse responses (i. the identiﬁed shocks are plausible.. Finally. We depart from the canonical version of the small-open-economy RBC model along four dimensions. Accordingly.1). 1991).

2002). ﬁrms are assumed to be subject to a working-capital constraint. Uribe. and allow for the observed nonmonotonic (hump-shaped) response of investment in response to a variety of shocks (see Uribe.4. 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. and ht denotes the fraction of time devoted to work in period t. ct denotes the cross-sectional ˜ average level of consumption in period t. Christiano. these two frictions prevent excessive investment volatility.g. induce persistence. Households take as given the process .. and allows the model to predict a more realistic response of domestic output to external ﬁnancial shocks. This constraint introduces a direct supply side eﬀect of changes in the cost of borrowing in international ﬁnancial markets. c (5. and Fisher.. Boldrin. ht ). Fourth. 1997).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 . Habit formation has been shown to help explain asset prices and business ﬂuctuations in both developed economies (e.2) where ct denotes consumption in period t. Third. 2001) and emerging countries (e.g. the process of capital accumulation is assumed to be subject to gestation lags and convex adjustment costs. 5. In combination. or catching up with the Joneses as in Abel (1990).146 Mart´ Uribe ın sumed to feature external habit formation.

We assume that households face costs of adjusting their foreign asset position. and smooth. 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. (5. for some d > 0. The single-period utility index U is assumed to be increasing in its ˜ ﬁrst argument. 1) denotes a subjective discount factor. Chapter 5 147 for ct . we compared a number of standard alternative ways to induce stationarity in the small open economy framework. The household’s periodby-period budget constraint is given by dt = Rt−1 dt−1 + Ψ(dt ) + ct + it − wt ht − ut kt .Lecture in Open Economy Macroeconomics. Households have access to two types of asset. capital rents. concave. The capital stock is assumed to be owned entirely by domestic residents. including the one used . purchases of investment goods. physical capital and an internationally traded bond. and purchases of ﬁnancial assets. and interest income bond holdings. decreasing in its second argument. kt denotes the stock of physical capital. Earlier in chapter ??. ut denotes the rental rate of capital. The parameter β ∈ (0. and the parameter µ measures the intensity of external habit formation. and it denotes gross domestic investment. Households have three sources of income: wages. The debt-adjustment cost function Ψ(·) is assumed ¯ ¯ ¯ to be convex and to satisfy Ψ(d) = Ψ (d) = 0. wt denotes the wage rate. households allocate their wealth to purchases of consumption goods. Rt denotes the gross interest rate faced by domestic residents in ﬁnancial markets. Each period.3) where dt denotes the household’s debt position in period t.

(5.148 Mart´ Uribe ın here. dt . This digression will be of use later in the paper when we analyze the ﬁrm’s problem. 2. Bank proﬁts are assumed to be distributed to domestic households in a lump-sum fashion.8 The process of capital accumulation displays adjustment costs in the form of gestation lags and convex costs as in Uribe (1997).6) where δ ∈ (0. the evolution of sit is given by si+1t+1 = sit . Producing one unit of capital good requires investing 1/4 units of goods for four consecutive periods.4) In turn. and conclude that they all produce virtually identical implications for business ﬂuctuations. which is precisely the shadow interest rate faced by domestic agents in the centralized problem (see the Euler condition (5. 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 ) . Suppose there is a continuum of banks of measure one that behave competitively. Then investment in period t is given by 1 4 3 it = sit . The The debt adjustment cost can be decentralized as follows. In addition. i=0 (5.10) below). taking as given Rt and Rt . 1) denotes the rate of depreciation of physical capital. banks face operational costs. that are increasing and convex in the volume of intermediation. 1. which are d d given by Rt [dt − Ψ(dt )] − Rt dt . The problem of domestic banks is then to choose the volume dt so as to maximize proﬁts. (5. 8 . Ψ(dt ). Suppose that ﬁnancial transactions between domestic and foreign residents require ﬁnancial intermediation by domestic institutions (banks). They capture funds from foreign investors at the country rate Rt d and lend to domestic agents at the rate Rt .5) The stock of capital obeys the following law of motion: s3t kt kt+1 = (1 − δ)kt + kt Φ . 3. Let sit denote the number of investment projects started in t − i for i = 0.

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. ut }∞ as well as c0 .Lecture in Open Economy Macroeconomics.3). k0 . ht+1 . The Lagrangian associated with the household’s optimization problem can be written as: ∞ L = E0 t=0 β t U (ct − µ˜t−1 . 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 ) . s0. 2.6).2) subject to the budget constraint (5. and to satisfy Φ(δ) = δ and Φ (δ) = 1. which is assumed to be strictly increasing. wt .t+1 . As discussed in chapters 3 and ??. λt νit . dt+1 }∞ so as to t=0 maximize the utility function (5. investment projects. 1. Households choose contingent plans {ct+1 . where λt . The introduction of capital adjustment costs is commonplace in models of the small open economy. concave. h0 . Rt . 3. and sit for c t=0 i = 0. 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. as deﬁned by the function Φ. R−1 d−1 . and a borrowing constraint of the form dt+j+1 j s=0 Rt+s j→∞ lim Et ≤0 (5.7) that prevents the possibility of Ponzi schemes.4)-(5. the laws of motion of total investment. and λt qt are the Lagrange multipliers associated with con- . and the capital stock given by equations (5. Chapter 5 149 process of capital accumulation is assumed to be subject to adjustment costs. The household takes as given the processes {˜t−1 .

the variables ct+1 . Note that in general the marginal utility of wealth will diﬀer from the marginal utility of consumption (λt = Uc (ct − µ˜t−1 .11) (5.8) 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. and (5.6). ht+1 .9) (5.5). The optimality conditions associated with the household’s problem are (5. ht )).12) (5. (5.10) (5.3).3). bec cause current consumption cannot react to unanticipated changes in wealth. 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 (5. Equation (5. Equation (5. (5.150 Mart´ Uribe ın straints (5.7) all holding with equality and Et λt+1 = Uc (ct+1 − µ˜t . and s0t+1 all reside in the information set of period t.15) It is important to recall that. by equating . ht+1 ) c c Et [wt+1 λt+1 ] = −Uh (ct+1 − µ˜t . respectively. Et λt+1 . because of our assumed information structure.13) (5.9) deﬁnes the household’s labor supply schedule.8) (5.4)-(5. (5.14) s3t+1 kt+1 s3t+1 kt+1 − + λt+1 ut+1 .

13) show how to price investment projects at diﬀerent stages of completion. qt . to the discounted value of renting the unit of capital for one period and then selling it. or Tobin’s Q. ut+1 + qt+1 .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.Lecture in Open Economy Macroeconomics.11)-(5.4. equation (5. Note that. Equation (5. Chapter 5 151 the marginal disutility of eﬀort in period t + 1 to the expected utility value of the wage rate in that period. ht ). Finally. 5.2 Firms Output is produced by means of a production function that takes labor services and physical capital as inputs.16) . thereby reducing their debt positions.15) is a pricing condition for physical capital. 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 )]. net of depreciation and adjustment costs. providing further incentives for households to save.10) is an asset pricing relation equating the intertemporal marginal rate of substitution in consumption to the rate of return on ﬁnancial assets. Intuitively. It equates the revenue from selling one unit of capital today. above its steady-state level d. 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. because of the presence of frictions to adjust bond holdings. Equations (5. (5. yt = F (kt . when the household’s debt position is. Equation (5. qt . ¯ say.

ht ) + wt ht + ut kt + πt + Rt κt . Firms hire labor and capital services from perfectly competitive markets. as shown in footnote 8. 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 . and concave. 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. denoted by df . ht ) + wt ht + ut kt + πt − κt−1 + κt . 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. increasing in both arguments. the working-capital constraint takes the form κt ≥ ηwt ht . . t t−1 d where πt denotes distributed proﬁts in period t. Then. Formally.152 Mart´ Uribe ın where the function F is assumed to be homogeneous of degree one. The debt position of the ﬁrm. 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. η ≥ 0. and Rt ≡ Rt 1−Ψ (dt ) is the interest rate faced by nonﬁnancial domestic agents.

for otherwise the ﬁrm would incur in unnecessary ﬁnancial costs. Chapter 5 153 We will limit attention to the case in which the interest rate is positive at all times. ∞ max E0 t=0 βt λt πt .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 . 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. ht ) + wt ht 1 + η d Rt d Rt − 1 d Rt + u t kt + π t . which would be suboptimal. ht ) − wt ht 1 + η d Rt d Rt − 1 d Rt − u t kt . That is.17) to eliminate πt from the ﬁrm’s objective function the ﬁrm’s problem can be stated as choosing processes for at . ht . and kt so as to maximize ∞ E0 t=0 βt λt λ0 at − at−1 + F (kt . subject to a no-Ponzi-game borrowing constraint of the form at+j j d s=0 Rt+s j→∞ lim Et ≤ 0. (5. which is increasing d in the interest rate Rt . λ0 We use the household’s marginal utility of wealth as the stochastic discount factor because households own domestic ﬁrms. 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 . the domestic residents. Using constraint (5.Lecture in Open Economy Macroeconomics. .

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). Alternative assumptions give rise to diﬀerent speciﬁcations of the wedge. or the higher the intensity of the working capital constraint. under a cashd in-advance timing the wedge takes the form 1 + η(Rt − 1).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. Then. Here we adopt the shopping-time timing. We assume that ﬁrms start out with no liabilities. 9 . (Rt − d 1)/Rt .154 Mart´ Uribe ın The ﬁrst-order conditions associated with this problem are (5. an optimal plan consists in holding no liabilities at all times (at = 0 for all t ≥ 0). dt represents the country’s net debt position.10). with distributed proﬁts given by d Rt − 1 d Rt πt = F (kt . This distortion is d larger the larger the opportunity cost of holding working capital. as well as the amount of debt intermediated by local banks. (5.9 We also observe that any process at satisfying equation (5. the no-Ponzi-game constraint holding with equality. (5.17). The precise form taken by this wedge depends on the particular timing assumed in modeling the use of working capital. η. ht ) − wt ht 1 + η − u t kt In this case. ht ) = ut . For instance.17) and the ﬁrm’s no-Ponzi-game constraint is optimal. ht ) = wt 1 + η (5. and d Rt − 1 d Rt Fh (kt .

It turns out that us up to ﬁrst order. This is because we empirically identiﬁed not only the distribution of the two shocks we wish to study. So using the economic model. one only needs to know the laws of motion of Rt and Rt to construct the coeﬃcients of the theoretical MA(∞) representation. We therefore close our model by introducing the law of motion of the country interest rate Rt . investment.35Rt−1 − 0.4. but also their contribution to business cycles in emerging economies. etc.50Rt + 0.29tbyt − 0. As indicated earlier. disturbance with mean zero and standard deviation 0.3 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. the variable tbyt stands for the trade balance- . This process is the estimate of the bottom equation of the VAR system (5.19tbyt−1 + r r t.Lecture in Open Economy Macroeconomics.63Rt−1 + 0.79ˆt + 0. where is an i.20) ı + 0. Chapter 5 155 5.61ˆt−1 + 0.i.d. we can generate the corresponding theoretical MA(∞) representation and compare it to its empirical counterpart.12ˆt−1 y y ı (5.). In formal terms.031. 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.11ˆt − 0.1) and is given by ˆ ˆ ˆ us ˆ us Rt = 0.

λt . 1.22) where 0. 1. it follows that both measures of private consumption are identical up to ﬁrst order. yt Mart´ Uribe ın tbyt = (5.i. Rt .23) An equilibrium is a set of processes ct+1 . is an i. ht+1 . it .4 Equilibrium. the national income and product accounts would measure private consumption as ct + Ψ(dt ) and not simply as ct . 10 .d.21) Because the process for the country interest rate deﬁned by equation (5. 3.4.83Rt−1 + rus t rus t . ct+1 . sit+1 for ˜ d i = 0. (5. Thus. individual consumption equals average consumption across households. and Parameter Values In equilibrium all households consume identical quantities. 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.007. 2. or c t = ct . Accordingly. wt . and νit for i = 0. qt . tbyt . which is assumed to be an exogenous random variable.20) us involves the world interest rate Rt . innovation with mean zero and standard deviation 5. yt . ¯ because of our maintained assumption that Ψ (d) = 0.156 to-GDP ratio and is given by:10 yt − ct − it − Ψ(dt ) . where the debtadjustment cost Ψ(dt ) are incurred by households. kt+1 . Rt . 2 satisfying In an economy like the one described by our theoretical model. Functional Forms. we estimate Rt as follows an AR(1) process and obtain ˆ us ˆ us Rt = 0. ˜ t ≥ −1. (5. ut . However. dt .

We set the steadystate real interest rate faced by the small economy in international ﬁnancial markets at 11 percent per year. h0 . 2 φ > 0. and debt adjustment costs. the time unit is meant to be one quarter. Our estimation procedure follows Christiano. There is no readily available estimates for these parameters for emerging economies. We therefore proceed to estimate them. We set the depreciation rate at 10 percent per year. Φ(x) = x − φ (x − δ)2 . y−1 . technology.23).18)-(5. ψ. we set γ = 2. We adopt the following standard functional forms for preferences. This value is consistent with an average US interest rate of about 4 percent and an average country premium of 7 percent. i0 . and Evans (2001) and consists in choosing values .22) describing the evolution of the world interest rate.455. F (k. h) = k α h1−α . and α = . c − µ˜ − ω −1 hω c 1−γ 1−γ U (c − µ˜. and µ. all holding with equality. There remain four parameters to assign values to. c−1 . and (5. i−1 . h) = c −1 . Chapter 5 157 conditions (5. Following Mendoza (1991). 2 ψ ¯ (d − d)2 . φ. a standard value in business-cycle studies. capital adjustment costs. t and equation (5. ω = 1. η. the processes for the exogenous innovations rus t and r. given c0 .32.Lecture in Open Economy Macroeconomics. Ψ(d) = In calibrating the model.16). both of which are in line with actual data.3)-(5.21). Eichenbaum. (5.

2. µ)]. the trade balance. Thus. φ. φ. µ) is given by argmax{ψ. The implied debt adjustment costs are small. let IRe denote the 192×1 vector of estimated impulse response functions and IRm (ψ. This matrix penalizes those elements of the estimated impulse response functions associated with large error intervals.11 In our exercise we consider the ﬁrst 24 quarters of the impulse response functions of 4 variables (output. µ) the corresponding vector of impulse responses implied by the theoretical model. we are setting 4 parameter values to match 192 points. which is a function of the four parameters we seek to estimate. φ. For A key diﬀerence between the exercise presented here and that in Christiano et al. η = 1. µ)] Σ−1e [IRe − IRm (ψ. 11 . Speciﬁcally. φ = 72. Then our estimate of (ψ. and µ = 0. η. 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.e.2 and the corresponding impulse responses implied by the model. η. whereas in Christiano et al. The resulting parameter estimates are ψ = 0. φ. investment.2. On the other hand. to 2 shocks (the US-interest-rate shock and the country-spread shock).φ.158 Mart´ Uribe ın for the four parameters so as to minimize the distance between the estimated impulse response functions shown in ﬁgure 5.8. country-interest-rate shocks and world-interest-rate shocks. the set of estimated impulse responses used in the estimation procedure are originated by a single shock. For ¯ example. η. and the country interest rate). capital adjustment costs appear as more signiﬁcant.µ} [IRe − IRm (ψ.η. IR where ΣIRe is a 192×192 diagonal matrix containing the variance of the impulse response function along the diagonal. η..00042. is that here the estimation procedure requires ﬁtting impulse responses to multiple sources of uncertainty (i.

8 0.edu/~mu2166/uribe_yue_jie/uribe_yue_jie. the trade balance-to-GDP ratio.455 0. 1990). the estimated degree of habit formation is modest compared to the values typically used to explain asset-price regularities in closed economies (e. Constantinides.00042 0.g. .32 72. The estimated value of η implies that ﬁrms maintain a level of working capital equivalent to about 3.77% 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.html. In the absence of capital adjustment costs.6 depicts impulse response functions of output.12 The left col12 The Matlab code used to produce theoretical impulse response functions is available on line at http://www. a 10 percent increase in investment for one year produces an increase in the capital stock of 0. Chapter 5 159 Table 5.columbia.88 percent.. 5. Table 7.5 Theoretical and Estimated Impulse Responses Figure 5.1 gathers all parameter values.6 months of wage payments.973 2 0. starting in a steady-state situation.2: Parameter Values Symbol β γ µ ω α φ ψ δ η R Value 0.96 percent. investment.204 1.025 1.Lecture in Open Economy Macroeconomics. the capital stock increases by 0.2 2. and the country interest rate. Finally.

5 5 10 15 20 Response of TB/GDP to εrus 2 0.1 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. .5 0.6: Theoretical and Estimated Impulse Response Functions Response of Output to εrus 0 0 −0.5 0.4 0.1 −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 −0.8 0. and the second column displays impulse responses to a country-spread shock ( r ).6 0.3 1 0.2 0 0 Response of Country Interest Rate to εr 5 10 15 20 Estimated IR -x-x.2 −0.2 0.5 −1 −1.5 0 5 10 15 20 −0.Model IR 2-std error bands around Estimated IR Note: The ﬁrst column displays impulse responses to a US interest rate shock ( rus ).4 1.160 Mart´ Uribe ın Figure 5.

6 The Endogeneity of Country Spreads According to the estimated process for the country interest rate given in ˆ ˆ ˆ us equation (5. Crossed lines depict theoretical impulse response functions. and current and past values of a ˆ ˆ set of domestic endogenous variables. ˆt−1 . yt . This information is reproduced from ﬁgures 5. output and investment contract in response to either a US-interest-rate shock or a country-spread shock. ˆt . the trade balance improves in response to either shock. tbyt .2 and 5. Second. Solid t lines display empirical impulse response functions. Third. the country spread St = Rt − Rt moves in response to four types of variable: its own lagged value St−1 (the autoregressive component). We therefore conclude that the scheme used to identify the parameters of the VAR system (5.3. the country interest rate displays a hump-shaped response to an innovation in the US interest rate. 5. The model replicates three key qualitative features of the estimated impulse response functions: First. Fourth. yt−1 .1) is indeed successful in isolating country-spread shocks and US-interest-rate shocks from the data. the country interest rate displays a monotonic response to a country-spread shock. and broken lines depict the associated two-standard-error bands. current us us and past US interest rates Rt and Rt−1 ). tbyt−1 .Lecture in Open Economy Macroeconomics. t 161 and the right column shows impulse responses to a country-spread shock ( r ). A natural ˆ ˆ ı ı question is to what extent the endogeneity of country spreads contributes . the exogenous country-spread shock r t (the sentiment component). Chapter 5 umn shows impulse responses to a US-interest-rate shock ( rus ).20).

e.29tbyt − 0. t . This process diﬀers from the one shown in equation (5.63. The ﬁrst exercise aims at gauging the degree to which country spreads amplify the eﬀects of world-interest-rate shocks. Speciﬁcally. St .11ˆt − 0. The reason is that doing so would alter the estimated process of the country spread shock r. given the past value ˆ ˆ ˆ us of the country spread. which is the negative of the coeﬃcient on the lagged country interest rate.61ˆt−1 + 0.22)). We note that in conducting this and the next counterfactual exercises we do not reestimate the VAR system. The process for the US interest rate is assumed to be unchanged (i. This parametrization has two properties of interest. the above speciﬁcation of the country-interest-rate process preserves the dynamics of the model in response to country-spread shocks. we assume that the process for the country interest rate is given by ˆ ˆ ˆ us ˆ us Rt = 0. 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. Mart´ Uribe ın We address this question by means of two counterfactual exercises.79ˆt + 0.63Rt−1 − 0.20) only in that the coeﬃcient on the contemporaneous US interest rate is unity and the coefﬁcient on the lagged US interest rate equals -0.19tbyt−1 + r t. Second. it implies that.12ˆt−1 y y ı (5. does not directly depend upon current or past values of the US interest rate. the current country spread. given by equation (5.. To this end. First.162 to exacerbating aggregate ﬂuctuations in emerging countries. St−1 = Rt−1 − Rt−1 .24) ı + 0.63Rt−1 + Rt − 0.

Lecture in Open Economy Macroeconomics. under the process for Rt given in equation (5.663 0. A hat on a variable denotes log-deviation from its non-stochastic steady-state value.20) and then with equation (5. the one given in equation (5.547 1.3: Endogeneity of Country Spreads and Aggregate Instability Std. The result is shown in table 5.3.429 3. This would amount to introducing two changes at the same time.547 1. or tby us ˆ.983 S 2.24)? To answer this question. or tby Variable Model No R ı Model No R ı y ˆ 1.819 0.429 4. due to r Baseline No yt ˆ Baseline No yt ˆ us ˆ.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. Dev.175 tby 1. we feed the theoretical model ﬁrst with equation (5.e. 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.20) or the one given in equation (5.429 4.663 0.347 1.24) and in each case compute a variance decomposition of output and other endogenous variables of interest. Chapter 5 163 Table 5.446 R 3.819 0.319 0. Dev.429 3.110 0. We ﬁnd that when the country spread is assumed not to respond directly to variations in the US interest rate (i.885 0. due to rus Std. when Rt follows .515 0.469 0..245 0. changes in the endogenous and the sentiment components of the country spread process..639 ˆ ı 2.983 Note: The variable S denotes the country spread and is deﬁned as S = R/Rus .580 1.622 2.640 4.784 0.509 1. Namely.623 4.420 0.e.866 1.

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.35Rt−1 + r t.50Rt + 0. t t 13 .25) Table 5.20)). 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. This indicates that the aggregate eﬀects of US-interest-rate shocks are strongly ampliﬁed by the dependence of country spreads on US interest rates. investment.63Rt−1 + 0. Speciﬁcally. 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. we replace the process for Rt given in equation (5. To this end. 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. (5.20) with the process ˆ ˆ ˆ us ˆ us Rt = 0. such as output and the external accounts.13 We conclude that the fact that country spreads respond to the state of domestic business conditions signiﬁcantly exacerbates aggregate instability in emerging countries. We ﬁnd that the equilibrium volatility of output.164 Mart´ Uribe ın the process given in equation (5.3 displays the outcome of this exercise.

Broadly. and (3) that the trade-balance-to-output ratio is signiﬁcantly more countercyclical in emerging markets than it is in developed countries.Chapter 6 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. 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. the available theoretical explanations fall into two categories: One is that emerging market economies are subject to more volatile shocks than are developed countries. (2) that private consumption spending is more volatile than output in emerging countries. Explaining this striking contrast between emerging and industrialized economies is at the top of the research agenda in small-open-economy macroeconomics. This and the following two chapters provide a progress report on the identiﬁcation and quantiﬁcation of exogenous sources of busi165 . but less volatile than output in developed countries.

1 Deﬁning the Terms of Trade The terms of trade are deﬁned as the relative price of exports in terms of imports. It follows that for many small countries. At the same time. Typically. and the real exchange rate in the postwar era. A number of empirical regularities emerge from the table: .166 Mart´ Uribe ın ness cycles in small open economies.2 Empirical Regularities Table 6. emerging countries specialize in exports of a few primary commodities. let Ptc denote a domestic CPI index. Because primary commodities display large ﬂuctuations over time. the terms of trade can be regarded as an exogenous source of aggregate ﬂuctuations. 6. Then the real exchange rate is given by Ptc /Ptm . agricultural products. or oil. 6. emerging countries are normally small players in the world markets for the goods they export or import. the terms of trade for that country are given by tott ≡ Ptx /Ptm . the real exchange rate (rer) is deﬁned as the relative price of consumption in terms of importable goods. Speciﬁcally. the terms of trade have the potential to be an important source of business cycles in developing countries. the components of aggregate demand. such as metals.1 displays summary statistics relating the terms of trade to output. The present chapter concentrates on terms-of-trade shocks. In the table. Letting Ptx and Ptm denote indices of world prices of exports and imports for a particular country.

70 Developing Countries 10. consumption. India.40 0.07 Oil Exporting Countries 18.30 0. Indonesia. Venezuela. and Nigeria.40 0. tott−1 ) σ(tot)/σ(y) ρ(tot. investment. The group of oil-exporting countries is formed by Mexico. i. c) ρ(tot. .Lecture in Open Economy Macroeconomics.39 0. the terms of trade. and Japan. UK.0 0.50 1. rer) Developed Countries 4.1: The Terms of Trade and Business Cycles Summary Statistic σ(tot) ρ(tott .0 0. Saudi Arabia. y. Philippines. Italy.77 0.38 0. tb) ρ(tot. All variables are expressed in percent deviations from a HP trend constructed using a smoothing parameter of 100. and tb denote. Chapter 6 167 Table 6.47 0. Algeria. Venezuela. y) ρ(tot. Korea. Mexico.42 Source: Mendoza (1995). Canada. and the trade balance.19 0. i) ρ(tot.34 0. Peru. France. The sample is 1955 to 1990 at annual frequency.28 0. Chile. and Thailand.33 0.24 0. Germany. respectively. c. All other variables are measured per capita at constant import prices.70 0. Taiwan.52 0.45 0. tables 1 and 3-6.78 0. Cameroon. Brazil. The terms of trade are measured as the ratio of export to import unit values with 1900=100. Note: tot. output.74 0.67 0. The group of developed countries is formed by the US. The group of developing countries is formed by Argentina.

Later in this chapter. and they are almost twice as volatile in oil-exporting countries as in developing countries. The information provided in table 6. 75 percent as volatile as output in developing countries. The terms of trade are procyclical. and 150 percent as volatile as output in oil-exporting countries.2. we attempt to answer this question by combining the empirical information contained in table 6. The correlation between the terms of trade and the trade balance is positive but small. Harberger (1950) and Laursen . The terms of trade are twice as volatile in emerging countries as in developed countries. They are twice as procyclical in developed countries as in developing countries. 2. 4. 6. The terms of trade display positive but small serial correlation. More than half a century ago. 3.1 is mute on the importance of terms of trade shocks in explaining movements in aggregate activity.168 Mart´ Uribe ın 1.1 with the theoretical predictions of a fully speciﬁed dynamic general equilibrium model of the open economy. 6. 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. The terms of trade are positively correlated with the real exchange rate.1 TOT-TB Correlation: Two Early Explanations The eﬀects of terms-of-trade shocks on the trade balance is an old subject of investigation. 5.

concluded that the eﬀect of terms of trade shocks on the trade balance depends crucially on the perceived persistence of the terms of trade. Consider the following behavioral equations deﬁning the dynamics of each component of aggregate demand. and mt denotes imports. within the context of a keynesian model.. where yt denotes output. This view remained more or less unchallenged until the early 1980s. when Obstfeld (1982) and Svensson and Razin (1983). Public consumption and . the conclusion that rising terms of trade should be associated with an improving trade balance.e. This conclusion became known as the Harberger-LaursenMetzler (HLM) eﬀect.Lecture in Open Economy Macroeconomics. 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 . Chapter 6 169 and Metzler (1950) formalized. This view became known as the Obstfeld-Razin-Svensson (ORS) eﬀect. gt denotes public consumption. ct denotes private consumption. 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. Let us look at the HLM and ORS eﬀects in some more detail. using a dynamic optimizing model of the current account. it denotes private investment. In their model a positive relation between terms of trade and the trade balance (i. xt denotes exports.

mt = µyt . we will assume that these two varibles are constant over time and given by gt = g ¯ and it = ¯ i. respectively. Consumption is assumed to be ¯ i an increasing linear function of output ct = c + αyt . with µ ∈ (0. Thus. whereas the term c + g + ¯ is referred to as the autonomous component of ¯ ¯ i domestic absorption. where g and ¯ are parameters.170 Mart´ Uribe ın private investment are assumed to be independent of output. the parameters α and µ are referred to as the marginal propensities to consume and import. respectively. The quantity of goods exported in period t is denoted by qt . 1) and c > 0 are parameters. 1). . is given by xt = tott qt . ¯ with α ∈ (0. the value of exports in terms of importables. Imports are assumed to be ¯ proportional to output. In the jargon of the 1950s. For simplicity. xt . Output as well as all components of aggregate demand are expressed in terms of import goods.

Similarly. It is worth noting that in the context of this model. ¯ where q is a positive parameter. µ. 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 the quantity of goods exported. 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.Lecture in Open Economy Macroeconomics. q . 1+µ−α 1+µ−α tbt = Clearly. is assumed to be constant and vigen by qt = q . xt . Chapter 6 171 where tott denotes the terms of trade. qt . and solving for output yields yt = ¯ c + g + ¯ + tott q ¯ ¯ i . The terms of trade are assumed to evolve exogenously. and mt from the national income identity. it . the sign of the eﬀect . 1+µ−α Letting tbt ≡ xt − mt denote the trade balance. we can write 1−α µ(¯ + g + ¯ c ¯ i) ¯ tott q − . the smaller is the marginal propensity ¯ to import. as a larger fraction of income is used to buy foreign goods. and the smaller is the marginal propensity to consume α. This positive relation between the terms of trade and the trade balance is stronger the larger is the volume of exports. gt . 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. Using the behavioral equations to eliminate ¯ ct .

Let tott denote the relative world price of exported goods in terms of imported goods. The model is therefore identical to the stochastic-endowment economy studied in chapter 2. so it takes the evolution of tott as exogenous. The economy is small in world product markets. yt = 1 for all t. We can then use the results derived in chapter 2 to draw the . therefore exports the totality of its endowment and imports the totality of its consumption. with tott taking the place of yt .5). The household. This is an economy inhabited by an inﬁnitely lived representative household with preferences described by the intertemporal utility function given in (2.3) prevents the household from engaging in Ponzi games. Suppose that the good the household consumes is diﬀerent from the good it is endowed with. This is the main contrast with the Obstfeld-Razin-Svensson eﬀect. Consider the small. The borrowing constraint given in (2.172 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. open. or the terms of trade. The resource constraint is then given by dt = (1 + r)dt−1 + ct − tott . Assume for simplicity that the endowment of exportable goods is constant and normalized to unity. endowment economy studied in chapter 2. 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 productivity shock At can be interpreted as a terms-of-trade shock. 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. and the Middle East. The 30 observations were taken from Mendoza (1995). East Asia. The . Chapter 6 173 following conclusion: if the terms of trade are stationary then an increase in the terms of trade produces an improvement in the current account. When terms of trade are nonstationary. A simple way to do this is to modify the RBC model of chapter ?? by assuming again that households do not consume the good they produce.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.Lecture in Open Economy Macroeconomics. In this case. An increase in the terms of trade produces an improvement in the trade balance if the terms of trade shock is transitory. shown with circles. Africa. including the G7 countries and 23 selected developing countries from Latin America. displays no pattern. Agents save in order to ensure higher future consumption. This conclusion can be extended to a model with endogenous labor supply and capital accumulation. an improvement in the terms of trade induces a trade balance deﬁcit. table 1. Figure 6. but as the serial correlation of the terms of trade shock increases. The cloud of points. Is the ORS eﬀect borne out in the data? If so. In this case. the value of income is expected to grow over time. so agents can aﬀord assuming higher current debts without sacriﬁcing future expenditures. an improvement in the terms of trade can lead to a deterioration in the current account driven by investment expenditures.

France.6 Argentina 0.1 0.28+0. .03ρ(T OT ).2 0.7 Source: Mendoza (1995).6 0. Saudi Arabia.23 + 0. and Thailand). Chile. Morocco. Nigeria. and Tunisia).1 0 0. T OT ) = 0.2 −0. United Kingdom. and 8 countries from Africa (Algeria. Germany. Philippines. and Argentina from the sample and is given by corr(T B. and Japan). The sample includes the G-7 countries (United States. Cameroon. Brazil. Canada. Venezuela).14ρ(T OT ).6 −0.4 TOT Serial Correlation 0.4 TB−TOT Correlation 0. Note: Each point corresponds to one country. Saudi Arabia. Kenya. 3 countries from the Middle East (Israel. Sudan. India.5 0. table 1. The dashed-dotted line is the OLS ﬁt after eliminating the G7 countries. The dashed line is the OLS ﬁt after eliminating Argentina from the sample and is given by corr(T B.174 Mart´ Uribe ın Figure 6. (Argentina.2 0 −0. The TOT serial correlation and the TB-TOT correlation are computed over the period 1955-1990. Indonesia. 6 countries from Latin America.4 −0. Italy.35−0.1: TOT Persistence and TB-TOT Correlations 0.12ρ(T OT ). Zaire. The solid line is the OLS ﬁt and is given by corr(T B. Korea. Peru. and Egypt). Mexico.8 0.3 0. T OT ) = 0. 6 countries from Asia (Taiwan. T OT ) = 0.

Argentina. . Eliminating these 8 countries (as well as the outlier Argentina) from the sample. they should be expected to induce a smaller response in the trade balance. a major oil exporter. the terms of trade are not likely to be exogenous. Eliminating Argentina from the sample one obtains a positive OLS slope of 0.14. 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. Argentina is the only country whose elimination from the sample results in a positive slope. the largest economies in the world.1 are likely to be large players in the world markets for the goods and services they import and/or export. For these countries. shown with a solid line.03 and is shown with a dash-dotted line in ﬁgure 6. that the negative slope in the OLS regression is driven by a single observation. the only country in the sample with a negative serial correlation of the terms of trade. The sign of the slope is indeed in line with the ORS eﬀect: As the terms of trade shocks become more persistent.1. The ﬁtted line using this reduced sample has a negligible slope equal to 0. The ORS 1 Indeed. and Saudi Arabia. Countries in this group would include all of the G7 nations. We conclude that the observed relationship between the TB-TOT correlation and the persistence of TOT is close to nil. A number of countries in ﬁgure 6. displays a small negative slope of -0. It is apparent in the graph.1. Does this conclusion suggest that the empirical evidence presented here is against the Obstfeld-Razin-Svensson eﬀect? Not necessarily.12. Chapter 6 175 OLS ﬁt of the 30 points.1 The corresponding ﬁtted relationship is shown with a broken line on ﬁgure 6. however.Lecture in Open Economy Macroeconomics.

Moreover. In turn. 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. At the same time. and. judging the empirical validity of the ORS eﬀect only on the grounds of raw correlations would be misplaced. An important step in the process of isolating terms-of-trade shocks—or any kind of shock. low levels of economic activity in the developed world are likely to be associated with a weak demand for primary commodities. As another example. suppose that domestic technology shocks are correlated with technology shocks in another country or set of countries. Not controlling for these shocks may result in erroneously attributing part of their eﬀect on the trade balance to the terms of trade. In this case. A case in point is given by world-interest-rate shocks. with deteriorated terms of trade for the emerging countries producing those commodities. The raw data is in principle driven by a multitude of shocks. as a result. Data analysis based purely on statistical methods will in general not result in a successful iden- . for that matter—is identiﬁcation. the terms of trade and the trade balance are moving at the same time. high world interest rates are associated with contractions in aggregate demand and improvements in the trade balance in emerging countries. some of these shocks may directly aﬀect both the trade balance and the terms of trade. but attributing all of the movement in the trade balance to changes in the terms of trade would be clearly misleading. High world interest rates may be associated with depressed economic activity in developed and emerging economies alike.176 Mart´ Uribe ın eﬀect requires isolating the eﬀect of TOT shocks on the trade balance. of which the terms of trade is just one. Under this scenario.

Similarly.Lecture in Open Economy Macroeconomics. The following exercise.1 Households This block of the model is identical to that of the RBC model studied in chapter ??. The household block of the model is identical to that of the standard RBC model studied in chapter ??. which follows Mendoza (1995). 6. In doing this. The economy is populated by a large number of identical house- . A nontradable good is a good that is neither exportable nor importable. a sector producing exportable goods. Chapter 6 177 tiﬁcation of technology shocks.3. and a sector producing nontradable goods.3 Terms-of-Trade Shocks in an RBC Model Consider expanding the real-business-cycle model of chapter ?? to allow for terms-of-trade shocks. Economic theory must be used be at center stage in the identiﬁcation process. The main diﬀerence with the model of chapter ?? is that the model studied here features three sectors: a sector producing importable goods. 6. we follow the work of Mendoza (1995). 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. 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. represents an early step in the task of identifying the effects of terms-of-trade shocks on economic activity in emerging economies.

ht denotes labor eﬀort.3) . h) = [1 + c(1 − h)ω ]−β . (6. 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 .178 holds with preferences described by the utility function ∞ Mart´ Uribe ın E0 t=0 θt U (ct . ht ). kt . The stock of capital evolves according to the following law of motion: kt+1 = (1 − δ)kt + it − Φ(kt+1 − kt ).1) where ct denotes consumption. ht ).2) where the function β is assumed to take the form β(c. (6. (6. We established in chapter ?? 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. and U is a period utility function taking the form [c (1 − h)ω ]1−γ . which they rent at the rate ut . 1−γ U (c. Households oﬀer labor services for a wage wt and own the stock of capital.

2)(6.5). Chapter 6 179 where it denotes gross investment. and is assumed to satisfy Φ(0) = Φ (0) = 0 and Φ > 0.2) and (6. Under these assumptions.4). the ﬁrst-order conditions of the household’s maximization problem . j→∞ (1 + r ∗ )j lim (6. 1] denotes the capital depreciation rate.Lecture in Open Economy Macroeconomics.1) subject to (6. the steady-state level of capital is not aﬀected by the presence of adjustment costs. the period budget constraint of the household can be written as dt = (1 + r ∗ )dt−1 + pc ct + it − wt ht − ut kt . capital adjustment costs help curb the volatility of investment in small open economy models like the one studied here. As discussed in chapter ??. t which serve the role of numeraire. Letting θt ηt and θt λt denote the Lagrange multipliers on (6.5) The household seeks to maximize the utility function (6.4) The relative prices pc . 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 ∗ . and ut are expressed in terms of importable goods. which is assumed to be an importable good. Households are subject to a no-Ponzigame constraint of the form Et dt+j ≤ 0. t (6. The parameter δ ∈ [0. wt . The function Φ introduces capital adjustment costs. Letting dt denote the debt position assumed by the household in period t and pc t denote the price of the consumption good.

ht+1 ) + Et ηt+1 β(ct+1 .9) ηt = −Et U (ct+1 . ht ) − ηt βc (ct .2).4).3. is produced by domestic ﬁrms. ht+1 ) (6. and Mart´ Uribe ın Uc (ct . and nontradable consumption goods. which are given by pc ct − pT cT − pN cN .11) . t t ct = [χ(cT )−µ + (1 − χ)(cN )−µ ]−1/µ . (6. (6.8) λt [1 + Φ (kt+1 − kt )] = β(ct . t t (6. Formally. ht ) = λt pc t (6. Firms operate in perfectly competitive product and input markets. ht )Et λt+1 ut+1 + 1 − δ + Φ (kt+2 − kt+1 ) (6. They choose output and inputs to maximize proﬁts. the relative prices of tradable and t t nontradable consumption goods in terms of importable goods. These ﬁrms operate a CES production function that takes tradable consumption goods.2 Production of Consumption Goods The consumption good. cN .10) 6. t t t t t where pT and pN denote. ct . ht )(1 + rt )Et λt+1 (6.7) (6. ht ) = λt wt λt = β(ct . cT .6) − Uh (ct . respectively. The ﬁrstorder conditions associated with this proﬁt-maximization problem are (6. as inputs. ht ) + ηt βh (ct .180 are (6.11) with µ > −1.5) holding with equality.

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). Formally. t t increases. From the second optimality condition. t t t (6. cX . (6. then the share of tradables in total consumption. cT = (cX )α (cM )1−α . and exportable consumption goods.12) 1 1+µ . pT /pc .14) where α ∈ (0. are produced using importable t consumption goods. 1 1+µ (6. which are given by pT cT − pX cX − cM . Firms are competitive and aim at maximizing proﬁts. given by pT cT /(pc ct ). one observes that if the elasticity of substitution between tradables and nontradables is less than unity (or µ > 0). 1) is a parameter. via a Cobbt t Douglas production function. t t t increases as the relative price of tradables in terms of consumption. Chapter 6 and cN t = cT t ct = cT t 1−χ χ 1 χ 181 1 1+µ pT t N pt pT t pc t 1 1+µ . cM .3 Production of Tradable Consumption Goods Tradable consumption goods. denoted cT .3. t t t t t .Lecture in Open Economy Macroeconomics. 6.

3. Note that because the importable good plays the role of numeraire. the three production technologies are given by X X yt = AX (kt )αX . we have that the relative price of importables in terms of the numeraire is always unity (pM = 1).17) M M yt = AM (kt )αM .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. respectively. The optimality t conditions associated with this problem are (6.4 Production of Importable.182 Mart´ Uribe ın where pX denotes the relative price of exportable goods in terms of imt portable goods. Exportable.18) .14) and: pX cX t t =α pT cT t t cM t = 1 − α. and Nontradable Goods Exportable and importable goods are produced with capital as the only input. t (6. t (6. whereas nontradable goods are produced using labor services only. or the terms of trade. This implication is a consequence of the assumption of Cobb-Douglas technology in the production of tradable consumption. 6. Formally. T cT pt t (6.15) (6.

and the vari- able hN denotes labor services employed in the nontradable sector. N pN yt t (6. t t t The optimality conditions associated with this problem are X ut kt = αX . input shares are constant. M . Chapter 6 and N yt = AN (hN )αN .22) According to these expressions. M.Lecture in Open Economy Macroeconomics. N . t t 183 (6. Firms t demand input quantities to maximize proﬁts. X pX yt t M ut kt = αM . M yt (6. yt denotes output of imN portable goods. . which are given by X M N X M pX yt + yt + pN yt − wt hN − ut (kt + kt ).20) (6. i The variable kt denotes the capital stock in sector i = X. and as a consequence of the assumption of Cobb-Douglas technologies.21) and wt hN t = αN . The factors Ai t denote exogenous and stochastic technology shocks in sectors i = X. and yt denotes output of nontradable goods.19) X M where yt denotes output of exportable goods.

26) 6.23) (6.184 Mart´ Uribe ın 6.6 Driving Forces There are four sources of uncertainty in this economy: One productivity shock in each of the three sectors (importable. labor. (2) The sectorial productivity shocks are assumed to be perfectly correlated. the markets for capital.25) Also. and the terms of trade. . (3) The technology shocks aﬀecting the production of importables and exportables are assumed to be identical.3. and nontradables must clear. X M kt = kt + kt .24) ht = hN . t (6.5 Market Clearing In equilibrium. 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 . exportable. and nontradable). (6. t and N cN = yt .3. t t t (6. That is. Mendoza (1995) imposes four restrictions on the joint distribution of the exogenous shocks: (1) all four shocks share the same persistence. (4) Innovations to productivity shocks and terms-of-trade shocks are allowed to be correlated. We assume that all shocks follow autoregressive processes of order one.

cT .6)-(6. kt . t t t t t=0 6. yt . σν T ). T t . kt . t N t = ψN T t . hN .3. E( p . AM . N t . σ 2p ). t t t t t t t λt }∞ satisfying equations (6. one matching key macroeconomic relations in developed countries. We are now ready to deﬁne a competitive equilibrium. dt . = ψT p t T + νt . Chapter 6 These assumptions give rise to the following laws of motion: p t. yt . ηt . wt .3. pX }∞ . AN . yt . cM . T 2 T νt ∼ N (0. p t 185 ln pX = ρ ln pX + t t−1 ∼ N (0. given the initial conditions t=0 k0 and d−1 and the exogenous processes {AX . kt . pN . ht . 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 . cN .3) and (6. ut . νt ) = 0. the parameters ρ and σ p are set to match the average serial cor- . 6. and the other matching key macroeconomic relations in developing countries. it . In calibrating the driving forces of the developed-country version of the model. t X M N X M cX . pc .26). pT .Lecture in Open Economy Macroeconomics.8 Calibration Mendoza (1995) presents two calibrations of the model.7 Competitive Equilibrium A stationary competitive equilibrium is a set of stationary processes {ct .

019 1 − ρ2 . 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). Mendoza (1995) sets the volatility of productivity shocks in the importable and exportable sectors at 0.165. and ψN 2 2 ψT σ 2p + σν T = 0.2 displays the parameter values implied by the above restrictions. . This completes the calibration of the parameters deﬁning exogenous driving forces in the developed-country model.014 1 − ρ2 . This implies that ψT σ p = 0. 2 2 ψT σ 2p + σν T Table 6.473. Using the information presented in table 1 of Mendoza (1995) yields ρ = 0.014. and σ p = 0.019 and the volatility of the productivity shock in the nontraded sector at 0. This implies that 2 2 ψT σ 2p + σν T = 0. Mendoza (1995) sets the correlation between the productivity shock in the exportable sector and the terms of trade at 0.047 1 − ρ2 .186 Mart´ Uribe ın relation and standard deviation of the terms of trade for the group of G7 countries.165.

04 0.47 0.61 -0.2: Calibration Parameter σp σν T ρ ψT ψN r∗ αX αM αN δ φ γ µ α ω β Developed Country 0.70 0.08 0.1 0.009 Developing Country 0.1 0.74 0.017 0.Lecture in Open Economy Macroeconomics.15 0.35 0.04 0.028 2.49 0.041 0.3 2.56 0.028 1.009 .41 -0.011 0.79 0.22 0.57 0.27 0.032 0.156 0.067 0.74 0. Chapter 6 187 Table 6.5 0.34 0.

Mendoza sets the standard deviation of productivity shocks in the traded sectors at 0.12 1 − ρ2 . This completes the calibration of the exogenous driving forces for the developing-country version .74 as in the developed-country model. This means that the parameter ψN takes the value 0.04 and their correlation with the terms of trade at -0.414.2. 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). 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.46.04 1 − ρ2 . and σ p = 0. This yields the restrictions: 2 2 ψT σ 2p + σν T = 0.188 Mart´ Uribe ın In calibrating the driving forces of the developing-country model.46 to match the observed average standard deviation of GDP and the correlation of GDP with TOT in developing countries. 2 2 ψT σ 2p + σν T The implied parameter values are shown in table 6. and ψT σ p = −0. This implies: ρ = 0.

The following list highlights a number of empirical regularities and comments on the model’s ability to capture them.9 Model Performance Table 6. 2 See Mendoza.69 Model .78 .58 .47 .12 .49 .3.44 .69 .72 .67 .78 .45 1 1 .11 1 1 .90 Model 2.95 ρx.0 RER Data 1.32 .41 .49 .39 .23 .49 .89 .96 .2 also displays the values assigned to the remaining parameters of the model. of the model.62 Model 3.70 .14 .18 .xt−1 G7 DCs .30 .32 1.62 .42 . 1995 for more details. Chapter 6 189 Table 6.28 .5 GDP Data 1.75 .74 .33 .2 6.27 1.17 -.86 1.01 I Data 1.80 .25 1.86 C Data 1.08 .11 .32 .79 (1995).66 .70 .39 .Lecture in Open Economy Macroeconomics.3 presents a number of data summary statistics from developed (G7) and developing countries (DCs) and their theoretical counterparts.03 .71 ρx.82 .32 -.78 .GDP G7 DCs .38 . .38 .59 Model 1.47 .60 .T OT G7 DCs 1 1 .57 Source: Mendoza DCs 1 1 1.25 .43 .85 .81 .94 ρxt .51 .78 .47 1.60 .34 .25 .44 Model .41 .52 .18 -. Table 6.3: Data and Model Predictions Variable σx σT OT G7 TOT Data 1 Model 1 TB Data 1.19 .68 .26 .99 .57 1 1 .84 .37 .

The failure of the model to capture the procyclicality of the trade balance in developed countries should be taken with caution. The model captures this empirical regularity. the terms of trade are procyclical. The terms of trade are positively correlated with the trade balance. but underestimates the TB-TOT correlation. recall that the parameter ρ is set to pin down the serial correlation of the terms of trade in developing and G7 countries. the trade balance is countercyclical in both. 5. 3. In the data. 4. The trade balance is countercyclical in DCs but procyclical in G7 countries. In the model. The terms of trade are less volatile than GDP. The model captures this fact relatively well. 6. the real exchange rate (RER) is measured as the ratio of the domestic CPI to an exchange-rate-adjusted. trade-weighted average of foreign CPIs. although much less so in developing countries than in G7 countries. the RER is deﬁned as the relative price of consumption in terms of importables and denoted by pc . The model fails to capture this fact. This fact is matched by construction. particularly for developing countries. In the data. 2. for other authors estimate negative TB-GDP correlations for developed countries. developed and developing countries. In the t . The model appears to overestimate the countercyclicality of the trade balance. In the model.190 Mart´ Uribe ın 1. The observed terms of trade are somewhat persistent.

Chapter 6 191 data. The model captures this fact. The reason for this .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. the volatility of output deviations from trend measured at import prices falls from 4. The RER is somewhat persistent (with a serial correlation of less than 0. with an autocorrelation above 0. When the same experiment is performed in the context of the developingcountry version of the model. 6.45 for both developing and G7 countries). one can run the counterfactual experiment of computing equilibrium dynamics after shutting oﬀ all sources of uncertainty other than the terms of trade themselves. although it overestimates somewhat the RER-GDP correlation. in the model the terms of trade explain about 88 percent of the volatility of output. the RER is procyclical. 7. Therefore.6 percent. In the context of the model of this section. Mendoza (1995) ﬁnds that when the volatility of all productivity shocks is set equal to zero in the developed-country version of the model.Lecture in Open Economy Macroeconomics.75 for both types of country.1 percent to 3. the terms of trade explain about 66 percent of output movements.3. shutting oﬀ the variance of the productivity shocks results in an increase in the volatility of output. the RER is highly persistent. In the model. This is accomplished by setting σν T = ψT = 0. one must set all productivity shocks at their deterministic steady-state values. When output is measured in terms of domestic prices.

because the variance of output can be decomposed into a nonnegative fraction explained by p t T and a nonnegative part explained by νt . T while νt aﬀects sectoral total factor productivities but not the terms of trade. Exercise 6.192 Mart´ Uribe ın increase in output volatility is that in the benchmark calibration the terms of trade are negatively correlated with productivity shocks—note in table 6.and developing-country versions of the model? . the model with only terms of trade shocks results when σν T is set equal to zero.1 Using the model presented in this section. Note that the parameter ψT must not be set to zero. 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. What fraction of output is explained by terms-oftrade shocks in the developed. Under this deﬁnition of shocks. compute a variance decomposition of output. An advantage of this approach is that. 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.2 that ψT < 0 for developing countries. the contribution of the terms of trade will always be a nonnegative number no larger than 100 percent. 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.

One stresses the role of policy credibility. and 6 are devoted to evaluating this hypothesis. 5.. We will analyze in some detail two very diﬀerent theories of overborrowing. in eﬃciently). During downturns. A second explanation holds that emerging countries suﬀer from more severe economic and political distortions that amplify the cycles caused by aggregate shocks. which aggravates the contraction.Chapter 7 Overborrowing Business cycles in emerging countries are characterized by booms and contractions that are larger in amplitude than those observed in developed countries. It suggests that during booms emerging economies borrow and spend excessively (i. the countries ﬁnd themselves with too much debt and are forced to engage in drastic cuts in spending. can have deleterious eﬀects 193 . Chapters 4. One possible explanation for this phenomenon is simply that emerging countries are subject to larger shocks.e. The hypothesis of overborrowing belongs to this line of thought . It shows that policies that in principle are beneﬁcial to the economy. which exacerbates the expansionary phase of the cycle.

These variables (and therefore the cost of external borrowing) are not controlled by individual agents. has been intensively used to understand overborrowing in the aftermath of ﬁnancial liberalization in the Southern Cone of Latin America in the 1970s. For instance. 1988). In McKinnon’s model. that some theories argue that regulatory policy may be the cause rather than the remedy to overborrowing. however. We will keep this issue in mind as we present the diﬀerent theories.194 Mart´ Uribe ın if the policymaker that is in charge of implementing it lacks credibility. As a result deposit guarantees open the door to excessive lending and increase the likelihood of generalized bank failures.1 Imperfect Policy Credibility The imperfect-credibility hypothesis is due to Calvo (1986. for example. The second theory we will discuss relies in existence of pecuniary externalities in the market for external funds. 1 . Its basic premise is quite simple. The public. which is not present in the aforementioned large-shock explanation of the emergingmarket business cycle. Suppose that the government. however.1 7. believes that the policy will be abandoned after a certain We note. A common theme in much of the overborrowing literature. announces the removal of a consumption tax. deposit guarantees induce moral hazard. as banks tend to undertake immoderately risky projects and depositors have less incentives to monitor the quality of banks’ loan portfolios. or on the value of nontradable output. In this brunch of the overborrowing literature. is the need for regulatory government intervention. 1987. This externality can give rise to ineﬃcient borrowing. possibly with good intentions. McKinnon’s (1973) model of deposit guarantees. but do depend on their collective behavior. the willingness of foreign lenders to provide funds to a given emerging economy might depend upon the countries’s aggregate level of external debt. debt limits faced by individual agents depend upon variables that are exogenous to them but endogenous to the economy.

they take advantage of what they perceive to be a temporarily lower consumption tax and increase spending while the policy lasts. In the aggregate. the consumption tax takes the form of inﬂation. it acts as an indirect tax on consumption.Lecture in Open Economy Macroeconomics. Consider a perfect-foresight economy populated by a large number of inﬁnitely lived households with preferences described . and the current account experiences a possibly sharp reversal. whereby purchases of consumption goods require holding money. In this case. imagine an economy in which households face a cash-inadvance constraint. and lack of credibility stems from the fact that agents disbelieve that the government will be able to cut deﬁcits to a level consistent with low inﬂation in the long run. the consumption tax also takes the form of inﬂation. Here. studies the consequences of a temporary inﬂation stabilization program. To visualize inﬂation as a consumption tax. the spending boom is ﬁnanced by current account deﬁcits. As a result. That is. spending collapses. Calvo (1986). The particular application we analyze in this chapter is a trade reform and is due to Calvo (1988). The imperfect-credibility theory of overborrowing can be applied to a variety of policy environments. At some point the euphoria ends (either because the tax cut is abandoned or because agents convince themselves that they are indeed permanent). Because inﬂation erodes the real value of money. Chapter 7 195 period. for instance. they interpret the policy reform as being temporary. Calvo (1987) applies the imperfect-credibility hypothesis to understand balance-of-payment crises.

and must be imported from abroad. we assume that the relative price of exportables in terms of importables.196 by the utility function ∞ Mart´ Uribe ın β t U (ct ). carried over from the previous period. t t−1 To prevent Ponzi games. For simplicity. t=0 where ct denotes consumption in period t. 1) denotes a subjective discount factor. Households use their inherited wealth and income to purchase consumption goods. and U denotes a period utility function assumed to be increasing and strictly concave. Com- . Households start each period with a stock of debt. ct . but can be exported. Consumption goods are not produced domestically. Debt is denominated in units of t importable goods and carries a constant interest rate r > 0. In addition. y > 0. the terms of trade. household receive a lump-sum transfer xt from the government each period. households are subject to the following borrowing constraint: dh t+j ≤ 0. This endowment is not consumed domestically. Each period. β ∈ (0. Imports are subject to a proportional tariﬀ τt . dh . receive a constant endowment of goods. is constant and normalized to unity. t→∞ (1 + r)j lim The fact that the period utility function is increasing implies that in the optimal plan the no-Ponzi-game constraint must hold with equality. The household’s sequential budget constraint is then given by dh = (1 + r)dh − y − xt + ct (1 + τt ). and to increase their asset position.

xt . Letting λ0 denote the Lagrange multiplier associated with the intertemporal budget constraint.1. Public outlays stem from interest payments. That is. The household’s problem consists in choosing sequences {ct .1) Note that λ0 is determined in period zero but is constant over time. Chapter 7 197 bining the sequential budget constraint and the no-Ponzi-game constraint holding with equality yields the following intertemporal budget constraint: ∞ (1 + r)dh −1 = t=0 1 1+r t [y + xt − ct (1 + τt )] To avoid inessential long-run dynamics. the government has access to ﬁnancial markets. (7. and the issuance of new public debt. and lump-sum transfers to households. 7. Its revenues originate in the collection of import tariﬀs.1 The Government Like households. we assume that the subjective and pecuniary discount rates are identical.Lecture in Open Economy Macroeconomics. we set β(1 + r) = 1. The resulting sequential t−1 . dh }∞ to maxt+1 t=0 imize their lifetime utility function subject to this intertemporal budget constraint. dg − dg . t t−1 rdg . the optimality conditions associated with this problem are the intertemporal budget constraint and U (ct ) = λ0 (1 + τt ).τt ct .

We t−1 assume that ﬁscal policy is such that in the long run the government’s debt position does not grow in absolute value at a rate larger than the interest rate. t t−1 Mart´ Uribe ın The variable τt ct − xt represents the primary ﬁscal surplus in period t and the variable −rdg + τt ct − xt represents the secondary ﬁscal surplus. t t combining the intertemporal budget constraints of the household and the government yields the folloiwng intertemporal economy-wide resource con- . Then. That is. In the second. This constraint states that the present discounted value of present and future primary ﬁscal surpluses must equal the government’s initial debt position.198 budget constraint of the government is given by dg = (1 + r)dg − τt ct + xt . the government implements a temporary tariﬀ reform. the government implements a permanent tariﬀ reform. We compare two polar tariﬀ regimes. In one. Let dt ≡ dh + dg denote the country’s net foreign debt position. we assume that the ﬁscal policy ensures that dg t = 0. t→∞ (1 + r)t lim This condition together with the government’s sequential budget constraint implies the following intertemporal government budget constraint: ∞ (1 + r)dg = −1 t=0 1 1+r t (τt ct − xt ).

7. to a new level τ L < τ H . The intertemporal resource constraint (7. We begin with the analysis of a permanent trade tariﬀ reform.1) that in this case consumption is constant over time.2) According to this expression. A competitive equilibrium is a scalar λ0 and a sequence {ct }∞ satisfyt=0 ing (7.1. It follows directly from the eﬃciency condition (7.2) then implies ¯ that c is given by ¯ c = y − rd−1 . (7. which we denote by τ H . the time path of τt is given by τt = τ L . The focal interest of our analysis is to compare the economic eﬀects of two alternative commercial policy reforms.Lecture in Open Economy Macroeconomics. t ≥ 0. One reduces the tariﬀ permanently.2).2 Equilibrium Under A Permanent Trade Reform Suppose that in period 0 the government unexpectedly implements a permanent tariﬀ reform consisting in lowering τt from its initial level. given the sequence of tariﬀs speciﬁed by the government’s tariﬀ policy and the initial debt position d−1 . Formally.1) and (7. the present discounted value of the stream of current and future trade surpluses must equal the country’s initial net debt position. ¯ . Chapter 7 straint: ∞ 199 (1 + r)d−1 = t=0 1 1+r t (y − ct ). Let the equilibrium level of consumption be denoted by c.

The announcement speciﬁes that the tariﬀ will be lowered from τ H to τ L between periods 0 and T − 1. (7.. implemented unexpectedly at time 0. Here.1) that consumption is constant over the . Any constant tariﬀ path. then the permanent reduction in the import tariﬀ induces no changes in consumption (i. the net foreign asset position.e.3 Equilibrium Under A Temporary Tariﬀ Reform Suppose now that in period 0 the government unexpectedly announces and implements a temporary trade liberalization.1. the announced path of τt is given by τL for 0 ≤ t < T for t ≥ T τt = H τ . It is clear from equation (7. Moreover.200 Mart´ Uribe ın Note that the equilibrium level of consumption is independent of the level at which the government sets the import tariﬀ. and the current account are all unaﬀected by the permanent trade liberalization. 7. Formally. gives rise to the same level of consumption. and that in period T it will be raised permanently to its original level τ H . the trade balance. ct equals c before and after the implementation of the ¯ permanent trade liberalization). Similarly. if the economy was in a steady state before the permanent reform. T > 0 denotes the length of the commercial liberalization policy.3) with τ L < τ H .

¯ .6). then we have that 1 + κ = 1+τ H 1+τ L 1/σ .5) and (7.5) The parameter κ is an increasing function of the intertemporal tariﬀ distortion (1 + τ H )/(1 + τ L ). Intuitively. We can therefore write 1 c 2 c 201 ct = for 0 ≤ t < T for t ≥ T .1) that c1 is greater than c2 . U (c) = c1−σ /(1 − σ). households substitute consumption in the low-tariﬀ period for consumption in the high-tariﬀ period. (7.Lecture in Open Economy Macroeconomics. We can then write c1 = (1 + κ)c2 . We can therefore write the above expression as c = (1 − β T )c1 + β T c2 . it follows from the eﬃciency condition (7. (7. Because the period utility function is concave. For example. for someκ > 0. Of course. the consumption stream must respect the intertemporal resource constraint (7. Chapter 7 periods 0 ≤ t < T and t ≥ T . This restriction implies the following relationship between c1 and c2 : y − rd−1 = (1 − β T )c1 + β T c2 .2). the level of ¯ consumption that results under a permanent trade reform. The left-hand side of equation (7. (7.4) where c1 and c2 are two scalars determined endogenously.6) is c.6) The equilibrium values c1 and c2 are the solution to the two linear equations (7. if the period utility function is of the CRRA form.

¯ This means that if the economy was at a steady state c before period t.202 Mart´ Uribe ın Because β T ∈ (0. and then fall in period T to a new long-run level c2 . This result implies that the temporary tariﬀ reform induces households to engage in a consumption path that has the same present discounted value but is less smooth than the one associated with a constant tariﬀ. ¯ then the announcement of the temporary tariﬀ reform causes consumption to rise to c1 at time 0. We therefore have that c 1 > c > c2 . Because households have concave preferences and because the present discounted value of wealth is the same in the constant-tariﬀ and the time-varying-tariﬀ economies.6). consider the problem of a benevolent social planner trying to design a tariﬀ policy that maximizes welfare subject to the constraint that the policy must belong to the family deﬁned in (7. 1). The planner’s objective function is to choose scalars c1 and c2 to maximize the household’s lifetime utility function evaluated at a consumption path given in (7. we have that the time-varying tariﬀ economy must result in lower welfare for the representative household than the constant-tariﬀ economy. the planner’s problem is: 1 − βT βT U (c1 ) + U (c2 ) 1−β 1−β max c1 . it follows from this expression that c is a weighted ¯ average of c1 and c2 . stay at that elevated level until period T − 1.3). To state this more formally.4) subject to the lifetime resource constraint (7. That is.c2 .

c = y. the solution to this problem is c1 = c2 . Thus. we have that ¯ ¯ . we have that before the trade reform consumption equals output. Consequently. Assume for simplicity that the initial net debt potion is nil (d−1 = 0).Lecture in Open Economy Macroeconomics. the economy expects tariﬀs to be constant forever. the current account. and U (c2 ) = λ. where λ denotes the Lagrange multiplier on the constraint. In the pre-reform equilibrium. β 1−β 1−β 1−β 203 Because the period utility function U (·) is assumed to be strictly concave. Clearly. Recalling that c1 > c = y > c2 . It then follows immediately from (7. These conditions are: U (c1 ) = λ. the objective function is strictly concave in c1 and c2 . It follows that the ﬁrst-order conditions of this problem are necessary and suﬃcient for a maximum. y − c − rd−1 . is nil. it describes a convex set of feasible pairs (c1 . a temporary trade liberalization policy of the type studied here is welfare dominated by a constant-tariﬀ regime. Chapter 7 subject to 1 y βT 2 1 − βT 1 − d−1 + = c + c . and the net foreign asset position induced by the temporary commercial liberalization policy.1) that the set of tariﬀ schemes that implements the planner’s problem solution satisﬁes τ L = τ H . because the constraint is linear in c1 and c2 . Also. c2 ). Consider the behavior of the trade balance. and so is the ¯ ¯ current account. the trade balance y − cc = 0.

The evolution of the net foreign debt position is given by t dt = (c1 − y) j=0 (1 + r)j > 0. The current account. evolves according to the following expression: cat = (y − c1 )(1 + r)t . is given by y − c1 < 0 y − c2 > 0 for 0 ≤ t < T for t ≥ T tbt = . Formally. . This expression states that the foreign asset position is negative and deteriorates over time at an increasing rate until period T . which we denote by tbt . Therefore. we have dt = dT −1 .204 Mart´ Uribe ın for t ≥ 0. Of course. According to this expression. 0 ≤ t < T. these paths for the current account and the asset position are unsustainable in the long run. denoted by cat and given by the change in the asset position. t ≥ T. the household cuts consumption to a point at which external debt stops growing and the current account experiences a sudden improvement to a balanced position. the path of the trade balance. 0 ≤ t < T. in period T . −(dt − dt−1 ). the current account is negative and deteriorates exponentially.

3). We have motivated overborrowing in the context of this model as stemming from the announcement of a temporary trade liberalization. Chapter 7 and cat = 0. Note that in this model overborrowing ends in a sudden stop in period T . t ≥ T. 205 The level of consumption that results after the demise of the trade reform. satisﬁes dT −1 = (1 + r)dT −1 + c2 − y. In this period.7) The model described in this section is one of overborrowing in the sense that it delivers an initial phase (0 ≤ t < T ) in which households embark in a socially ineﬃcient spending spree with external debt growing at an increasing rate and the external accounts displaying widening imbalances. the dynamics between periods 0 and T − 1 are identical as the ones associated with the temporary trade liberalization. but that the public disbelieves this announcement and instead believes that τt will follow the path given in (7. It is worth noting that in this particular model the terms ‘temporariness’ and ‘imperfect credibility’ are equivalent in a speciﬁc sense.Lecture in Open Economy Macroeconomics. c2 . (7. Suppose instead that the government announces a permanent trade reform. therefore. This is because consumption decisions during the period 0 ≤ t < T are based on expectations of a future tariﬀ increase regardless of whether the government explicitly announces it . by stating that τt would be reduced to τ L for good. the country experiences a reversal of the current account and a sharp contraction in domestic absorption. Clearly.

that the policy becomes credible to the public. note that the diﬀerence equation dt = (1+r)dt−1 −y +c.2 Thus. . From the point of view of period T . This shows that the equilibrium path of consumption is identical whether the policy is temporary or permanent but imperfectly credible. such as output. It follows from our previous analysis that consumption must be constant from t = T on. contrary to the public’s expectations.7). The ﬁnancial friction typically takes the form of a collateral constraint imposed by foreign lenders. the government maintains the trade reform (τt = τ L ). and. Comparing this expression with (7. moreover. where c is the level of consumption prevailing for t ≥ T . Suppose now that in period T .206 Mart´ Uribe ın or simply the public believes it will take place. It could be a stock. A theme of this section is that 2 To see this. a constant path of consumption is sustainable over time only if the asset position is also constant over time. the situation is one in which the tariﬀ is constant forever.2 Financial Externalities We now study a class of models of overborrowing that have in common the assumption of a ﬁnancial friction that depends upon a varible that is endogenously determined in the model but that individual agents take as exogenous in their optimization problems. consumption must satisfy dT −1 = (1 + r)dT −1 − y + c. or a ﬂow. such as external debt per capita. implies a path of dt that converges to plus or minus inﬁnity at a rate larger than r (implying a violation of the no-Ponzi-game constraint in the ﬁrst case and a suboptimal accumulation of wealth in the second) unless c is such that (1 + r)dT −1 − y + c equals d−T . That is. A constant level of consumption can only be sustained by a constant level of assets. And the varible in question takes various forms. 7. it follows that c must equal c2 . for t ≥ T .

The key diﬀerence between these two formulations is that the consumer internalizes the ﬁrst borrowing constraint. episodes in which the debt limit binds). The question is whether the two formulations give rise to diﬀerent equilibrium distributions of debt. Consider the following two alternative ¯ ¯ speciﬁcations of such constraint: dt ≤ d and Dt ≤ d. but does not internalize the second one because it features the cross-sectional average of debt..1 The No Overborrowing Result Imagine a theoretical environment in which foreign lenders impose a borrowing constraint on emerging countries. where dt denotes the individual household’s net external debt in period t. which is out of his control. and one in which foreign lenders regard the emerging country as a single investment opportunity and look only at aggregate variables in deciding whether to lend or not. The economy is assumed to be populated by a large number of households with .Lecture in Open Economy Macroeconomics. because it involves its own level of debt.e. 7. These two speciﬁcations are meant to capture two distinct lending environments: One in which foreign lenders base their loan decisions on each borrower’s capacity to repay.2. Chapter 7 207 the nature of this variable is a key determinant of whether the model will or will not generate overborrowing. Dt denotes the average ¯ net external debt across all households in the economy in period t. and d is a constant. and in particular whether the one based on aggregate variables delivers more frequent crises (i. The present analysis is based on Uribe (2006). Consider ﬁrst the case of an aggregate borrowing constraint.

Households have access to a single risk-free bond denominated in units of consumption that pays the interest rate r when held between periods t and t + 1. Output is produced using hours as the sole input with the technology ezt F (k ∗ . For concreteness.1) and assume that θt+1 = β(Ct . respectively.8) where ct denotes consumption. The function F is assumed to be increasing. (7.4. where zt is a productivity shock assumed to be exogenous and stochastic. ht ). ht ). and to satisfy the Inada conditions. the cross sectional averages of consumption and hours. In equilibrium. and the function β is assumed to be decreasing in its ﬁrst argument and decreasing in its second argument. we have that Ct = ct and Ht = ht . The sequential budget constraint is then given by dt = (1 + rt−1 )dt−1 + ct − ezt F (k ∗ .208 preferences described by the utility function ∞ Mart´ Uribe ın E0 t=0 θt U (ct . Ht )θt for t ≥ 0 and θ0 = 1. All of the results in this chapter go through for any speciﬁcation of θt that is exogenous to the household. concave. because all households are assumed to be identical. . we adopt the speciﬁcation studied in section (4. Households take the evolution of Ct and Ht as exogenous. such as land. and k ∗ is a ﬁxed factor of production. The variables Ct and Ht denote. ht ). ht denotes hours worked. and θ denotes a subjective discount factor.

The quantity (rt − r)dt . ht ) − (7. when the borrowing ¯ constraint binds. the no-Ponzi-game constraint holding with equality. ht ) = β(Ct . As a result. Ht )(1 + rt )Uc (ct+1 . Chapter 7 In addition. ht . When the borrowing constraint does not bind (dt < d). At the ¯ world interest rate r. households compete for a ﬁxed amount of loans d. dt } to maximize its utility function subject to the sequential budget constraint and the no-Ponzi-game constraint. and Uh (ct . The ﬁrst-order conditions of this problem are the sequential budget constraint.10) Uc (ct .9) for all t The household chooses processes {ct . the demand for loans exceeds d. By contrast. households face a no-Ponzi-game constraint of the form 209 j→∞ lim dt+j /(1 + r)j ≤ 0 (7. domestic agents borrow less than the total amount of funds foreign lenders are willing to invest in the domestic economy. ht ) = ezt Fh (k ∗ .Lecture in Open Economy Macroeconomics. represents a pure ﬁnancial . in this case the domestic interest rate equals the world interest rate (rt = r). we have that in equilibrium Dt must equal ¯ dt . Because all agents are identical. ht+1 ) Debt accumulation is subject to the following aggregate constraint: ¯ Dt ≤ d. and consequently the domestic interest rate rt rises to a point at which everybody is happy holding ¯ exactly d units of loans. ht ) Uc (ct .

(7. ht ) = β(ct . ht )(1 + rt )Et Uc (ct+1 . the ﬁnancial rent generates a resource cost for the domestic economy. In this case. Intermediate cases are also possible. In the second polar case. dt = (1 + r)dt−1 + ct − ezt F (k ∗ .16) The last of these expressions is a slackness condition stating that if the borrowing constraint is not binding then the domestic interest rate must equal the world interest rate. In this case. rt ≥ r.13) (7. A stationary competitive equilibrium in the economy with an aggregate borrowing constraint is a set of processes {dt .12) (7.11) (7. and ¯ (dt − d)(rt − r) = 0.210 Mart´ Uribe ın rent. ht ). ht ). ht ) = ezt Fh (k ∗ . There are two polar cases. .15) Uc (ct . Uc (ct . ct . and that if the domestic interest rate is strictly above the world interest rate the borrowing constraint must be binding. ¯ dt ≤ d. ht+1 ).14) (7. ht } satisfying the following conditions: − Uh (ct . the rent is appropriated by foreign banks. It is important to specify who appropriates this rent. which then distribute it to households in a lump-sum fashion. the ﬁnancial rent is appropriated by domestic banks. rt . ht ) (7. In one. We ﬁrst study the case in which the ﬁnancial rent is appropriated domestically. the emergence of rents does not represent a loss of resources for the country.

ht ) = λt λt − λt µt = β(Ct . Under the alternative polar assumption that these rents accrue to foreign investors. we have that the optimality conditions associated with the household’s problem are the above two constraints. the household’s optimization problem consists in maximizing the utility function (7. the labor eﬃciency condition (7. and Uc (ct .8) subject to the constraints dt = (1 + r)dt−1 + ct − ezt F (k ∗ . respectively. ht ) and ¯ dt ≤ d. This is because we are assuming that the ﬁnancial rent that emerges when the borrowing constraint is binding stays within the country. In this case. Ht )(1 + rt )λt+1 . Letting θt λt and θt λt µt denote the Lagrange multipliers on the sequential budget constraint and the borrowing constraint.10). the resource constraint would have featured the domestic interest rate rt instead. Chapter 7 211 Note that the resource constraint (7. household take explicitly into account the borrowing limit.Lecture in Open Economy Macroeconomics.13) features the world interest rate and not the domestic interest rate. In this environment. Consider now an environment in which the borrowing constraint is imposed at the level of the individual household.

212 µt ≥ 0 ¯ (dt − d)µt = 0.

Mart´ Uribe ın

The ﬁrst and second of these expressions states that in periods in which the borrowing constraint binds (i.e., when µt > 0), the marginal utility of an extra unit of debt is not given by the marginal utility of consumption Uc (ct , ht ) but by the smaller value Uc (ct , ht )(1 − µt ). The reason behind this is that in this case an extra unit of debt tightens the borrowing constraint even more and therefore carries a shadow punishment, given by Uc (ct , ht )µt utils. A competitive equilibrium in the economy with an individual borrowing constraint is a set of processes {dt , µt , ct , ht } satisfying the following conditions: − Uh (ct , ht ) = ezt Fh (k ∗ , ht ) Uc (ct , ht ) (7.17) (7.18) (7.19) (7.20) (7.21) (7.22)

Uc (ct , ht )(1 − µt ) = β(ct , ht )(1 + r)Et Uc (ct+1 , ht+1 ) dt = (1 + r)dt−1 + ct − ezt F (k ∗ , ht ). ¯ dt ≤ d µt ≥ 0 ¯ (dt − d)µt = 0.

We wish to establish that the equilibrium behavior of external debt, consumption, and hours is identical in the economy with an aggregate borrowing constraint and in the economy with an individual borrowing constraint.

Lecture in Open Economy Macroeconomics, Chapter 7

213

That is, we want to show that the processes {dt , ct , ht } implied by the system (7.11)-(7.16) is identical to the one implied by the system (7.17)-(7.22). To this end, we will show that by performing a simple variable transformation, the system (7.17)-(7.22) can be written like the system (7.11)-(7.16). Deﬁne the shadow interest rate rt as ˜ 1+r . 1 − µt

1 + rt = ˜

(7.23)

Note that µt must be nonnegative and less than unity. This last property follows from the fact that, from equation (7.18), a value of µt greater than or equal to unity would imply that the marginal utility of consumption Uc (ct , ht ) is inﬁnite or negative. It follows that rt is greater than or equal to ˜ r. Furthermore, it is straightforward to see that µt > 0 if and only if rt > r ˜ and that µt = 0 if and only if rt = r. We can therefore write the system ˜ (7.17)-(7.22) as − Uh (ct , ht ) = ezt Fh (k ∗ , ht ) Uc (ct , ht ) (7.24) (7.25) (7.26) (7.27) (7.28) (7.29)

Uc (ct , ht ) = β(ct , ht )(1 + rt )Et Uc (ct+1 , ht+1 ) ˜ dt = (1 + r)dt−1 + ct − ezt F (k ∗ , ht ) ¯ dt ≤ d rt ≥ r ˜ ¯ r (dt − d)(˜t − r) = 0.

The systems (7.11)-(7.16) and (7.24)-(7.29) are identical, and must therefore

214

Mart´ Uribe ın

deliver identical equilibrium processes for dt , ct , and ht . This result demonstrates that whether the borrowing constraint is imposed at the aggregate or the individual level, the real allocation is the same. In other words, the imposition of the borrowing constraint at the aggregate level generates no overborrowing. What happens is that the market interest rate in the economy with the aggregate borrowing limit conveys exactly the same signal as the Lagrange multiplier µt in the economy with the individual borrowing constraint.

Resource Costs When rents from ﬁnancial rationing are appropriated by foreign lenders, the equilibrium conditions of the economy with the aggregate borrowing constraint are as before, except that the resource constraint becomes

dt = (1 + rt+1 )dt−1 + ct − ezt F (k ∗ , ht ).

The fact that the domestic interest rate, rt ≥ r, appears in the resource constraint implies that when the borrowing constraint is binding and rt > r, the country as a whole loses resources in the amount (rt − r)dt . These resources represent pure rents paid to foreign lenders. When rents are appropriated by foreign lenders, it is no longer possible to compare analytically the dynamics of external debt in the economies with the aggregate debt limit and in the economy with the individual debt limit. We therefore resort to numerical methods to characterize competitive equilibria. Preferences and technologies are parameterized as follows: U (c, h) =

**Lecture in Open Economy Macroeconomics, Chapter 7 c − ω −1 hω
**

1−σ

215

/(1−σ), β(c, h) = 1 + c − ω −1 hω

−ψ

, and F (k ∗ , h) = k ∗ α h1−α ,

where σ, ω, ψ, k ∗ , and α are ﬁxed parameters. Table 7.1 displays the values Table 7.1: Parameter Values σ 2 ω 1.455 ψ 0.0222 α 0.32 r 0.04 κ 7.83 k∗ 78.3 πHH = πLL 0.71 z H = −z L 0.0258

assigned to these parameters. The time unit is meant to be one year. The values for α, ω, σ, and R∗ are taken from Schmitt-Groh´ and Uribe (2003). e The parameter ψ is set to induce a debt-to-GDP ratio, d/y, of 50 percent in the deterministic steady state. The calibrated value of κ is such that in the economy without the debt limit, the probability that dt is larger than κ is about 15 percent. I set the parameter k ∗ so that its market price in the deterministic steady state is unity. The productivity shock is assumed to follow a two-state symmetric Markov process with mean zero. Formally, zt takes on values from the set {z 1 , z 2 } with transition probability matrix π. I assume that and z 1 , z 2 and π satisfy z 1 = −z 2 and π11 = π22 . I set π11 equal to 0.71 and z 1 equal to 0.0258. This process displays the same serial correlation (0.58) and twice as large a standard deviation (2.58 percent) as the one estimated for Canada by Mendoza (1991). The choice of a process for the productivity shock that is twice as volatile as the one observed in a developed small open economy like Canada reﬂects the view that the most salient distinction between business cycles in developed and developing countries is, as argued in chapter 1, that the latter are about twice as volatile as the former. The model is solved using the Chebyshev parameterized expectations

216

Mart´ Uribe ın

method. The state space is discretized using 1000 points for the stock of debt, dt . The parameterization of expectations uses 50 coeﬃcients. We compute the equilibrium for three model economies: An economy with no debt limit, an economy with a debt limit and ﬁnancial rents accruing to domestic residents, and an economy with a debt limit and ﬁnancial rents ﬂowing abroad.3 The Matlab code that implements the numerical results reported in this section are available at http://www.columbia.edu/~mu2166/ overborrowing/overborrowing.html. Figure 7.1 displays with a solid line the equilibrium probability distribution of external debt in the economy with an aggregate debt limit and ﬁnancial rents from rationing accruing to domestic agents. According to the no-overborrowing result obtained earlier, this economy is identical to the one with a household-speciﬁc debt limit. The ﬁgure shows with a dashcrossed line the distribution of debt in the economy with an aggregate debt limit and ﬁnancial rents accruing to foreign lenders. As a reference, the ﬁgure also displays, with a dashed line, the debt distribution in an economy without a debt limit. The main result conveyed by the ﬁgure is that the distribution of debt in the economy with a debt limit is virtually unaﬀected by whether ﬁnancial rents are assumed to ﬂow abroad or stay within the country’s limits.4 The reason behind this result is that the resource cost

The procedure approximates the equilibrium with reasonable accuracy. The DenHaanMarcet test for 5-percent left and right tails yields (0.047,0.046) for the economy without a debt limit, (0.043,0.056) for the economy with a debt limit and rents owned domestically, and (0.048,0.056) for the economy with a debt limit and rents ﬂowing abroad. This test was conducted using 1000 simulations of 5000 years each, dropping the ﬁrst 1000 periods. 4 This no-overborrowing result is robust to a more stringent debt limit. We experimented lowering the value of κ by 25 percent, from 7.8 to 5.9. This smaller value of the debt limit is such that in the unconstrained economy the probability that at is larger than κ is about 30 percent. Under this parameterization, We continue to ﬁnd no overbor3

Lecture in Open Economy Macroeconomics, Chapter 7

217

**Figure 7.1: Equilibrium Distribution of External Debt
**

0.07 No Resource Costs Resource Costs No Debt Limit 0.06

0.05

Probability

0.04

0.03

0.02

0.01

0 −10

−5

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5 external debt

10

15

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. This implication. is the result of two properties of the equilibrium dynamics. such as land or structures. the debt distribution in the economy with an aggregate borrowing limit and rents accruing to foreign lenders is virtually identical to the distribution of debt in the economy with an aggregate debt limit and rents accruing to domestic households. Second. Theoretically. for examrowing. we have limited attention to a constant debt limit. and the external debt is about 40 percent of GDP when the economy hits the debt limit. The Role of Asset Prices Thus far.008 = 40 × 0. about 0. In practice. it produces a country interest-rate premium of less than 2 percent on average. This observation implies that the average cost of remitting ﬁnancial rents abroad is less than 0. First. as demonstrated earlier. The debt constraint binds on average less than once every one hundred years. this type of borrowing limit have been shown to help explain observed macroeconomic dynamics during sudden stops. as they tend to exacerbate the contractionary eﬀects of negative aggregate shocks.218 Mart´ Uribe ın incurred by the economy when ﬁnancial rents belong to foreigners is fairly small.02 × 100−1 percent of GDP per year. debt limits take the form of collateral constraints limiting the size of debt to a fraction of the market value of an asset. Speciﬁcally.008 percent of annual GDP. This is because states in which the collateral constraint is binding are associated with sharp declines in stock prices and ﬁre sales of collateral (see. is identical to the debt distribution in the economy with an individual borrowing limit. the economy seldom hits the debt limit. which. This is because agents engage in precautionary saving to mitigate the likelihood of ﬁnding themselves holding too much debt in periods in which the interest rate is above the world interest rate. in turn. when the debt limit does bind.

Lecture in Open Economy Macroeconomics. Individual households do not internalize this constraint. that is. In that period. The central question for the issues being analyzed in this section is whether these ﬁre sales are more or less severe when the collateral constraint is imposed at an aggregate level as opposed to at the level of the individual borrower. it chooses kt+1 . The household’s optimization problem consists in choosing processes {ct . To model a time-varying collateral constraint. kt . yt = ezt F (kt . The sequential budget constraint of the household is given by dt = (1 + rt−1 )dt−1 + ct + qt (kt+1 − kt ) + ezt F (kt . Formally. assume that output is produced via an homogeneous-of-degree-one function F that takes labor and land as inputs. Chapter 7 219 ple. dt .30) Note that in period t. ht ) (7. 2010). Consider ﬁrst the case in which foreign investors impose a collateral constraint at the country level of the form Dt ≤ κqt k ∗ . here we will assume that there is a market for land. kt+1 } to maxi- . the household chooses the amount of land that it will use in production in period t + 1. Mendoza. Suppose further that the aggregate per capita supply of land is ﬁxed and given by k ∗ > 0. the household’s land holdings. Unlike in the previous section. are predetermined. ht ). Let qt denote the market price of land in terms of consumption goods. ht .

and dt ≤ κqt k ∗ . qt . (7.15). and debt are identical to those of its no-land-market counterpart.32) is a stochastic discount factor given by the equilibrium marginal rate of consumption substitution between periods t and t + j. this expression states that the price of land equals the present discounted value of its future expected marginal products. t=0 (7. A stationary competitive equilibrium with an aggregate collateral constraint and ﬁnancial rents accruing domestically is given by a set of stationary stochastic processes {dt .220 Mart´ Uribe ın mize the utility function (7. It is an Euler equation associated with the use of land. ht+1 )]} . (7. there is an additional ﬁrst-order condition.32). Iterating this expression forward yields ∞ qt = Et j=1 Λt. (7. rt . is given by qt = Et {Λt. ht .t+1 [qt+1 + ezt+1 Fk (k ∗ . evaluated at equilibrium quantities.9). The ﬁrst-order conditions associated with this optimization problem with respect to consumption. hours.t+j ≡ Uc (ct+j .11)-(7. In the present environment. ht+j ) Uc (ct .t+1 }∞ satisfying (7.8) subject to the sequential budget constraint (7. ht ) j−1 β(ct+s .13). (7.30) and the no-Ponzi-game constraint (7. however.t+j ezt+j Fk (k ∗ .34) .31) where Λt. ct . ht+j ).31). This condition. ht+s ) s=0 (7.33) Intuitively. Λt. (7.

as ﬁrst noted by Auernheimer and Garc´ ıa-Saltos (2000). the presence of the price of land on the right-hand side of this borrowing constraint introduces an externality. 221 (7. Comparing this expression with its counterpart in the economy with an aggregate borrowing constraint (equation (7.36) where rt ≥ r denotes the shadow interest rate as deﬁned by equation (7. dt ≤ κqt kt+1 . However.33)). takes as exogenous the evolution of the price of land. The pricing equation for land takes the form 1 1 − 1 + r 1 + rt ˜ qt 1 − κ = Et {Λt. we observe that the fact that the shadow value of collateral. ˜ Iterate this expression forward to obtain ∞ q t = Et j=1 Λt. qt . In this case. Chapter 7 and (rt − r)(dt − κqt k ∗ ) = 0. given by 1/(1 + r) − 1/(1 + rt ).t+1 [qt+1 + ezt+1 Fk (k ∗ . That is. all external loans are extended at the world interest rate r. The household internalizes this borrowing limit.23). (7. being a price takier.35) Consider now the case in which the collateral constraint is imposed at the level of each borrower.Lecture in Open Economy Macroeconomics. is nonnegative ˜ .t+j ezt+j Fk (k ∗ . ht+j ) j−1 s=0 1−κ 1 1+r − 1 1+˜t+s r . This is because the individual household. ht+1 )]} .

that the individual agent discounts future marginal products of land less heavily in the economy with the internalized borrowing constraint than in the economy with an aggregate borrowing constraint. A stationary competitive equilibrium with an individual collateral constraint and ﬁnancial rents accruing domestically is given by a set of stationary stochastic processes {dt . Λt. namely.36). ˜ we will see shortly that the real value of land falls dramatically during such periods. ct .34).32). Indeed.37) . the fact that in the economy with an internalized collateral constraint the value of collateral is higher than it is in an economy with an aggregate collateral constraint suggests that borrowing is less limited when the collateral constraint is internalized.26). the value of land is likely to be higher in the economy in which the collateral constraint is internalized than in an economy in which it is not.28).24)-(7. Note that the above expression for qt does not state that the price of land should be higher in periods in which the shadow interest rate rt exceeds r. and (˜t − r)(dt − κqt k ∗ ) = 0.t+1 } satisfying (7.222 Mart´ Uribe ın implies. rt . dt . (7. r (7. This is because when the collateral constraint is internalized the individual agent values the ﬁnancial service provided by land. intuitively one should not expect the no-overborrowing result of the previous section to be overturned by the introduction of a time-varying collateral constraint of the type considered in this section. ˜ (7. In turn. Thus. qt . The above expression does state that when rt is larger than r. ht . collateral. ceteris paribus. ˜ all other things equal. (7. (7.

A solid line corresponds to the economy with an internal collateral constraint. 6 The DenHaan-Marcet test for 5-percent left and right tails yields (0. Similarly. The distribution of debt is virtually identical in the economy with an individual collateral constraint and in the economy with an aggregate collateral constraint.83. To ascertain whether the imposition of an aggregate collateral constraint induces external overborrowing.6 The top-left panel of ﬁgure 7.columbia.061) for the economy with an individual collateral constraint.1. But the collapse of land prices is In the deterministic steady state we have that qt = 1. and a dashed line corresponds to the economy with an aggregate collateral constraint. Chapter 7 223 The only diﬀerence between the equilibrium conditions of the economy with an aggregate collateral constraint and those of the economy with an individual collateral constraint is the Euler condition for land (equation (7. whether the collateral constraint is imposed at the individual or the aggregate levels appears to make no diﬀerence for the equilibrium dynamics of stock prices or consumption. as shown in the top-right and bottom-left panels of the ﬁgure. Note that when the stock of debt is high agents engage in ﬁre sales of land resulting in sharp declines in its market price.2 displays the unconditional distribution of external debt.36)). so that κqt k∗ = 7.5 The model is solved using the Chebyshev parameterized expectations method.0.06) for the economy with an aggregate collateral constraint. which now takes the value 0.Lecture in Open Economy Macroeconomics. dropping the ﬁrst 1000 periods.edu/ ~mu2166/overborrowing/overborrowing.0. qt . except for the parameter κ. which is the value assigned to κ in the economy with the constant debt limit. This test is conducted using 5000 simulations of 5000 years each. The Matlab code that implements the numerical results reported in this section are available at http://www.048. we compute equilibrium dynamics numerically. 5 .html.043.31) versus equation (7. and (0. I calibrate the economy as in the previous subsection.

055 1.04 probability 0.98 0.96 0.99 0. and ‘Agg CC’ stands for Aggregate Collateral Constraint.4 9.6 9.03 Eqt 0.95 −5 0 External Debt 5 10 0.02 0.94 −5 Indiv CC Agg CC 0 5 External Debt Average Interest Rate 1.2 10 9.2: Equilibrium Under a Time-Varying Collateral Constraint Unconditional Distribution of Debt 0. .04 1.03 −5 Indiv CC Agg CC 0 5 External Debt 10 Note: ‘Indiv CC’ stands for Individual Collateral Constraint.05 0.8 Ec t 9.035 1.05 1.045 ER t Average Stock Prices 10 Average Consumption 10.2 −5 Indiv CC Agg CC 0 5 External Debt 10 1.01 0 −10 Indiv CC Agg CC 1.224 Mart´ Uribe ın Figure 7.01 1 0.97 0.

t+1 . land prices are indeed higher in the economy with an individual debt limit. when the borrowing constraint is imposed at the aggregate level. During a crisis. Formally.2). rt replaces rt . As a result. the demand for land is higher in the economy . Chapter 7 225 quantitatively similar in the two economies.Lecture in Open Economy Macroeconomics.t+1 falls. the ﬁre sale of land is driven by a drop in the stochastic discount factor Λt. rt and ˜ rt increase.t+1 . generating expectations of a decline in Λt. The contraction in real estate prices is caused by the increase in interest rates as the economy approaches the debt limit. depressing the value of the asset. note that the Euler equation for bond holdings is given by 1 = (1 + rt )Et Λt. in line ˜ with the intuition developed earlier in this section.t+1 . When Λt. When it is imposed at the individual level. To see that in a crisis the stochastic discount factor falls. It follows that the current model predicts underborrowing. but this diﬀerence is quantitatively small. This allows households in the economy with the individual borrowing limit to actually hold on average more debt than households in the economy with an aggregate borrowing limit (see the top left panel of the ﬁgure 7. The intuition behind this result is that in the economy with the individual borrowing limit. Finally. households internalize the fact that holding land relaxes the borrowing limit. The fact that land prices are slightly higher in the economy with the individual borrowing limit means that in this economy the value of collateral is on average higher than in the economy with an aggregate borrowing limit. future expected marginal products of land are discounted more heavily.

when the borrowing limit is internalized the shadow price of funds. The reason why in this class of models households do not have a larger propensity to borrow under an aggregate debt limit is that the market and social prices of international liquidity are identical (in the case of a constant debt limit) or almost identical (in the case of a debt limit that depends on the price of land). Second.3.226 Mart´ Uribe ın with an individual debt limit than in the economy in which the collateral service provided by land is not internalized. that the no-overborrowing result is robust to allowing for a debt limit that is increasing in the market value of a ﬁxed factor of production. when the debt ceiling binds. given by the pseudo interest rate rt . Importantly. thereby inducing overborrowing. it does so for all agents simultaneously. . in the economy with the individual debt constraint. Two features of the economies studied in this section are crucial in generating the equality of market and social prices of debt. The absence of either of the abovementioned two features may cause the market price of foreign funds to be below the social price. This causes land prices to be higher in the economy with the internalized borrowing constraint allowing households to borrow more. We will return to the issue of underborrowing in section 7.2. This property is a consequence of the assumption of homogeneity across economic agents. the shadow price of funds equals the world interest rate even as households operate arbitrarily close to the debt ceiling. It follows from the analysis of this section. First. is constant and equal to the world interest rate r except when the debt ˜ ceiling is binding. The next section explores this issue in more detail.

2 The Case of Overborrowing The present section provides three variations of the environment studied thus far that give rise to overborrowing. There is a continuum of agents of measure one. Chapter 7 227 7. or initial asset positions. and agents are heterogeneous. Suppose that in the absence of a debt ceiling households with high expected endowment consume ca > y +κ units in period 1 and the rest of the households consume . Speciﬁcally. taken from Uribe (2007). Heterogeneous Agents The following example. and in the third the collateral is a ﬂow that depends on the relative price of nontradables. I assume that agents are identical in all respects except for their period-2 endowments. agents are heterogeneous in endowments. The example is in the context of a two-period.2. in the second agents face a debt-elastic interest rate. preferences. whereas in period 2 half of the households receive an endowment y a > y and the other half receive a smaller endowment y b < y a .Lecture in Open Economy Macroeconomics. describes a situation in which overborrowing occurs because debt limits do not bind for all agents at the same time. The economy faces a constant debt ceiling κ per capita. Here. is a continuous function of aggregate spending. which. in period 1 all households receive the same endowment y. such as diﬀerences in endowments. in turn. In the ﬁrst example. endowment economy without uncertainty. Agents receiving the larger future endowment have a stronger incentive to borrow in period 1 to smooth consumption over time. The central result obtains under a variety of sources of heterogeneity.

when du ≤ κ. Figure 7. When the borrowing ceiling κ is imposed at the level of each individual household. we also have that di < κ. aggregate external debt per capita equals du = (ca + cb )/2 − y. and . the equilibrium interest rate equals the world interest rate r. half of the households—those with high period-2 endowment— are constrained and consume y + κ units. Two alternative situations are possible. Clearly. This case takes place when in the absence of a debt constraint debt per capita does not exceed the ceiling κ.3: Overborrowing in an Economy with Heterogeneous Agents cb < y + κ units. That is.228 Mart´ Uribe ın Figure 7. whereas the other households are unconstrained and consume cb . Aggregate external debt per capita equals di = (κ + cb − y)/2 < du . Now suppose that the debt ceiling is imposed at the aggregate level. In this case. One is that the aggregate debt limit is not binding. In the unconstrained equilibrium.3 depicts the equilibrium in the absence of a debt constraint.

Speciﬁcally. 7 . the domestic interest rate exceeds the world interest rate. then the economy is ﬁnancially rationed. the combination of heterogeneous consumers and a debt limit imposed at the aggregate level induces overborrowing in equilibrium. economic heterogeneity. if du > κ). and aggregate borrowing per capita is given by da = κ > di . This service. is not priced in the competitive equilibrium. while other assets serve as collateral only to domestic lenders.. When the debt limit κ is imposed at the individual level. if the aggregate level of external debt in the unconstrained environment exceeds the ceiling (i. Suppose that a domestic ﬁnancial market existed in which frugal households (households with relatively low future endowments) could borrow exInterestingly. Some assets are recognized as liquid collateral by both domestic and foreign lenders. Caballero and Krishnamurthy show that in ﬁnancially underdeveloped economies this type of heterogeneity produces an externality whereby the market price of international liquidity is below its social marginal cost. That is. intertemporal marginal rates of substitution are not equalized across households. Alternatively. external borrowing is higher when the debt ceiling is imposed at the aggregate level.7 This overborrowing result relies on the absence of a domestic ﬁnancial market.e. although of a diﬀerent nature. is also the root cause of overborrowing in the dual-liquidity model of emerging-market crisis developed by Caballero and Krishnamurthy (2001). Chapter 7 229 consumption of each agent equals the level attained in the absence of any borrowing constraint. External debt is given by da = du > di .Lecture in Open Economy Macroeconomics. however. It follows that. regardless of whether the aggregate debt limit is binding or not. the group of more frugal consumers provides a ﬁnancial service to the group of more lavish consumers by placing comparatively less pressure on the aggregate borrowing constraint. there is heterogeneity in the provision of liquidity across assets. In their model. Overborrowing occurs because of a ﬁnancial externality.

that in the economy analyzed in this section the social planner cared only about the well being . suppose. In this case. in equilibrium. It follows that with a domestic ﬁnancial market. Alternatively. To see this. the sum of external and domestic debt) be limited by κ. A comment on the concept of overborrowing when agents are heterogeneous is in order. one can safely interpret any excess external debt in the economy with an aggregate debt limit over the economy with an individual debt limit as suboptimal. or overborrowing. This is because the competitive equilibrium associated with the economy featuring an individual debt limit coincides with the optimal allocation chosen by a social planner that internalizes the debt limit. The term overborrowing has a negative connotation.230 Mart´ Uribe ın ternally and lend internally to lavish households. intertemporal marginal rates of substitution would be equal across households and the consumption allocation would equal the one emerging under an aggregate collateral constraint. referring to a suboptimal amount of external ﬁnancing. In this case. foreign lenders may realistically impose that total debt held by lavish households (i. When agents are heterogeneous it is not necessarily the case that the debt distribution associated with the economy featuring an aggregate debt limit is less desirable than the one implied by the economy with an individual debt limit. a domestic ﬁnancial market would be ineﬀective in eliminating overborrowing. on the assumption that foreign lenders will keep the external debt limit on lavish agents equal to κ. In the models with homogeneous agents and a constant debt limit studied earlier in this paper.. This reemergence of the nooverborrowing result relies. for instance. the overborrowing result disappears. however.e.

they do not internalize the dependence of the interest rate on their individual debt positions.4. with ρ > 0.2. the social planner would favor the equilibrium associated with an aggregate borrowing limit over the one associated with an individual debt limit. (7. Then d∗ must satisfy the condition 1 = (1 + r + ρ(d∗ ))β. Debt-Elastic Country Premium In section 4.38) .Lecture in Open Economy Macroeconomics. we studied a way to induce stationarity in the small-openeconomy business-cycle model consisting in making the country interest rate a function of the cross sectional average of external debt per capita. In this case. Because individual households take the evolution of the aggregate debt position. Let d∗ > 0 denote the steady-state value of debt in this economy. Formally. Dt . The reason why the cost of funds is debt elastic is unspeciﬁed in this simple setting. let the country interest rate be given by an increasing function of aggregate external debt of the form rt = r + ρ(Dt ). we have that dt = Dt . Chapter 7 231 of agents with high period-2 endowments. where dt is the individual level of debt held by the representative household. As a result. as exogenous. We study this class of models in chapter 8. an externality emerges whereby the economy assumes more external debt than it is socially optimal. but it could be due to the presence of default risk as in models of sovereign debt. agents do not internalize that their individual borrowing contributes to increasing the cost of external funds. In equilibrium. In this case.

rt = ρ Dt qt k ∗ dt in the case of an aggregate debt limit.232 Mart´ Uribe ın where. is strictly lower than the social cost of foreign funds.g. (7.39). 2003). so that rt = r + ρ(dt ).38) and (7. This discrepancy. Auernheimer and Garc´ ıa-Saltos (2000) derive a similar result in a model in which the interest rate depends on the leverage ratio. Schmitt-Groh´ and Uribe. given by r + ρ(dt ) + dt ρ (dt ). is absent in the economy of the previous sections. Let d∗∗ > 0 denote the steady-state level of external debt in this economy. That is. which is key in generating overborrowing. β is a constant subjective discount factor. As noted earlier. in the Auernheimer-Garc´ ıa-Saltos model an externality emerges even in this latter case. . as usual.39) Comparing equations (7. That is. e Assume now that the debt-elastic interest-rate schedule is imposed at the level of each individual household. and rt = ρ( qt kt+1 ) in the case of an individual debt limit. r + ρ(dt ). We note that in the economy with the aggregate debt limit the market price of foreign funds. it is clear that because ρ > 0. we have that d∗ > d∗∗ . qt . because agents do not internalize the eﬀect that their borrowing behavior has on the price of land.. It can be shown that d∗∗ is determined by the condition 1 − βd∗∗ ρ (d∗∗ ) = (1 + r + ρ(d∗∗ ))β. the economy with the ﬁnancial externality generates overborrowing. This steadystate condition arises in virtually all formulations of the small open economy with utility-maximizing households (e.

Lecture in Open Economy Macroeconomics. cN ) ≡ ωcT t t t + (1 − ω)cN t . Our exposition follows Bianchi’s formulation. Chapter 7 Nontraded Output As Collateral 233 Consider now a variation of the model analyzed thus far in which the object that serves as collateral is output. Households are assumed to have access to a single. In this case. aggregate demand falls causing the relative price of nontradables to collapse. Since this variable serves as collateral. The period utility function takes the form U (c) = (c1−σ − 1)/(1 − σ). . the borrowing constraint tightens exacerbating the economic contraction.41) where cT denotes consumption of tradables and cN denotes consumption of t t nontradables.40) with the usual notation. internationally-traded bond that pays the constant interest rate r. The consumption good is assumed to be a composite of tradable and nontradable consumption as follows: 1−1/η 1−1/η 1/(1−1/η) ct = A(cT . risk-free. in the context of a three-period model. Suppose that due to a negative shock. one-period. This mechanism was ﬁrst studied by Korinek (2010). (7. Consider a small open endowment economy in which households have preferences of the form ∞ E0 t=0 β t U (ct ). (7. extends the Korinek model to an inﬁnite-horizon quantitative setting. Bianchi (2010). Here. deﬁned as the relative price of nontradable goods in terms of tradables. the value of nontradable output in terms of tradable goods falls. the main mechanism for inducing overborrowing is the real exchange rate.

t T N and yt and yt denote the endowments of tradables and nontradables. t t t (7. Households choose a set of processes {cT . dt } to maximize (7. However. ct .41)-(7. even though their collective t absorptions of nontradable goods is a key determinant of this relative price. κN > 0 are parameters. just as in the case in which the value of land is used as collateral.40) t t T N subject to (7. . yt } and the initial debt t position d−1 . yt .43).42) where dt denotes the amount of debt assumed in period t and maturing in t + 1. because each individual household takes the real exchange rate pN as exogenously determined. t (7. given the processes {pN . t t pN = t 1−ω ω cT t cN t 1/η . cN ) = λt . cN . this borrowing constraint introduces an externality ` la Auernheimer a and Garc´ ıa-Saltos (2000). re- spectively. pN denotes the relative price of nontradables in terms of tradables. The borrowing constraint takes the form T N dt ≤ κT yt + κN pN yt . The ﬁrst-order conditions of this problem are (7. Households internalize this borrowing limit.43) where κT .41)-(7.43) and G(cT . Both endowments are assumed to be exogenous and stochastic.234 The household’s sequential budget constraint is given by Mart´ Uribe ın T N dt = (1 + r)dt−1 + cT − yt + pN (cN − yt ).

As usual the Euler equation (7. µt } satisfying t N N G(cT . and λt and µt denote the Lagrange multipliers on the sequential budget constraint (7. t t+1 (7. t t which in turn equals λt . when the collateral constraint binds. Chapter 7 λt = β(1 + r)Et λt+1 + µt . In equilibrium. and T N µt (dt − κT yt − κN pN yt ) = 0.43). t Then.45) . the market for nontradables must clear. yt+1 ) + µt . yt ) = β(1 + r)Et G(cT . when the collateral constraint does not bind.cN ) 1/η t t cT t denotes the marginal util- ity of tradable consumption. During ﬁnancial crises. equates the marginal beneﬁt of assuming more debt with its marginal cost. cN ).44). reﬂecting a shadow penalty for trying to increase debt when the collateral constraint is binding. N cN = yt .Lecture in Open Economy Macroeconomics. respectively. a competitive equilibrium is a set of processes {cT . the beneﬁt of increasing dt by one unit is the marginal utility of tradables G(cT . but the marginal cost increases to β(1 + r)Et λt+1 + µt . β(1+r)Et λt+1 . cN )) t t t t A(cT . During tranquil times. the marginal utility of increasing debt is unchanged.44) where G(cT . t 235 (7. dt .42) and the collateral constraint (7. µt ≥ 0. The marginal cost of an extra unit of debt is the present discounted value of the payment that it generates in the next period. cN ) ≡ ωU (A(cT . That is.

cT t cT t 1/η N 1−1/η yt T µt dt − κT yt − κN 1/η N 1−1/η yt = 0. Individual agents do not take this eﬀect into account in choosing their consumption plans. . yt } and the initial condition d−1 .46) (7. The Socially Optimal Equilibrium The socially optimal policy aims at attaining the allocation implied by an optimization problem that takes into account the dependence of collateral on the aggregate consumption of tradables. This is the nature of the ﬁnancial externality in this model. Such allocation is the solution to the following social planner’s problem: ∞ {cT .236 T dt = (1 + r)dt−1 + cT − yt t T dt ≤ κT yt + κN Mart´ Uribe ın (7.49) T N given processes {yt .47) means that during contractions in which the absorption of tradables falls the collateral constraint endogenously tightens. (7.47) 1−ω ω 1−ω ω µt ≥ 0.dt } t max E0 t=0 N β t U (A(cT . A benevolent government would be interested in designing policies that induce households to internalize the ﬁnancial externality. yt )) t . The fact that cT appears on the right-hand-side of the equilibrium version t of the collateral constraint (7.48) (7.

In . This internalization implies that the endogenous variable cN . cT . which we reproduce here for convenience: T dt = (1 + r)dt−1 + cT − yt t T dt ≤ κT yt + κN 1−ω ω cT t 1/η N 1−1/η yt . yt ) = β(1+r)Et [G(cT . yt+1 )] +µt t t t+1 t+1 (7. the social planner internalizes the fact that in the competitive equilibrium the market for nontraded goods clears at all times.46) and (7. N and Γ(cT . Chapter 7 237 subject to the equilibrium conditions (7. The ﬁrst-order conditions associated with this problem are the above two constraints and N N N N G(cT .50) T µt dt − κT yt − κN 1−ω ω cT t 1/η N 1−1/η yt =0 (7.Lecture in Open Economy Macroeconomics. The right-hand side of this expression contains the equilibrium level of consumption of tradables.47). whose evolution is taken as endogenous by the t social planner but as exogenous by the individual household. yt ) ≡ t κN η 1−ω ω N yt cT t 1−1/η denotes the amount by which an extra unit of tradable consumption relaxes the borrowing constraint (7. is replaced everywhere by the exogenous variable t N yt . (7.51) and µt ≥ 0. yt+1 ) + µt+1 Γ(cT .47). Also.52) where µt denotes the Lagrange multiplier on the borrowing constraint (7. yt )+µt Γ(cT .47).

45) and (7.50)-(7. yt ) reﬂecting the t t fact that an extra unit of consumption of tradables rises the relative price of nontradables. Shortly. we wish to design ﬁscal instruments capable of supporting the socialplanner allocation as the outcome of a competitive equilibrium. (7. Optimal Fiscal Policy The competitive equilibrium conditions and the social-planner equilibrium conditions diﬀer only in the Euler equation (compare equations (7. and (7. Speciﬁcally. The social-planner equilibrium is then given by a set of processes {cT . The question we entertain here is whether there exists a ﬁscalpolicy scheme that induces households to internalize their collective eﬀect on the credit limit and thereby makes the competitive-equilibrium conditions identical to the social-planner equilibrium conditions. the marginal utility of tradable consumption from a social point of view is given by the sum of the N N direct marginal utility G(cT .50)). let τt denote the tax on debt and st denote the lump-sum transfer. the budget constraint of he household .47). yt ) and the factor µt Γ(cT . however. µt } t satisfying (7.52). thereby making the collateral constraint marginally less tight.46). dt . It turns out that such optimal ﬁscal policy takes the form of a proportional tax on external debt and a lump-sum transfer that rebates the entire proceeds from the debt tax equally among households.238 Mart´ Uribe ın periods in which the borrowing constraint is binding. Then. That is. we will compare the macroeconomic dynamics induced by the competitive equilibrium and the social-planner equilibrium. we wish to address the issue of how to implement the latter. Before doing so.

In the aggregate. The Euler equation t associated with this problem is of the form G(cT .Lecture in Open Economy Macroeconomics. Of course.49). given the processes T N {pN . given by the current marginal utility of tradable consumption G(cT .53) . It is straightforward to establish that a competitive equilibrium in this economy is given by processes {cT . ct . yt . the more t+1 t+1 costly it is for households to accumulate debt.40) subject to t t this budget constraint and conditions (7.46)-(7.41) and (7. dt } to maximize (7. µt } t satisfying (7. yt . This expression says that households choose a level of t+1 t+1 consumption at which the marginal beneﬁt of an extra unit of debt. yt ) = β(1 + r)(1 + τt )Et G(cT . It follows that the higher the tax rate on debt. t t t Households choose processes {cT . the government rebates the tax to households in a lump-sum fashion by adopting a balanced-budget rule of the form st = τt−1 (1 + r)dt−1 . cN . τt . t t+1 (7. which are common to both the competitive equilibrium without taxes and the social planner’s equilibrium. β(1 + r)(1 + τt )Et G(cT . and N N G(cT . cN ). cN ). dt . cN ) = β(1 + r)(1 + t t τt )Et G(cT . this tax cost of debt is only an individual perception aimed at distorting household’s spending behavior.43). st } and the initial debt position d−1 . equals t t the marginal cost of debt. yt+1 ) + µt . given by the expected present discounted value of the after-tax interest payment measured in terms of utils. Chapter 7 is given by 239 T N dt = (1 + r)(1 + τt−1 )dt−1 + cT − yt + pN (cN − yt ) − st . cN ).

When the borrowing constraint does bind in the current period or when it does not bind either currently or in any state of the next period.240 Mart´ Uribe ın T N given a ﬁscal policy τt . yt+1 ) t+1 (7. Thus. the competitive equilibrium conditions in the economy with taxes and the social planner’s equilibrium conditions diﬀer only in their respective Euler equations. the government does not tax external debt (τt = 0).54) According to this expression. exogenous processes {yt . the tax rate is set at zero. given by (7. in which the borrowing constraint does not bind (µt = 0) and is not expected to bind in the next period (µt+1 = 0 in all states of period t + 1). N β(1 + r)Et G(cT .53) and (7. and the initial condi- tion d−1 . The optimal ﬁscal policy then is the tax process {τt } that makes these two Euler equations equal to each other. yt }. in tranquil periods. yt ) t t+1 . It is easy to establish that the optimal tax process is given by τt = N N β(1 + r)Et µt+1 Γ(cT . In periods of uncertainty. when the collateral constraint does not bind in the current period but has some probability of binding in the next period (µt = 0 and µt+1 > 0 in some states of t + 1). The numerical exercise conducted by Bianchi (2010) considers an approximately optimal tax policy in which the government levies a tax on debt equal to the one prescribed by the optimal tax policy only in periods in which the borrowing constraint is not binding in the current period but does bind in at least one of the possible states of period t + 1. yt+1 ) − µt Γ(cT . The output .50). The model is calibrated at an annual frequency. the government taxes debt holdings to discourage excessive spending and external borrowing.

035 0. 1) for i = 1. η = 0.04. especially when the borrowing limit is not binding in either the CE or SP economies or when it is binding in the CE but not in the SP economy. . An empirical measure of traded output is deﬁned as GDP in the manufacturing. 2.91. and nontraded output as the diﬀerence between GDP and GDP in the traded sector. Let the T N optimal debt accumulation rule be dt = D(dt−1 . The functions D and D s are increasing in the level of debt s (D1 > 0. the 2010 version of Bianchi’s paper does not specify how the output series were detrended. D1 > 0) when the borrowing constraint is not binding but are des creasing in the level of debt (D1 < 0. D is larger than D s . ω = 0.46 0. Using data from the World Development Indicators from 1965 to 2007.22 0.90 0. ∼ N (0. yt . and in which units they are expressed. There are also signiﬁcant diﬀerences between the debt-accumulation behavior in the CE and SP economies: First. Chapter 7 241 process is assumed to follow a bivariate AR(1) process. β = 0. σ = 2.32. and mining sectors.83. yt . Second.45 0. yt ) in the competiT N tive equilibrium (CE) and dt = D s (dt−1 . Bianchi ﬁnds that the optimal debt accumulation decision is quite different when the borrowing constraint binds and when it does not. agriculture.022 yt−1 T yt−1 1 t 2 t .8 The remaining parameters are calibrated as follows: κT = κN = 0. D1 < 0) when the borrowing constraint is binding. and r = 0. given the 8 Unfortunately. This means that the CE and SP economies experience capital outﬂows (dt − dt−1 < 0) when the borrowing constraint binds. the output process is estimated to be with i t T yt N yt 0 0.047 = + N −0.Lecture in Open Economy Macroeconomics.31. yt ) in the social-planner (SP) equilibrium.

But these crises do not appear to inﬂict too much pain to the representative household.242 Mart´ Uribe ın levels of sectoral output. is 5 percent on average. is 5.5 percent in the CE and 0. Finally. the presence of overborrowing in this economy has quantitatively important eﬀects on the frequency and size of economic crises. This modest welfare cost of overborrowing is due to the fact that in this economy output is assumed to be exogenous. Bianchi ﬁnds that on average the representative household of the CE economy requires an increase of only one tenth of one percent of its consumption stream to be as happy as the household of the SP economy. These predictions of the model point at a signiﬁcant degree of overborrowing. there is a 15 percent probability that debt in the CE is higher than the upper bound of the support of the stationary distribution of debt in the SP economy. the borrowing constraint binds at a higher level of debt in the SP economy than in the CE economy. Moreover.5 percent in the SP economy. The probability of a crisis. The next section shows that relaxing this strong assumption can lead to a surprising result. under the present calibration. and is increasing in the level of debt. the initial contraction in consumption in a crisis is higher in the CE economy than in the SP economy. Third. deﬁned as a situation in which the borrowing constraint is binding and capital outﬂows (dt − dt−1 < 0) are larger than one standard deviation. The required tax on external debt that corrects this ineﬃciency. .

Chapter 7 243 7. . Rebucci. Chen. etc. deﬁned as a situation in which the competitive equilibrium produces more debt accumulation than the social planner equilibrium. For an increase in the labor supply causes the supply of nontradables to rise. tightening the borrowing limit. hereafter BCORY. thereby increasing income at any given wage rate. To see this. In equilibrium. may in turn cause a fall in the value of nontraded income in terms of tradables. the market value of some asset. however. traded output.3 The Case of Underborrowing One lesson we can derive from the models of overborrowing based on collateral constraints is that the assumption of what precise object is used as collateral (a constant. nontraded output. This simple and realistic extension can fundamentally alter the nature of the ﬁnancial externality. The key modiﬁcations introduced by BCORY (2009) is to assume that the labor supply is endogenous and that nontradables are produced using labor—recall that Bianchi’s model assumes that output is exogenous. and Young (2009).2. which. a way to relax the borrowing constraint is to supply more hours of work. borrowing is limited by income. From a private point of view. if the elasticity of substitution of tradables for nontradables is low (less than unity). suppose that.) can have crucial consequences for whether or not the presence of the borrowing constraint causes overborrowing. that under plausible calibrations can produce underborrowing.Lecture in Open Economy Macroeconomics. In this section we stress this idea by considering a modiﬁcation of Bianchi’s (2010) model due to Benigno. this can have a deleterious eﬀect on the country’s ability to borrow. as in the Bianchi (2010) model. Otrok.

h) = hδ t δ 1−σ −1 . the representative household is assumed to have preferences described by the utility function ∞ E0 t=0 β t U (ct . ht .55) where ht denotes hours worked in period t.in the present environment households internalize the beneﬁt that working longer hours has on their ability . 1−σ is assumed to be increasing in consumption and decreasing in hours worked. is assumed to be exogenous and stochastic.57) where κ > 0 is a parameter. this borrowing limit contains on its right-hand side a variable that is endogenous to households. As before. (7. t t t (7. The sequential budget constraint is of the form T dt = (1 + r)dt−1 + cT − yt + pN cN − wt ht .56) where wt denotes the real wage expressed in terms of tradables. The endowT ment of tradables. Note that. namely. yt . unlike the Bianchi (2010) model. ht ).244 Mart´ Uribe ın Formally. given by c− U (c. (7. Borrowing in international markets is limited by income: T dt ≤ κ(yt + wt ht ).41). the consumption good is a composite of tradables and nontradables and the aggregation technology is given by equation (7. The period utility function. In particular.

245 The household’s optimization problem consists in choosing processes {ct .55) subject to the agt t gregation technology (7. The ﬁrst-order conditions associated with this problem are identical to those derived for the Bianchi (2010) model. λt denotes the Lagrange multiplier associated with the sequential budget constraint. and µt denotes the Lagrange multiplier associated with the borrowing constraint.41). Chapter 7 to borrow. We t assume that free entry guarantees zero proﬁts in the nontraded sector. and the borrowing constraint (7. giving households an extra incentive to supply hours to the labor market.57). subject to the production technology. an increase in hours raises labor income thereby enlarging the value of collateral and relaxing the borrowing limit.56). in the fact that at the going wage rate. dt } to maximize the utility function (7. given by pN yt − wt ht . This expression shows that periods in which the borrowing constraint is binding (µt > 0). cN . ht ) = λt (wt + κµt /λt ). were. as before. Speciﬁcally. cT .Lecture in Open Economy Macroeconomics. given by wt +κµt /λt . the sequential budget constraint (7. Firms produce nontradables using a linear technology that takes labor as the sole input of production. This incentive to work originates. output of tradables is given N by yt = ht . exceeds the market wage rate wt . This . ht . the shadow real wage. as explained earlier. The problem of the ﬁrm consists in choosing ht to maximize N proﬁts. except for the emergence of a labor supply expression of the form: −Uh (ct .

we can rewrite the borrowing constraint (7. now not from the household’s perspective.43) in yet another way by using the zero-proﬁt condition wt = pN to get rid of wt . the eﬃciency condition t pN = t 1−ω ω cT t cN t 1/η N to get rid of pN . we can t write equation (7.246 means that p N = wt t at all times. given by equation (7. households take the variables that appear on the right-hand side of this expression as exogenous. The key diﬀerence between the two models is that whereas in the present model the above expression holds only in equilibrium. Note that both in the present model and in Bianchi’s. but from an equilibrium perspective. t which is identical to the borrowing constraint assumed by Bianchi (2010). Noting N that the zero-proﬁt condition implies that wt ht = pN yt at all times. Mart´ Uribe ın It is of interest to examine the shape of the borrowing limit. and the technological relation yt = ht get rid of yt . in Bianchi’s model it holds both in equilibrium and at the level of the individual household. the market-clearing condition yt = cN t t N N to get rid of cN . when κT = κN = κ.43). This t .56) as: T N dt ≤ κ(yt + pN yt ). To understand why the incentives of households to work and in that way relax the borrowing constraint can be counterproductive in equilibrium.

The latter is. i. in equilibrium increasing hours might actually shrink the borrowing possibility set.5 to about 0. that an increase in hours expands the borrowing limit. BCORY (2009) ﬁnd that the competitive equilibrium yields a lower average debt-to-output ratio and a smaller probability that the borrowing constraint will bind than the social planner’s equilibrium. and Neumeyer and Gonz´lez-Rozada. an increase in hours produces a oneto-one increase in the supply of nontradables which drives the relative price of this type of goods down so much that the value of nontraded output ends up falling. That is. the model generates underborrowing. or.Lecture in Open Economy Macroeconomics. BCORY (2009) argue that this is indeed a realistic possibility. They then compute both the competitive equilibrium and the social planner’s equilibrium. Chapter 7 yields the following equilibrium borrowing limit 1 − ω T 1/η 1−1/η ht c ω t 247 T dt ≤ κ yt + This expression says that. the solution to a maximization problem in which the endogeneity of the wage rate. .76 and calibrate the rest of the parameters of the model using values that are plausible for the typical emerging economy. This will be the case when tradables and nontradables are poor substitutes. wt .57) is internalized. is less than unity. η. Existing estimates of the elasticity of substitution η for emerging countries yield values ranging from slightly below 0. more precisely. as before.83 (see. unlike the perception of the individual household. 1992. a BCORY (2009) set η at 0.e. Ostry and Reinhart. for instance. In this case.. 2003). when the elasticity of substitution between these two types of good. on the right-hand side of (7.

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7.2.4

Discussion

We close this section by reiterating that in models in which borrowing is limited by a collateral constraint, the emergence of overborrowing depends crucially on what objects are assumed to serve as collateral. This adds an element of discretionality to the analysis because in the class of models reviewed here the collateral constraint is assumed in an ad hoc fashion. This conclusion suggests two priorities for future research in this area. One is empirical and should aim at answering a simple question: what do foreign lenders accept as collateral from borrowers residing in emerging countries? The second line of research suggested as important by the current state of the overborrowing literature is theoretical. It concerns the production of microfoundations for the type of borrowing constrains analyzed in this chapter. The hope here is that through such foundations we will be able to narrow the type of items that can sensibly be included on the right-hand side of the borrowing constraint.

Chapter 8

Sovereign Debt

Why do countries pay their international debts? This is a fundamental question in open-economy macroeconomics. 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. Thus, 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. 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. Defaulting on international ﬁnancial contracts appears to have no legal consequences. If agents have no incentives to pay their international debts, then lenders should have no reason to lend internationally to begin with. Yet, 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 249

250 pure legal enforcement.

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Two main reasons are typically oﬀered for why countries honer their international debts: economic sanctions and reputation. Economic sanctions may take many forms, such as seizures of debtor country’s assets located abroad, trade embargoes, import tariﬀs and quotas, etc.1 Intuitively, the stronger is the ability of creditor countries to impose economic sanctions, the weaker the incentives for debtor countries to default. 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. Being isolated from international ﬁnancial markets is costly, as it precludes use of the current account to smooth out consumption in response to aggregate domestic income shocks. As a result, countries may choose to repay their debts simply to preserve their reputation and thereby maintain access to international ﬁnancing. This chapter investigates whether the existing theories of sovereign debt are capable of explaining the observed levels of sovereign debt. Before plunging into theoretical models of country debt, however, we will present some stylized facts about international lending and default that will guide us in evaluating the existing theories.

The use of force by one country or a group of countries to collect debt from another country was not uncommon until the beginning of the twentieth century. In 1902, an attempt by Great Britain, Germany, and Italy to collect the public debt of Venezuela by force prompted the Argentine jurist Luis-Mar´ Drago, who at the time was serving ıa as minister of foreign aﬀairs of Argentina, to articulate a doctrine stating that no public debt should be collected from a sovereign American state by armed force or through the occupation of American territory by a foreign power. The Drago doctrine was approved by the Hague Conference of 1907.

1

Lecture in Open Economy Macroeconomics, Chapter 8

251

8.1

Empirical Regularities

Table 8.1 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. The table also 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. In eﬀect, for the countries considered in the sample, the debt-to-GNP ratio at the onset of a default or restructuring episode was on average 14 percentage points above normal times. The information provided in the table is silent, however, about whether the higher debt-to-GNP 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 or both. Table 8.1 also shows the country premium paid by the 9 emerging countries listed over a period starting on average in 1996 and ending in 2002. During this period, 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. There is evidence that country spreads are higher the higher the debt-to-GNP ratio. Akitoby and Stratmann (2006), estimate a semielasticity of the spread with respect to the debt-to-GNP ratio of 1.3 (see their table 3, column 4). That is, they estimate ∂ log country spread = 1.3. ∂debt-to-GNP ratio

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Table 8.1: Debt-to-GNP Ratios and Country Premiums Among Defaulters Average Debt-to-GNP Ratio 37.1 30.7 58.4 33.6 70.6 38.2 55.2 31.5 41.3 44.1 Debt-to-GNP Ratio at Year of Default 54.4 50.1 63.7 112.0 46.7 70.6 21.0 46.3 58.1 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. Debt-to-GNP ratios are averages over the period 1970-2000. Country spreads are measured by EMBI country spreads, produced by J.P. Morgan, and expressed in basis points, and are averages through 2002, with varying starting dates as follows: Argentina 1993; Brazil, Mexico, and Venezuela, 1992; Chile, Colombia, and Turkey, 1999; Egypt 2002; Philippines, 1997. 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; Brazil 1983; Chile 1972 and 1983; Egypt 1984; Mexico 1982; Philippines 1983; Turkey 1978; Venezuela 1982 and 1995. Colombia did not register an external default or restructuring episode between 1970 and 2002. Source: Own calculations based on Reinhart, Rogoﬀ, and Savastano (2003), tables 3 and 6.

Lecture in Open Economy Macroeconomics, Chapter 8

253

Thus, if, as documented in table 8.1, the debt-to-GNP ratio is 14 percentage points higher at the beginning of a debt default or restructuring episode than during normal times, and the average country spread during normal times is about 640 basis points, it follows that at the beginning of a default episode the country premium increases on average by 1.3 × 640 × 0.14 = 116 basis points, or 1.16 percent. This increase in spreads might seem small for a country that is at the brink of default. We note, however, 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. Country spreads are known to respond systematically to other variables that may take diﬀerent values during normal and default times. For instance, 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. Because around default periods inﬂation tends to be high and foreign reserves tend to be low, these two factors contribute to higher country spreads in periods immediately preceding a default episode. Table 8.2 displays empirical probabilities of default for 9 emerging countries over the period 1824-1999. On average, the probability of default is about 3 percent per year. That is, countries defaulted on average once every 33 years. Table 8.2 also reports the average number of years countries are in state of default or restructuring after a default or restructuring episode. After a debt crisis, countries are in state of default for about 11 years on average. If one assumes that while in state of default countries have limited access to fresh funds from international markets, one would conclude that

023 0.040 0.030 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. Rogoﬀ.051 0.254 Mart´ Uribe ın Table 8.046 0. Source: Own calculations based on Reinhart.040 0. table 1. Therefore. and Savastano (2003).011 0.034 0.2: Probability of Default and Length of Default State 1824-1999 Probability of Default per year 0. the average probability is conditional on at least one default in the sample period. .017 0.006 0.

But the connection between being in state of default and being in ﬁnancial autarky should not be taken too far.2 The Cost of Default Default and debt restructuring episodes are typically accompanied by signiﬁcant declines in aggregate activity.Lecture in Open Economy Macroeconomics. where Tijt is a measure of average bilateral trade between countries i and . For being in state of default with a set of lenders. does not necessarily preclude the possibility of obtaining new loans from other lenders with which the borrower has no unpaid debts. then maintaining access to international trade could represent a reason why countries tend to honor their international ﬁnancial obligations. Sturzenegger (2003) ﬁnds that after controlling for a number of factors that explain economic growth. Rose (2005) investigates this issue empirically. 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 countries. Default episodes are also associated with disruptions in international trade. Rose estimates an equation of the form M ln Tijt = β0 + βXijt + m=0 φm Rijt−m + ijt . Chapter 8 255 default causes countries to be in ﬁnancial autarky for about a decade. the cumulative output loss associated with default or debt restructuring episodes in the 1980s was of about 4 percent over four years. 8.

a common language. sharing of land borders.256 Mart´ Uribe ın j in period t. country-pair-speciﬁc dummies. The main focus of Rose’s work is the estimation of the coeﬃcients φm . The variable Xijt is a vector of regressors including (current and possibly lagged) characteristics of the country pair ij at time t such as combined output. respectively. that takes the values 0. or both countries i and j engaged in an IMF program at time t. The sample contains 283 Paris-Club debt-restructuring deals. 1. a common border. combined population. whereas high-income country pairs trade more. if neither. Rose ﬁnds sensible estimates of the parameters pertaining to the gravity model. etc. distance. membership to the same free trade agreement. sharing of a common language. The Paris Club is an informal association of creditor-country ﬁnance ministers and central bankers that meets to negotiate bilateral debt rescheduling agreements with debtorcountry governments. or membership in a regional free trade agreement trade more. Specifically. Rose’s empirical model belongs to the family of gravity models. Landlocked countries and islands trade . combined area. 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. The regressor Rijt is a proxy for default. Countries that share a common currency. or 2. The vector Xijt also includes current and lagged values of a variable IM Fijt . It 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. Rose identiﬁes default with dates in which a country enters a debt restructuring deal with the Paris Club. one. countries that are more distant geographically trade less.

If this is indeed the case. The inception of IMF programs is associated with an cumulative contraction in trade of about 10 percent over three years.Lecture in Open Economy Macroeconomics.07. Chapter 8 257 less. Thus. M m=0 φm 1+M = −0. then the coeﬃcients φm would be picking up the combined eﬀects of trade sanctions and of general economic distress during default episodes. which may be associated with a general decline in international trade that is unrelated to trade sanctions by the creditor country. 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. i. Mart´ ınez and Sandleris (2008) estimate the following variant of Rose’s gravity model: M M ln Tijt = β0 + βXijt + m=0 φm Rijt−m + m=0 γm Gijt−m + ijt . to be about 15 years. as measured by the debt restructuring variable Rijt has a signiﬁcant and negative eﬀect on bilateral trade. M .. Rose estimates the parameter φm to be on average about -0. Based on this ﬁnding. .07. and most of the colonial eﬀects are large and positive. Default. the cumulative eﬀect of default on trade is about one year worth of trade in the long run. and the lag length. Rose concludes that one reason why countries pay back their international ﬁnancial obligations is fear of trade disruptions in the case of default. To disentangle these two eﬀects. Do the estimated values of φm really capture the eﬀect of trade sanctions imposed by creditor countries to defaulting countries? Countries undergoing default or restructuring of their external ﬁnancial obligations typically are subject to severe economic distress.e.

not just with those with which the debtor country is renegotiating debt arrears. or 10. However.258 Mart´ Uribe ın where Gijt−m is a binary variable taking the value one if either country i or country j is a debtor country renegotiating in the context of the Paris Club in period t. evidence of trade sanctions would require a point estimate for M m=0 φm that is negative and signiﬁcant. they obtain a point estimate of 15 m=0 φm that is positive and equal to 0. and evidence of a general eﬀect of default on trade would require a negative and signiﬁcant estimate of Sandleris estimate 15 m=0 M m=0 γm . Notice that. if creditors behave collectively by applying sanctions to defaulters whether or not they are directly aﬀected then the γm coeﬃcients might in part be capturing sanction eﬀects. One is of the form M M ln Tijt = β0 + βXijt + m=0 φm CREDijt−m + m=0 γm Gijt−m + ijt . This regressor is meant to capture the general eﬀect of default on trade with all trading countries. unlike variable Rijt .41. Mart´ ınez and Sandleris control for collective-sanction eﬀects by estimating two additional variants of the gravity model.01. . In this version of the gravity model. when a country enters in default its international trade falls by about 40 percent over 15 years with all countries. variable Gijt is unity as long as one of the countries is a renegotiating debtor. This result would point at the absence of trade sanctions if creditor countries acted in isolation against defaulters. M . More importantly. That is. at 0. The sign of the point estimates are robust to setting the number of lags. Mart´ ınez and γm to be -0. and zero otherwise. regardless of whether or not the other country in the pair is the renegotiating creditor. 5.

But when the lag length is set at 15 years. The variable ACREDijt takes the value 1 if one of the countries in the pair ij is a defaulter negotiating its debt in the context of the Paris Club in period t and the other country is the negotiating Paris Club member (the aﬀected creditor).19.01. respectively. 5. Evidence of trade sanctions would require be negative and signiﬁcant. The second variant of the gravity model considered aims at disentangling the individual and collective punishment eﬀects. N ACREDijt . the point estimate turns negative and equal to -0.09. Chapter 8 259 where CREDijt is a binary variable that takes the value 1 if one of the countries in the pair ij is a debtor renegotiating its debt and the other is a creditor. The variable N ACREDijt takes the value 1 if one of the countries in the pair ij is a defaulter negotiating its debt in the context of the Paris Club in period t and the other country is a nonnegotiating Paris Club member (a nonaﬀected creditor). At lag lengths of 0. and 0. The variable N OT CREDijt takes the value 1 if one of the countries in the pair ij is a .Lecture in Open Economy Macroeconomics.19. ACREDijt . independently of whether or not it is renegotiating with the debtor country in the pair. 0. The point estimate of M m=0 M m=0 φm to φm turns out to be sensitive to the lag length considered. and 10 years the point estimate is positive and equal to 0. and N OT CREDijt are all binary variables taking the values 1 or 0. It takes the form: M M ln Tijt = β0 + βXijt + m=0 M φm ACREDijt−m + m=0 ijt . ξm N ACREDijt−m + m=0 γm N OT CREDijt−m + Here.

0119. respectively. Virtually all of the observed decline in the bilateral trade of debtors after a default episode can be attributed to economic distress and not to punishment inﬂicted by creditors. evidence of individual and collective trade sanctions would require both M m=0 φm and M m=0 ξm to be negative and signiﬁcant. In this variant of the model. and -0. given by M m=0 ξm . If one believes that a reasonable period over which creditors apply trade sanctions to defaulting debtors is less than a decade.5629. respectively. 0.0246. the point estimate is 0. Speciﬁcally. given by M m=0 φm . We interpret the work of Mart´ ınez and Sandleris as suggesting that the importance of trade sanctions as a cost of default depends crucially upon one’s beliefs regarding the magnitude of the delay with which creditors are able or willing to punish defaulter debtors. if one believes that creditors have good memory and are capable of castigating defaulting debtors many years (more than a decade) after a default episode. and 15. 10. then the gravity model oﬀers little evidence of trade sanctions to defaulters.2314. -0. 0.4675. However.3916 at lag lengths of 0.0854. 5. is again sensitive to the speciﬁed lag length. the cumulative eﬀect of default on trade between defaulters and directly aﬀected creditors.0631. Speciﬁcally. at lag lengths of 0. 5. and 0.260 Mart´ Uribe ın defaulter negotiating its debt in the context of the Paris Club in period t and the other country is not a member of the Paris Club. The cumulative eﬀect of default on trade between defaulters and nonaﬀected creditors. 10. then the gravity model identiﬁes a signiﬁcant punishment component in the observed decline in . and 15 years. is consistently negative and robust across lag lengths. taking positive values at short and medium lag lengths and turning negative at long lag lengths. However. it takes the values -0. -0.

without loss of generality. Before the realization of the state of nature.2 Consider a one-period economy facing a stochastic endowment given by ys = y + s.Lecture in Open Economy Macroeconomics. . The material in this section draws from the inﬂuential work of Grossman and Van Huyck (1988). and in states in which ds is positive. . where s = 1. the household can buy insurance from foreign lenders in the form of state-contingent debt contracts. Chapter 8 261 bilateral trade following default episodes of about 50 percent of the trade volume cumulated over 15 years. y > 0 is a constant. In states in which ds is negative. that 1 < 2 < ··· < S. . the borrowing country receives a payment from the rest of the world.3 Default Incentives With State-Contingent Contracts The focus of this section is to analyze the structure of international debt contracts when agents have accesss to state-contingent ﬁnancial instruments but may lack commitment to honor debt obligations. the borrowing country makes a payment to the rest 2 A similar exposition appears in Obstfeld and Rogoﬀ (1996). Speciﬁcally. and s is a random endowment shock with mean zero. . 8. Let us assume. There are S > 1 possible states of nature. S denotes the state of nature. The variable ds can take positive or negative values. . these debt contracts stipulate that the country must pay ds units of goods to foreign lenders in state s.

S.1) The representative household in the domestic economy seeks to maximize the utility function S πs u(cs ). the household’s budget constraint is given by cs = y + s − ds (8. In each state of nature s = 1.262 Mart´ Uribe ın of the world. letting πs denote the probability of occurrence of state s.1 Optimal Debt Contract With Commitment The household’s problem consists in choosing a state-continget debt contract ds . Formally. We begin by considering the case in which households can commit to honor their promises. to maximize the utility function (8. s = 1.3) We are now ready to characterize the form of the optimal external debt contract.2) subject to the partic- . 8. · · · . S. the zero-expected-proﬁt condition can be written as S πs ds = 0. s=1 (8. · · · . Foreign lenders are assumed to be risk neutral.2) where cs denotes consumption in state of nature s and u(·) denotes a strictly increasing and strictly concave utility index.3. and to face an opportunity cost of funds equal to zero. s=1 (8. to operate in a perfectly competitive market. These assumptions imply that debt contracts carrying an expected payment of zero are suﬃcient to ensure the participation of foreign investors.

3). for all s. Under the optimal contract.1). transfer resources to the rest .3). The ﬁrst-order conditions associated with the representative household’s problem are (8. (8. ds = s. and u (cs ) = λ.1) and to the budget constraint (8.Lecture in Open Economy Macroeconomics. The Lagrangian associated with this problem can be written as S L= s=1 πs [u(y + s − ds ) + λds ] . Note that λ is not state contingent. The associated debt payments are exactly equal to the endowment shocks. or cs = y. domestic risk-averse households transfer all of their income uncertainty to risk-neutral foreign lenders.1). In this way. this expression states that consumption is constant across states of nature. the optimal external debt contract achieves perfect consumption smoothing. In particular. where λ denotes the Lagrange multiplier associated with the participation constraint (8. in exchange. That is. under the optimal contract consumption equals the average endowment in all states. Noting that the multiplier λ is independent of the state of nature. the domestic households receive payments from the rest of the world when the endowment realization is low and. Chapter 8 263 ipation constraint (8.

After consuming this resources. It then follows that any debt contract must include the additional incentive-compatibility constraint ds ≤ 0. payments to (from) the rest of the world are larger the farther is output above (below) its mean value. d s which means that transfer payments to the rest of the world move one to one with income innovations..e. there are no negative consequences for not paying debt obligations. the debtor country would be better oﬀ consuming the resources it owes. so debtors cannot be punished for having defaulted. Indeed.4) . In addition.264 Mart´ Uribe ın of the world when the domestic endowment is high. the world simply ends.2 Optimal Debt Contract Without Commitment In the economy under analysis. in states in which the endowment is above average).3. Furthermore. debtors have incentives not to pay. The perfect-risk-sharing equilibrium we analyzed in the previous subsection was built on the basis that the sovereign can resist the temptation to default. we have dds = 1. in our one-period world. In eﬀect. 8. the country would default in any state in which the contract stipulates a payment to the rest of the world. What if this commitment to honoring debts was absent? Clearly. (8. in any state of the world in which the contract stipulates a payment to foreign lenders (i.

It follows immediately that risk-averse households (i. As a result. y ≡ Eys . for all s. Because in the economy without commitment international transfers are . This is a trivial contract stipulating no transfers of any sort in any state.. and to the incentive-compatibility constraint (8. It follows that under lack of commitment international risk sharing breaks down.2) subject to the participation constraint (8.e. Chapter 8 265 for all s. the consumption plan under commitment is constant across states. The representative household’s problem then consists in maximizing the utility function (8. commitment is welfare increasing. to the budget constraint (8.Lecture in Open Economy Macroeconomics. This consumption proﬁle has the same mean as the one that can be supported with commitment.4). Restrictions (8. Put diﬀerently.4) together state that debt payments must be zero on average and never positive.1). the country is in complete ﬁnancial autarky and must consume its endowment in every state cs = y + s. The only debt contract that can satisfy these two requirements simultaneously is clearly ds = 0. for all s. households with concave preferences) are worse oﬀ in the ﬁnancially autarkic economy. whereas the one associated with autarky inherits the volatility of the endowment process. namely.3). No meaningful debt contract can be supported in equilibrium.1) and (8. However.

exports. One would expect that this type of actions would deter borrowers from defaulting at least as long as debt obligations do not exceed the value of the seizure.3).2) subject to the participation constraint (8. this means that the incentive-compatibility constraint now takes the form ds ≤ k. (8.266 constant (and equal to zero) across states. and to the incentive-compatibility constraint (8. What is the shape of the optimal debt contract that emerges in this type of environment? We model direct sanctions by assuming that in the case of default lenders can seize k > 0 units of goods from the delinquent debtor.). It follows that the borrower will honor all debts not exceeding k in value.1). Formally. . the derivative of debt payments with respect to the endowment is unity at all endowment levels. d s Mart´ Uribe ın This result is in sharp contrast with what we obtained under full commitment.5) The representative household’s problem then consists in maximizing the utility function (8. Direct Sanctions Suppose that foreign lenders (or their representative governments) could punish defaulting sovereigns by seizing national property (such as ﬁnancial assets. In that case. we have that dds = 0.5). to the budget constraint (8. etc.

3) implies that across states in which the . (8.5).e. The ﬁrst-order conditions associated with the representative household’s problem are (8. i.8) In states in which the incentive-compatibility constraint does not bind. and u (cs ) = λ − γs .1). and the slackness condition (8.7) (k − ds )γs = 0.Lecture in Open Economy Macroeconomics.6) that the marginal utility of consumption equals λ for all states of nature in which the incentive compatibility constraint is not binding. when ds < k. (8. This means that consumption is constant across all states in which the incentive-compatibility constraint does not bind. It then follows from optimality condition (8..8) states that the Lagrange multiplier γs must vanish. (8. The budget constraint (8. where λ denotes the Lagrange multiplier associated with the participation constraint and γs denotes the Lagrange multiplier associated with the incentive-compatibility constraint in state s (there are S such multipliers in total. one for each state of nature). (8. Chapter 8 The Lagrangian associated with this problem can be written as S 267 L= s=1 πs [u(y + s − ds ) + λds + γs (k − ds )] .6) γs ≥ 0.3). the slackness condition (8.

This is because in relatively low-endowment states (i. Based on our analysis of the case with commitment. in which large payments to the rest of the world take place in states of nature featuring large endowments. states in which the incentive-compatibility constraint does not . (8.e.9) We will show shortly that the debt contract described by this expression is indeed continuous in the endowment. it is natural to conjecture that the optimal contract will feature the incentive compatibility constraint binding at relatively high levels of income and not binding at relatively low levels of income. This means that under the optimal debt contract without commitment but with direct sanctions the borrower enjoys less insurance than in the case of full commitment. Let ¯ denote the smallest endowment level at which the incentive compatibility constraint binds. Formally. we have ¯ d+ k ds = s for for s s <¯ ≥¯ . we will show that as S → ∞. payments to foreign lenders must diﬀer from the endowment innovation we have that ¯ ds = d + s. then the constant d is indeed positive. (8. where d is a constant.10) ¯ We will also show that if this condition holds.268 Mart´ Uribe ın incentive-compatibility constraint is not binding. ¯ for all s in which ds < k. we have that ¯ d + ¯ = k. In particular. s by only a constant.. Then.

as ¯ πs (d + s <¯ 0 = = s <¯ s) + s ≥¯ πs k ¯ πs (¯ + d) s ≥¯ ¯ πs (d + πs s <¯ s) + ¯ = d+ ¯ = d− s ≥¯ s + s ≥¯ πs ¯ πs ( s − ¯). ¯ To see that if condition (8. as long as ¯ ≤ S. Chapter 8 269 ¯ bind) the borrower must pay d+ s . To show that this conjecture indeed holds.1) and to the restriction that the debt contract . Clearly. with density π( ). i. H ]. The optimal ¯ contract sets d and ¯ to maximize the utility function (8.10) holds then d is positive. which implies that ¯ d= s ≥¯ πs ( s − ¯). it is convenient to assume that there is a continuum of states. given simply by s.Lecture in Open Economy Macroeconomics. with L < H. which is a larger sum than the one that is stipulated for the same state in the optimal contract with full commitment.1).2) subject to the participation constraint (8. we have that the right-hand side of the above expression is ¯ positive. we made use of the conjecture that the debt contract is continuous in the endowment.e. which indicates that debt payments must be nil on average. ¯ In showing that d is positive. as long as the incentive compatibility constraint binds.. and therefore d > 0. in the interval [ L . write the participation constraint (8.

we wish to show that this condition emerges as ¯ part of the optimal contract. diﬀerentiating the participation constraint. ¯ Clearly. given by ¯ L ¯ (d + )π( )d + [1 − F (¯)]k = 0.12) Combining equations (8.12) we obtain ¯ ¯ ¯ −u (y − d)[(y − d) − (y + ¯ − k)] + [u(y − d) − u(y + ¯ − k)] = 0. Given d and ¯. we obtain ¯ ¯ [(y + ¯ − k) − (y − d)]π(¯)d + F (¯)dd = 0 (8. then the implied transfer payment is continuous in .11) where F (¯) ≡ π( )d denotes the probability that is less than ¯. Our analysis shows that the case with no commitment and direct sanctions falls in between the case with full commitment and the case with no . Note that we are not imposing the continuity restriction (8. ¯ Diﬀerentiating this expression with respect to d and ¯ and setting the result equal to zero. This result proves that that if the optimal contract problem has a local maximum.270 Mart´ Uribe ın take the form given in (8. At the same time. ¯ L (8. the utility function is given by ¯ L H ¯ u(y − d)π( )d + ¯ u(y + − k)π( )d .9). this expression is satisﬁed if d + ¯ = k.10). yields ¯ ¯ ¯ − u (y − d)F (¯)dd + [u(y − d) − u(y + ¯ − k)]π(¯)d¯ = 0.11) and (8. Rather.

1 provides a graphical representation of this comparison. the derivative of the optimal payment with respect to the endowment. Figure 8. As mentioned earlier. In the absence of commitment. dds /d s s equals unity for s < ¯ (as in the case with full commitment). if the ability of creditors to impose sanctions is suﬃciently limited—speciﬁcally. perhaps paradoxically. Finally. if k = 0—then ¯ = 1 and the optimal contract stipulates ﬁnancial autarky as in the case with neither commitment nor direct sanctions. if k > then ¯ > S S— and the optimal contract is identical to the one that results in the case of full commitment. in this case the risk-averse debtor country transfers all of the risk to risk neutral lenders.Lecture in Open Economy Macroeconomics. the higher the welfare of the debtor countries themselves. consumption smoothing is a direct function of the ability of the lender to punish debtors in the case of default. consumption is perfectly smooth across states and equal to the average endowment. In the model with commitment. It follows. it is of interest to compare the consumption proﬁles across states in the model with commitment and in the model with direct sanctions and no commitment. and equals zero for larger than ¯ (as in the case without commitment and no direct sanctions): 1 dds = d s 0 s s <¯ ≥¯ . Chapter 8 271 commitment and no direct sanctions. Note also that if the sanction is suﬃciently large—speciﬁcally. Consumption is ﬂat in low-endowment states (from 1 to ¯) and . In particular. that the larger the ability of creditors to punish debtor countries in case of default. By contrast.

1: Consumption Proﬁles Under Full Commitment and No Commitment With Direct Sanctions ys k cs s cc = y s ¯ d 0 ¯ ε s Note: cc and cs denotes the levels of consumption under full coms s mitment and direct sanctions. respectively. ys denotes output. . and s denotes the endowment shock.272 Mart´ Uribe ın Figure 8.

. Time is at the center of any reputational model of debt. Second. Because ﬁnancial autarky entails the cost of an elevated consumption volatility. the proﬁle is no longer ﬂat across all states of nature. the model we have in mind can no longer be a one-period model like the one studied thus far. ﬁnancial exclusion has the potential to support international lending. we will assume that the debtor country lives forever and has preferences described by the utility function ∞ S β t=0 t s=1 πs u(cs ).Lecture in Open Economy Macroeconomics. the ﬂat segment of the consumption proﬁle is lower than the level of consumption achieved under full commitment. Instead. assume that creditors have the ability to exclude delinquent debtors from ﬁnancial markets. 2. 273 The reduced ability of the risk averse agent to transfer risk to risk neutral lenders is reﬂected in two features of the consumption proﬁle. First. . Reputation Suppose now that creditors do not have access to direct sanctions to punish debtors who choose to default. Debtor countries pay their obligations to maintain their performing status. Accordingly. Second. the contract stipulates that in . S}. but time independent. and it stipulates precise payments in every date t ≥ 0 and state s ∈ {1. . That is. Consider designing a debt contract with the following three characteristics: First. payments are state contingent. it is signed before period 0. . Chapter 8 increasing in the endowment in high-endowment states (from ¯ to S ). Clearly.

1). the policy of honoring the debt contract in date/state (s.13) The left-hand side of this expression is the welfare level associated with maintaining a good standing. Third. t). it suﬃces to maximize the period utility index. the policy of never defaulting— i. Because the problem is stationary. The right-hand side represents the welfare level associated with ﬁnancial autarky.e. for every state and date pair (s.274 Mart´ Uribe ın any state s. t) and in every possible subsequent date/date— welfare dominates the policy of defaulting in (s. in the sense that the optimal contract is time independent. S s=1 πs u(y+ s −ds ). These restrictions imply that the following incentive compatibility constraint must hold in each state of nature: β 1−β S u(y + s − ds ) + πs u(y + s=1 s − ds ) ≥ u(y + s ) + β 1−β S πs u(y + s ). The Lagrangian associated with this problem is S L = πs u(y + s=1 S s − ds ) + λ s=1 S πs ds β 1−β S + s=1 γs u(y + s − ds ) + πs u(y + s=1 s − ds ) − u(y + s) − β 1−β S πs u(y + s=1 s) The ﬁrst-order conditions associated with the problem of choosing the trans- .. s=1 (8. the country must pay ds to foreign lenders independently of t. t). subject to the above incentive-compatibility constraint and to the participation constraint (8.

and that transfers are of the form ds = d + s. Chapter 8 fer schedule ds are λ 1+ γs πs 275 u (y + s − ds ) = + β 1−β S s=1 γs (8. where ¯ d is a constant.15) is not binding—low-endowment states in which the incentives to default are small. we have that the marginal utility of consumption must be constant across these states.14) becomes λ 1+ β 1−β S s=1 γs u (y + s − ds ) = Because the right-hand side of this expression is independent of the state of nature s. consumption and payments to or from the rest of the world behave exactly as in the case with direct sanctions: domestic risk-averse agents transfer their endowment shock plus a constant to risk-neutral foreign lenders. in turn. In these states. (8.15) In states in which the incentive compatibility constraint (8.15) stipulates that the Lagrange multiplier γs must vanish.Lecture in Open Economy Macroeconomics. This. the optimality condition (8. implies that consumption is constant ¯ across these states. What is the pattern of transfers in states in which the incentive compat- .14) and the slackness condition β 1−β S γs u(y + s − ds ) + πs u(y + s=1 s − ds ) − u(y + s) − β 1−β S πs u(y + s=1 s) = 0. Note that over these states. as payments to creditors are either negative or small—the slackness condition (8.

restriction (8. which yields dds u (y + s − ds ) − u (y + = d s u (y + s − ds ) s) .to highendowment states.16) change s as we evalluate that expression at diﬀerent states of nature.13) holds with equality: β u(y + s − ds ) + 1−β S s=1 β πs u(y + s − ds ) = u(y + s ) + 1−β S πs u(y + s ).276 Mart´ Uribe ın ibility constraint is binding? In these states. s and s in which the incentive compatibility constraint binds and such that s > s.and left-hand sides of (8. Only the ﬁrst terms on the right. If and s are very close to each other. showing the incentive β 1−β S s=1 compatibility constraint holding with equality. Notice that in equation (8. s=1 (8.16) with respect to the current transfer and the current endowment.16).and by how much? To answer these questions. then we can approximate the eﬀect on the optimal transfer of moving from one state to the other by diﬀerentiating (8. Because the incentive compatibility constraint binds only when the riskaverse agent must make payments (ds > 0)—there are no incentives to default when the risk-averse agent receives income from the risk-neutral lender—and because the utility index is strictly concave. the terms s) πs u(y + s and s β 1−β S s=1 πs u(y + s − ds ) are both unchanged as we move from to .16) How does the optimal transfer ds vary across states in which the collateral constraint is binding? Does it increase as one moves from low. it follows that u (y + s − ds ) > u (y + s) in all states in which the incentive compati- . consider two states.

but less than one for one. This does not mean that default incentives are weaker the higher is the level of the endowment. u(y + s ). a small increase in current endowment.) It follows that in states in which ds > 0. the higher is the current level of endowment. It might seem counterintuitive that as the current endowment increases the payment to creditors that can be supported without default also increases. the higher is the level of payments to foreign lenders that can be supported without inducing default. s. raises the current-period utility associ- ated with not defaulting. The incentive compatibility constraint tends to bind in relatively high-endowment states. the higher is the level of current consumption that can be achieved upon default. u(y + − ds ).Lecture in Open Economy Macroeconomics. ds > 0. the higher is the current endowment. d s That is. Recall that the analysis in this paragraph is restricted to states in which the incentive compatibility constraint is binding. payments to the foreign lender increase with the level of income. We close by noting that the positive slope of the payment schedule with respect to the endowment (when the incentive compatibility constraint is binding) presents a contrast with the pattern that emerges in the case of . (This is because the period utility function is assumed to be strictly concave. The intuition behind the direct relation between income and payments is that given a positive level of current payments. This implies that when the incentive compatibility constraint binds we have 0< dds < 1. Chapter 8 277 bility constraint binds. After all. by more than it raises the utility associated with the alternative of defaulting.

In the real world. optimal risk-sharing arrangements stipulate positive payoﬀs in low-income states and negative payoﬀs in high-income states. which implies that the slope of the payment schedule equals zero. represents the ﬁrst formalization of this idea. we focus on the polar case of a single non-state-contingent asset. we remove the assumption that ﬁnancial markets are complete. An implication of this result is that default incentives are stronger in high-income states and weaker in low-income states. As a result.278 Mart´ Uribe ın direct sanctions. One of our goals in this section is to explain this empirical regularity. To this end. when the incentive compatibility constraint binds payments equal the maximum punishment k. The debtor is no longer able to design debt contracts that pay a high interest rate in good states and a low interest rate in bad states. countries tend to default during economic contractions. The pioneer model of Eaton and Gersowitz (1981). Our version of the Eaton-Gersowitz model . the optimal ﬁnancial contract facilitates a smooth level of consumption across states of nature.4 Default Incentives With Non-State-Contingent Contracts In a world with complete ﬁnancial markets. Indeed. as documented earlier in this chapter. however. debts assumed in the current period impose ﬁnancial obligations in the next period that are independent of whether income in that period is high or low. In this way. In that case. In this environment. debtors facing high debt obligations and low endowments will have strong incentives to default. which we study in this section. 8.

If the household is in good ﬁnancial standing. and i. the household can be either in good ﬁnancial standing or in bad ﬁnancial standing. y ].Lecture in Open Economy Macroeconomics. As a result. u is a period utility function assumed to be strictly increasing and strictly concave.i. 279 Consider a small open economy populated by a large number of identical individuals. and β ∈ (0. where ct denotes consumption in period t. Chapter 8 follows Arellano (2005). consumption of a household in bad ﬁnancial standing is given by c = y.. 1) is a parameter denoting the subjective discount factor. the representative household is endowed with yt units of consumption goods. If it chooses to default. Preferences are described by the utility function ∞ E0 t=0 β t u(ct ). with a distribution featuring a bounded support Y ≡ [y.d. Each period t ≥ 0. then it immediately acquires a bad ﬁnancial status. If it chooses to honor its debt. then it is prevented from borrowing or lending in ﬁnancial markets. This endowment is assumed to be exogenous. stochastic. If the household is in bad ﬁnancial standing. Formally. the household is forced to consume its endowment. We drop the time subscript in expressions where all variables are dated in the current period. . ¯ At the beginning of each period. it can choose to default on its debt obligations or to honor its debt.

it remains in that status forever. This means that once the household falls into bad standing. d . 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 ). This is because of the assumed i. where d denotes the household’s debt due in the current period. This is because the default decision in the next period depends on the amount of debt due then.d. Households that are in good standing and choose not to default face the following budget constraint: c + d = y + q(d )d . . but not on the level of debt acquired in the previous period and due in the current period. and q(d ) denotes the market price of the household’s debt. The household enters in bad standing when it defaults on its ﬁnancial obligations. which implies that its current value conveys no information about future expected endowment levels. Notice also that q(·) is independent of the current level of output. nature of the endowment. d.280 Mart´ Uribe ın then it maintains its good ﬁnancial standing until the beginning of the next period.i. then bond prices would depend on the level of the current endowment. We assume that ‘bad ﬁnancial standing’ is an absorbent state. d denotes the debt acquired in the current period and due in the next period. If instead we had assumed that y was serially correlated. Note that the price of debt depends on the amount of debt acquired in the current period and due next period.

y) denotes the value function associated with being in good ﬁnancial standing. y) = max{v b (y). Chapter 8 Here.e. 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. We denote the default set by . y) = max u(y + q(d )d − d) + βEv g (d .. where v g (d. d subject to ¯ d ≤ d. y ) . we demonstrate that this intuition is in fact correct. the value function associated with continuing to participate in capital markets (i.Lecture in Open Economy Macroeconomics. v c (d. We do so in steps. The Default Set The default set contains all endowment levels at which a household chooses to default given a particular level of debt. y denotes next period’s endowment. It is then reasonable to conjecture that default is more likely the larger the level of debt and the lower the current endowment. In what follows. ¯ The parameter d > 0 is a debt limit that prevents agents from engaging in Ponzi games. In this economy. y) and is given by v c (d. y)}. 281 For an agent in good standing. and is given by v g (d. not defaulting) is denoted by v c (d.

for all y ∈ Y . y ) ≥ u(y) + βEv b (y ) ≡ v b (y). It follows that if q(d)d − d ≥ 0 for some ¯ d ≤ d. v c (d. This proposition states that if the household has a level of debt that puts it at risk of default. Because it is never in the agent’s interest to default when its asset position is nonnegative (or d ≤ 0). y ) ≥ v b (y ). v g (d.e. The ﬁrst inequality follows from the fact that d is a feasible point of the constrained maximization problem that appears on the right¯ hand side of the ﬁrst line of the above expression—i. then if it is to continue to participate in the . y ) ¯ d <d ≥ u(y + q d d − d) + βEv g (d. Formally. q(d)d − d ≥ 0 and because. then D(d) = ∅..282 D(d). the default set is deﬁned by Mart´ Uribe ın D(d) = {y ∈ Y : v b (y) > v c (d. y) ≡ max u(y + q(d )d − d) + βEv g (d . by assumption. Then. an economy that chooses not to default will run a trade surplus. ¯ Proposition 8. y)}. ¯ Proof: Suppose that q d d − d ≥ 0 for some d ≤ d.1 If D(d) = ∅. then q(d )d − d < 0 for all d ≤ d. d satisﬁes d ≤ d. The following proposition shows that at debt levels for which the default set is not empty. by deﬁnition. The second inequality holds because. it follows that D(d) is empty for all d ≤ 0.

then y1 ∈ D(d) for any y1 < y2 . y) ≡ ∂v c (d. Let b c vy (y) ≡ ∂v b (y)/∂y and vy (d. We have shown that the default set is an interval with a lower bound given by the lowest endowment y. then v b (y1 ) > v c (d.1. y) = u (y + q(d )d − d).2 If y2 ∈ D(d) and y1 < y2 . We now show that the default set D(d) is a larger interval the larger the stock of debt. y)/∂y. By the envelope theorem. Chapter 8 283 ﬁnancial market. y) < 0. Put diﬀerently. Consider any y ∈ Y such that y ∈ D(d). In other worlds. Proof: Suppose D(d) = ∅. the proposition states that in this model the economy runs trade deﬁcits only when its debt positon is such that there is no endowment realization that would induce it to default (i. we ¯ have that q(d )d − d < 0 for all d ≤ d. That is. We now establish that in this economy households tend to default in bad times. This means that if v b (y2 ) > v c (d. that u (y + q(d )d − d) > u (y). when d is such that D(d) = ∅). Proposition 8. v b (y) − v c (d. if y2 ∈ D(d). for all y ∈ D(d). it will devote part of its current endowment to servicing the debt. 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 a lower level of income. Speciﬁcally. y) is a decreasing function of y for all y ∈ D(d). y1 ) for y1 < y2 .e. It follows that vy (y) − vy (d. This implies.Lecture in Open Economy Macroeconomics. b c vy (y) = u (y) and vy (d. the higher .. By proposition 8. then y1 ∈ D(d). by strict concavity b c of u. y2 ) for y2 ∈ D(d). Equivalently. Put diﬀerently. if the default set is not empty then it is indeed an interval with lower bound given by the lowest endowment level y.

y ∗ (d)). Second. y) > 0.3 If D(d) = ∅. where y ∗ (d) is increasing in d if y ∗ (d) < y . the larger the probability of default. y ∗ (d)]. y ∗ (d)) dy ∗ (d) = b ∗ d . ¯ Proof: We already proved that the default set D(d) is an interval.1). Summarizing. given the stock of debt. . the larger the stock of debt.284 the debt. These two results are in line with the stylized facts presented earlier in this chapter. indicating that at the time of default countries tend to display above-average debt-to-GNP ratios (see table 8. We then conclude that dy ∗ (d) > 0. dd as stated in the proposition. every y ∈ D(d) satisﬁes v b (y) − v c (d. we have obtained two important results: First. c dd vy (y (d)) − vy (d. it folc lows that vd (d. y)/∂d. It follows that y ∗ (d) is given either by y or (implicitly) by v b (y ∗ (d)) = v c (d. Diﬀerentiating ¯ this expression yields v c (d. then D(d) is an interval. y) < 0 for all y ∈ D(d). y ∗ (d)) c b c where vd (d. [y. Using the deﬁnition of vd (d. default is more likely the lower the level of output. At the same time. Mart´ Uribe ın Proposition 8. b c we showed that vy (y) − vy (d. y) and applying the envelope theorem. y ∗ (d)) < c 0. We have shown that vy (y ∗ (d))−vy (d. y) ≡ ∂v c (d. the higher the probability of default. By deﬁnition. y ∗ (d)) = −u (y ∗ (d) + q(d )d − d) < 0.

Lecture in Open Economy Macroeconomics. dd 1 + r∗ The inequality follows because by deﬁnition F ≥ 0 and because. one obtains Prob {y ≥ y ∗ (d )} . is nondecreasing in the stock of debt. It follows that the country spread. by proposition 8. . Chapter 8 Default Risk and the Country Premium 285 We now characterize the behavior of the country interest-rate premium in this economy. given by the diﬀerence between 1/q(d ) and 1 + r ∗ . 1 + r∗ q(d ) = Taking derivative with respect to next period’s debt yields dq(d ) −F (y ∗ (d ))y ∗ (d ) = ≤ 0. Letting F (y) denote the cumulative density function of the endowment shock. We assume that foreign lenders are risk neutral and perfectly competitive. equating the expected rate of return on the domestic debt to the risk-free world interest rate. y ∗ (d ) ≥ 0. It follows that the expected rate of return on the country’s debt must equal r ∗ . Let the world interest rate be constant and equal to r ∗ > 0.3. If the country does not default. Therefore. foreign lenders receive nothing. we can write 1 − F (y ∗ (d )) . If the country does default. foreign lenders receive 1/q(d ) units of goods per unit lent. q(d ) 1 + r∗ = The numerator on the right side of this expression is the probability that the country will not default next period.

8. To illustrate this insight in a simple setting. At a ﬁrst glance. This assumption 3 For an example of a deterministic model with sovereign debt supported by reputation. but that saving in these markets is allowed after default. a .4 The country spread.5 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 it from the possibility to borrow or lend in international ﬁnancial markets. consider a deterministic economy. Why should defaulting countries not be allowed to save? Bullow and Rogoﬀ (1989) have shown that prohibiting defaulters to lend to foreign agents (or save in foreign assets) is crucial for the reputational model to work. If delinquent countries were not allowed to borrow but could run current account surpluses. where dt denotes the level of external debt ast=0 sumed in period t and due in period t + 1.286 We summarize this result in the following proposition: Mart´ Uribe ın Proposition 8. it might seem that what is important is that defaulters be precluded from borrowing in international ﬁnancial markets. Suppose that a reputational equilibrium supports a path for external debt given by {dt }∞ . see Eaton and Fern´ndez (1995). given by 1/q(d ) − 1 − r ∗ is nondecreasing in the stock of debt.3 Assume that default is punished with perpetual exclusion from borrowing in international ﬁnancial markets. no lending at all could be supported on reputational grounds alone.

dt ≤ 0 for all t ≥ 0. then it will have no incentives to honor any debts outstanding in that period. The evolution of the equilibrium level of debt is then given by dt = (1 + r ∗ )dt−1 − tbt .Lecture in Open Economy Macroeconomics. dT −1 ≤ 0. then no foreign investor would want to lend to this country in period T − 1. Let dT be the maximum level of external debt in this equilibrium sequence. Thus. if the country is excluded from borrowing starting in period T − 1. To see this. notice that if the country defaults at some date T > 0. That is. That is. 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 maintian a level of consumption no lower than the ones that would have obtained in the absence of default. That is. we arrive at the conclusion that default in period T implies no debt at any time. Continuing with this logic. Chapter 8 287 and the fact that the economy operates under perfect foresight imply that any reputational equilibrium featuring positive debt in at least one date must be characterized by no default. To see . dT ≥ dt for all t ≥ −1. no foreign investor will be willing to lend to the country in period T − 2. because the probability of default is nil. It follows from this result that in an equilibrium with positive external debt the interest rate must equal the world interest rate r ∗ > 0. Does it pay for the country to honor this debt? The answer is no. In turn. for t ≥ 0. where tbt ≡ yt − ct denotes the trade balance in period t. The country premium is therefore also nil. dT −2 ≤ 0. As a result. since default would occur for sure one period later.

tbT +2 is the trade balance prevailing in period T + 2 under the original (no default) debt sequence {dt }. (8. Using (8. Let the debt position acquired in the period of default be dT +1 = −tbT +1 . again. in period T + 1 the country can achieve the save level of trade balance (and hence consumption) as under the no-default strategy. we obtain dT +2 = dT +2 − (1 + r ∗ )2 dT < 0. let dt for t > T denote the post-default path of external debt. We have shown that the defaulting strategy can achieve the no-default level of . where.17) Because by assumption dT ≥ dT +1 and r ∗ > 0. We have that −tbT +1 = dT +1 −(1+r ∗ )dT .17) and the fact that tbT +2 = (1 + r ∗ )dT +1 − dT +2 . we have that dT +1 < 0. which implies that dT +1 = dT +1 − (1 + r ∗ )dT . without having to borrow internationally. That is. where tbT +1 is the trade balance prevailing in period T +1 under the original debt sequence {dt }. The inequality follows because by assumption dT +2 ≤ dT and r ∗ > 0.288 Mart´ Uribe ın this. Let the external debt position in period T + 2 in the default strategy be dT +2 = (1 + r ∗ )dT +1 − tbT +2 .

can be supported by the debt path dt satisfying dt = dt − (1 + r ∗ )t−T dT . But the result also holds in a stochastic environment (see Bullow and Rogoﬀ. 1989). Continuing in this way. . no external debt can be supported in equilibrium. For simplicity. It follows that it pays for the country to default immediately after reaching the largest debt level dT . The fact that the entire postdefault debt path is negative implies that the country could also implement a post default path of trade balances tbt satisfying tbt ≤ tbt for t ≥ T + 1 and tbt < tbt for at least one t ≥ T + 1 and still generate no positive debt at any date t ≥ T + 1. Therefore. In other words. we derived this breakdown result using a model without uncertainty. tbt for t ≥ T + 1.Lecture in Open Economy Macroeconomics. Chapter 8 289 trade balance in period t + 2 without requiring any international borrowing. which is strictly negative for all t ≥ T + 1. But we showed that default in this perfect foresight economy implies zero debt at all times. one obtains that the no-default sequence of trade balances. alloweing the country to save in international markets after default implies that no equilibrium featuring strictly positive levels of debt can be supported on reputational gourds alone. This new path for the trade balance would be strictly preferred to the no-default path because it would allow consumption to be strictly higher than under the no-default strategy in at least one period and to be at least as high as under the no-default strategy in all other periods (recall that tbt = yt − ct ).

290 Mart´ Uribe ın .

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