Productivity and Preferences in a Small Open Economy

Abstract

Following Hall (Journal of Labor Economics, Vol. 15 (1997), pp. S223–S250) it is increasingly common to incorporate preference, as well as productivity, perturbations in calibrated general equilibrium models. We assess the performance of a small open economy stochastic growth model (based on the Blanchard–Yaari framework) under alternative driving processes. Whilst both models provide familiar descriptions of the aggregate economy, we find that the model driven by productivity disturbances has clear advantages in explaining the behaviour towards foreign asset accumulation.

Productivity, Preferences and UIP Deviations in an Open Economy Business Cycle Model

“…Labor share is 0.6 and 0.577 for UK and US annual data. We take the consumption and leisure curvature of 2 (Corsetti et al 2008) and 4 (Chadha et al 2001). The elasticity of substitution between home and foreign goods in UK is 1.5 as in Chari et al (2002).…”

“…Essentially, we take the flexible price two-country, two sector model derived by Benigno and Thoenissen (2008) and emphasize the specification of driving forces as in Chadha et al (2001). The model is driven variously by forcing variables in domestic and overseas traded and non-traded productivity shocks, domestic and overseas preference shocks and by deviations from the UIP condition for the exchange rate.…”

“…We adopt the specification of Stockman and Tesar (1995) and Chadha et al (2001) by investigating the role of both productivity and preference shocks for an open economy. We use both traded sector and non-traded sector productivity, which drive the input and hence product price, shocks to the allocation of time spent in work over leisure, which affects labor supply, stochastic deviations in the UIP condition, which directly affects the terms of trade.…”

“…We have an utility function similar to Chadha et al (2001). The elasticity of intertemporal substitution in leisure 1 ηξ −1 is −0.2; the elasticity of labor supply in this model is around 4; the discount factor β, CRRA ρ, depreciation coefficient δ and labor share α are taken from standard open economy and real business cycle literature such as Corsetti et al (2008), Chari et al (2002); we take elasticity of substitution among consumables θ, κ from Corsetti et al; the share of traded goods ω, ω * are taken as 0.45 in accordance with the literature; for home bias feature in traded goods, we take average value share of UK produced goods in UK and US GDP, υ and υ * , respectively; interest spread ε is a yield discount when holding foreign bond and is calibrated as 280 base points annually by Selaive and Tuesta (2003); the cost of capital adjustment b is calibrated to match UK output volatility; we set net foreign asset position a as zero in benchmark case; the persistence and volatility of shocks are estimated on UK data Benigno (2001).…”

“…But by themselves may not provide a resolution as they seems to imply relatively acyclical current account dynamics and a reduction of real exchange rates along with higher domestic supply (see Chadha et al 2001). This is because preference shocks alter the equilibrium point in the household trade-off between leisure and consumption.…”