An Open Economy RBC Model
Valerio Nispi Landi*
First version: November 2018
This version: November 2021
1 The Model1
The model presented in these lecture notes is an open economy real business cycle model
along the lines of Mendoza (1991) and Schmitt-Grohé and Uribe (2003). The model is the
small- open-economy version of the framework described in the RBC lecture notes. In this
model households can also trade with the rest of the world, both goods and financial assets.
The small-open-economy assumption implies that domestic households take the international
interest rate as given. I assume that domestic and foreign households consume the same good.
I present two versions of this model. The first version features complete international financial
markets: domestic households can trade a complete set of Arrow-Debreu securities with the
rest of the world. In the second version, there exist only one international asset, so financial
markets are incomplete.
1.1 Households
1.2 Complete international financial markets
The representative household solves the following optimization problem:
∞ 1−σ
h1+ϕ
X
t t
max E0 β ct − κL
{ct ,it ,ht ,kt ,bt+1 }∞
t=0
t=0
1+ϕ
ct + it + Et (st,t+1 bt+1 ) = rtk kt−1 + bt + wt ht − tt + Γt
s.t.
2
κI it
kt = (1 − δ) kt−1 + 1 − 2 it−1 − 1
it
* Bank of Italy, International Relations and Economics Directorate. Email: [email protected]
1
In these lecture notes I derive the equations used to simulate the model in the Dynare files
soe one comp.mod and soe one inc.mod, and I explain how to compute the steady state. The notes are prelim-
inary, if you find any error or inaccuracies, feel free to contact me. The views expressed in these notes are those
of the author and do not necessarily reflect those of the Bank of Italy.
1
where bt denotes a random variable indicating the number of assets purchased in period t to
be delivered in each state of period t + 1. The variable st,t+1 is the period-t price of an asset
that pays one unit of good in a particular state of period t + 1, divided by the probability of
occurrence of that state given information available in period t. Notice that the utility function
is non-separable between consumption and labor, as standard in the open economy literature.
Remainder notation is standard. The Lagrangian function reads:
(∞ ( 1−σ
X
t h1+ϕ
t
− λt ct + it + st,t+1 bt+1 − rtk kt−1 − bt − wt ht + tt − Γt
L = E0 β ct − κL
t=0
1+ϕ
( " 2 # )))
κI it
−qt λt kt − (1 − δ) kt−1 − 1 − −1 it ,
2 it−1
where λt and qt are lagrangian multipliers. In each state of the world in period t, first order
conditions (foc) with respect to (wrt) consumption:
−σ
h1+ϕ
ct − κL t = λt . (1)
1+ϕ
Foc wrt labor:
−σ
h1+ϕ
ct − κL t κL hϕt =wt λt
1+ϕ
κL hϕt = wt . (2)
Foc wrt bonds:
λt+1
st,t+1 = β . (3)
λt
Notice that the latter equation holds state by state, so it does not feature the usual expectation
operator. Taking conditional expectations on both sides we can get:
λt+1
Et [st,t+1 ] = βEt . (4)
λt
Take the foc wrt capital and apply the conditional expectation operator on both sides:
k
0 = −qt λt + β λt+1 rt+1 + qt+1 λt+1 (1 − δ)
λt+1 k
qt = βEt rt+1 + (1 − δ) qt+1 . (5)
λt
2
Do the same for investment:
" 2 #
it it κI it
0 = −λt + qt λt 1 − κI −1 − −1 +
it−1 it−1 2 it−1
( " 2 #)
it+1 it+1
+β qt+1 λt+1 κI −1
it it
" 2 # ( " 2 #)
κI it it it λt+1 it+1 it+1
1 = qt 1− − 1 − κI −1 + κI βEt qt+1 −1 .
2 it−1 it−1 it−1 λt it it
(6)
In the rest of the world, an equation similar to (3) holds:
λ∗t+1
st,t+1 =β ∗ , (7)
λt
where starred letters denote foreign variables. Notice that domestic and foreign households
share the same discount factor. Combining (3) and (7) one can get the following risk-sharing
condition:
λt+1 λt
=
λ∗t+1 λ∗t
λt λt−1
∗
= ∗
λt λt−1
λt λ0
∗
= ∗
λt λ0
λt = λ0 , (8)
which implies that households in different countries are fully insured each other, because
marginal utilities are constant over time. In the derivation, I have assumed that foreign la-
bor and consumption are constant and equal to steady-state domestic and labor consumption
(λ∗t = λ0 = λ).
1.3 Incomplete international financial markets
The representative household solves the following optimization problem:
∞ 1−σ
h1+ϕ
X
t t
max E0 β ct − κL
{ct ,it ,ht ,kt ,bt }∞
t=0
t=0
1+ϕ
2
κD
ct + it + bt = rtk kt−1 + rt−1
r∗
bt−1 + wt ht − tt + Γt − 2
bt − b̄
s.t.
2
κ i
kt = (1 − δ) kt−1 + 1 − 2I it−1
t
−1 it ,
3
where bt denotes holding of an international asset yielding a real gross interest rate rtr∗ . Domestic
households pay a quadratic adjustment cost when they change the net financial position with
the rest of the world: this assumption ensures the existence of a determinate steady state and
a stationary solution.2 The Lagrangian function reads:
1+ϕ 1−σ
(∞ ( ( " 2 # )
X h κI i t
L = E0 βt ct − κL t − qt λt kt − (1 − δ) kt−1 − 1 − −1 it
t=0
1+ϕ 2 it−1
κD 2 oo
λt ct + it + bt − rtk kt−1 − rt−1
r∗
bt − wt ht + tt − Γt + bt − b̄ ,
2
where λt and qt are lagrangian multipliers. Foc wrt international bonds:
λt 1 + κD bt − b̄ = βEt (λt+1 rtr∗ ) .
(9)
The other equations are equal to the complete-market counterparts. The international interest
rate follows an autoregressive process:
1
rtr∗ = (1 − ρp ) + ρp rt−1
r∗
+ vtp , (10)
β
where vtp ∼ N 0, σp2 is a foreign interest rate shock.
1.4 Firms
There is a representative firm producing the consumption/investment good yt using a Cobb-
Douglas production function:
α
yt = at kt−1 h1−α
t , (11)
where at is the total factor productivity, which follows an autoregressive process:
log (at ) = (1 − ρa ) log (a) + ρa log (at−1 ) + vta (12)
and vta ∼ N (0, σa2 ) is a technology shock. The firm maximizes real profits Γt , taking input
prices as given (notice that the problem is not dynamic):
α
max at kt−1 h1−α
t − wt ht − rtk kt−1 .
ht ,kt−1
2
See Schmitt-Grohé and Uribe (2003) and Boileau and Normandin (2008) for a thorough analysis on this
issue.
4
Foc wrt capital:
α−1
at kt−1 αh1−α
t = rtk
α
at kt−1 ht1−α
α = rtk
kt−1
αyt = rtk kt−1 . (13)
Foc wrt labor:
(1 − α) yt = wt ht . (14)
1.5 Government
The government finances public expenditure gt by raising lump-sum taxes:
gt = tt ,
where gt follows an autoregressive process:
log (gt ) = (1 − ρg ) log (g) + ρg log (gt−1 ) + vtg (15)
and vtg ∼ N 0, σg2 is a public spending shock.
1.6 Market clearing
The trade balance is defined as follows:
κD 2
tbt = yt − ct − it − gt − bt − b̄ , (16)
2
assuming that adjustment costs are paid to the rest of the world. In order to get an expression
for the evolution of the net financial asset position, we rearrange the budget constraint:
κD 2
ct + it + bt = rtk kt−1 + rt−1
r∗
bt−1 + wt ht − tt + Γt − bt − b̄
2
κD 2
ct + it + gt + bt = rtk kt−1 + rt−1
r∗
bt−1 + wt ht + Γt − bt − b̄
2
r∗ κD 2
ct + it + gt + bt = yt + rt−1 bt−1 − bt − b̄
2
r∗ κD 2
bt = tbt + rt−1 bt−1 − bt − b̄
2
r∗ κD 2
−bt = −tbt − rt−1 bt−1 + bt − b̄ (17)
2
r∗ κD 2
dt = −tbt + rt−1 dt−1 + bt − b̄
2
κD 2
tbt r∗
= −dt + rt−1 dt−1 + dt − d¯ (18)
2
5
where:
dt = −bt . (19)
and adjustment costs are missing under complet markets.
2 Equilibrium
If markets are complete, the equilibrium conditions of the model are the following:
−σ
h1+ϕ
t
λt = ct − κL
1+ϕ
λt = λ0
( k )
λt+1 rt+1 + (1 − δ) qt+1
1 = βEt
λt qt
κL hϕt = λt wt
" 2 #
κI it
kt = (1 − δ) kt−1 + 1 − −1 it
2 it−1
" 2 #
κI it it it
1 = qt 1 − − 1 − κI −1 +
2 it−1 it−1 it−1
( " 2 #)
λt+1 it+1 it+1
+ κI βEt qt+1 −1
λt it it
α
yt = at kt−1 h1−α
t
(1 − α) yt = wt ht
αyt = rtk kt−1
log (at ) = (1 − ρa ) log (a) + ρa log (at−1 ) + vta .
There are 10 equations for 10 endogenous variables:
Xt ≡ λt , ct , rtk , wt , ht , yt , kt , qt , it , at .
The model features one exogenous shocks, vta . Notice that the trade balance and the external
financial position of the economy do not affect the other equilibrium conditions. Moreover,
under complete international financial markets, government spending and interest rate shocks
do not play any role. If financial markets are incomplete, λt is not constant anymore and
equation (8) is replaced by (9). Foreign interest rate can affect the dynamics of the model:
6
equation (10) and shock vtp should be added. Moreover, we should add the resource constraint:
yt = ct + it + gt + tbt
where:
κD 2
r∗
tbt = −dt + rt−1 dt − d¯
dt−1 +
2
and we should add variables tbt and dt . Notice that, also government spending affects the
dynamics of the economy (and we also add equation 15 and the shock vtg )
3 Steady State
Variables without time index denote the steady state level. Under incomplete financial markets,
once parameter d¯ is calibrated, one can compute the steady state by following exactly the same
steps described in the lectures notes on the RBC model. Equations (12), (10), and (15) in the
steady state imply:
a = a
1
rr∗ =
β
g = g.
Parameter a just affects the scale of the economy: I will calibrate it in order to normalize y = 1.
Moreover, I set h = 13 , and I will compute κL ex post. In the steady state (3) implies:
¯
d = d.
In the steady state (5) implies:
q = 1,
which gives according to (6):
1
rk = − (1 − δ) .
β
Once we have rk , we can get the steady state of k by (13):
αy
k= ,
rk
and in turn we get i from the law of motion of capital:
i = δk.
Using (14) we can find w:
(1 − α) y
w= .
h
7
Using (??) and (18), the steady-state level of consumption is:
1
c = y − i − g − d¯ −1 .
β
Using (2) one can recover the value for κL :
w
κL = .
hϕ
Marginal utility of consumption:
−σ
h1+ϕ
λt = c − κL .
1+ϕ
Using (11), we can get the value for the calibration of a consistent with y = 1:
y
a= .
k α h1−α
If financial markets are complete, equation (8) implies:
λt = λ0 .
Notice that λ0 is a parameter of the model: I calibrate λ0 at the same value of its incomplete-
markets counterpart, in order to have the same steady-state consumption in the two versions
of the model.
Bibliography
Boileau, M. and Normandin, M. (2008). Closing International Real Business Cycle Models with
Restricted Financial Markets. Journal of International Money and Finance, 27(5):733–756.
Mendoza, E. G. (1991). Real Business Cycles in a Small Open Economy. The American
Economic Review, pages 797–818.
Schmitt-Grohé, S. and Uribe, M. (2003). Closing Small Open Economy Models. Journal of
International Economics, 61(1):163–185.
