Firms, which produce tradable and nontradable intermediate goods, are managed in
accordance with the preferences of their owners, finitely-lived households. Therefore, firms
also have finite-planning horizons. The main substantive implication of this assumption is the
presence of a substantial equity premium driven by impatience.6 Firms are subject to nominal rigidities in price setting as well as real adjustment costs in labor hiring and investment. They
pay capital income taxes to governments and wages and dividends to households.
Retained earnings are insufficient to fully finance investment, so firms must borrow from
financial intermediaries. If earnings fall below the minimum required to make the contracted
interest payments, the financial rigidities in price setting as well as real adjustment costs in labor hiring and investment. They
pay capital income taxes to governments and wages and dividends to households.
GIMF contains a limited menu of financial assets. Government debt consists of one-period
bonds denominated in domestic currency. Banks offer households one-period fixed-term
deposits, their source of funds for loans to firms. These financial assets, as well as ownership
of firms, are not tradable across borders. OLG households may, however, issue or purchase
tradable U.S.-dollar-denominated obligations.
Banks pay a market rate of return on deposits, and charge a risk premium on loans. Because of the costs of bankruptcy (capital can only be liquidated at a discount), the lending rate includes an external financing premium, which varies directly with the debt-to-equity (leverage) ratio—the financial accelerator effect. Non-linearities imply steep increases in the risk premium for large negative shocks to net worth.Banks pay a market rate of return on deposits, and charge a risk premium on loans. Because of the costs of bankruptcy (capital can only be liquidated at a discount), the lending rate includes an external financing premium, which varies directly with the debt-to-equity (leverage) ratio—the financial accelerator effect. Non-linearities imply steep increases in the risk premium for large negative shocks to net worth.
Uncovered interest parity does not hold, due to the presence of country risk premiums. The
premiums create deviations, both in the short run and the long run, between interest rates in asset positions are represented by nominal non-contingent one-period bonds denominated in
U.S. dollars.
Banks pay a market rate of return on deposits, and charge a risk premium on loans. Because of the costs of bankruptcy (capital can only be liquidated at a discount), the lending rate includes an external financing premium, which varies directly with the debt-to-equity (leverage) ratio—the financial accelerator effect. Non-linearities imply steep increases in the risk premium for large negative shocks to net worth.Banks pay a market rate of return on deposits, and charge a risk premium on loans. Because of the costs of bankruptcy (capital can only be liquidated at a discount), the lending rate includes an external financing premium, which varies directly with the debt-to-equity (leverage) ratio—the financial accelerator effect. Non-linearities imply steep increases in the risk premium for large negative shocks to net worth.
Uncovered interest parity does not hold, due to the presence of country risk premiums. The
premiums create deviations, both in the short run and the long run, between interest rates in
different regions, even after adjustment for expected changes in exchange rates.
D. International Dimensions and Spillovers
All bilateral trade flows are explicitly modeled, as are the relative prices for each region, including exchange rates. These flows include the export and import of intermediate and final goods. They are calibrated in the steady state to match the flows observed in the recent data. International linkages are driven by the global saving and investment decisions, a by-product of consumers’ finite horizons. This leads to uniquely defined current account balances and net foreign asset positions for each reg
D. International Dimensions and Spillovers
All bilateral trade flows are explicitly modeled, as are the relative prices for each region, including exchange rates. These flows include the export and import of intermediate and final goods. They are calibrated in the steady state to match the flows observed in the recent data. International linkages are driven by the global saving and investment decisions, a by-product of consumers’ finite horizons. This leads to uniquely defined current account balances and net foreign asset positions for each reg
Along with uncovered interest parity, and long-term movements in the world real interest
rate, the magnitude of the international trade linkages is the main determinant of spillover
effects from shocks in one region to other regions in the world.
E. Fiscal and Monetary Policy
Fiscal policy is conducted using a variety of expenditure and tax instruments. Government spending may take the form of either consumption or investment expenditure, or lumpsum transfers to either all households or targeted towards LIQ households. Revenue accrues from the taxes on labor and corporate income, consumption taxes, and lumpsum taxes. The model also allows for tariffs on imported goods to be a potential source of public revenue. Government investment spending augments public infrastructure, which depreciates at a There is a fiscal policy rule which ensures long-run sustainability, while allowing for short- run counter-cyclical policies. Changes in both labor and capital income taxes provide the instrument to put the rule into effect, but this can be replaced with other tax, transfer or spending instruments if that is considered more realistic for a specific region. First, the fiscal rule ensures that in the long run, the government debt-to-GDP ratio—and hence the deficit- to-GDP ratio—eventually converges to its target level. This excludes the possibility of sovereign default, as well as the risk that out-of-control financing requirements of the government will override monetary policy. Second, the rule allows for countercyclical fiscal policy as it embodies automatic stabilizers.
E. Fiscal and Monetary Policy
Fiscal policy is conducted using a variety of expenditure and tax instruments. Government spending may take the form of either consumption or investment expenditure, or lumpsum transfers to either all households or targeted towards LIQ households. Revenue accrues from the taxes on labor and corporate income, consumption taxes, and lumpsum taxes. The model also allows for tariffs on imported goods to be a potential source of public revenue. Government investment spending augments public infrastructure, which depreciates at a There is a fiscal policy rule which ensures long-run sustainability, while allowing for short- run counter-cyclical policies. Changes in both labor and capital income taxes provide the instrument to put the rule into effect, but this can be replaced with other tax, transfer or spending instruments if that is considered more realistic for a specific region. First, the fiscal rule ensures that in the long run, the government debt-to-GDP ratio—and hence the deficit- to-GDP ratio—eventually converges to its target level. This excludes the possibility of sovereign default, as well as the risk that out-of-control financing requirements of the government will override monetary policy. Second, the rule allows for countercyclical fiscal policy as it embodies automatic stabilizers.
When conducting monetary policy, the central bank uses an inflation-forecast-based interest
rate rule. The central bank varies the gap between the actual policy rate and the long-run
equilibrium rate to achieve a stable target rate of inflation over time.
