Why Global and Local Solutions of Open-Economy Models with Incomplete Markets Differ and Why it Matters

51 Pages Posted: 14 Aug 2023

See all articles by Oliver de Groot

Oliver de Groot

University of Liverpool - Management School (ULMS)

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Date Written: August 2023

Abstract

Global and local methods used to study open-economy incomplete-markets models yield different cyclical moments, impulse responses, spectral densities and precautionary savings. Endowment and RBC model solutions obtained with first-order, higher-order, and risky-steady-state local methods are compared with fixed-point-iteration global solutions. Analytic and numerical results show that the differences are due to the near-unit-root nature of net foreign assets under incomplete markets and inaccuracies of local methods in computing their autocorrelation. In a Sudden Stops model, quasi-linear methods that handle occasionally binding constraints understate the size of credit constraint multipliers, financial premia and macroeconomic responses.

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Suggested Citation

de Groot, Oliver and Durdu, Ceyhun Bora and Mendoza, Enrique G., Why Global and Local Solutions of Open-Economy Models with Incomplete Markets Differ and Why it Matters (August 2023). NBER Working Paper No. w31544, Available at SSRN: https://ssrn.com/abstract=4539922

Oliver De Groot (Contact Author)

University of Liverpool - Management School (ULMS) ( email )

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Enrique G. Mendoza

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

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