This paper was written for the conference “International Capital Mobility: New Perspectives” to be held December 19-22, 1992 in Tel-Aviv and organized jointly by The Bank of Israel, The Centre for Economic Policy Research, and the Sapir Center for Development at Tel-Aviv University. The paper is expected to be published as part of the conference’s proceedings. Comments and suggestions by Eduardo Borensztein, Mohsin Khan, Assaf Razin, Andrew Rose, Linda Tesar, and Peter Wickham are gratefully acknowledged. The views expressed here are the author’s only and do not represent those of the International Monetary Fund.
From 1985 to 1992, the International Monetary Fund’s annual International Capital Markets report has documented in detail the radical structural changes that have transformed finance into a competitive international industry.
This Fisherian separation of savings and investment ensures that the domestic real interest rate is always equal to the world’s real interest rate. Thus, perfect capital mobility in this framework implies the familiar condition that the domestic economy faces an infinitely elastic supply of savings at the level of the world’s interest rate.
In a perfect—foresight setup, Fisherian separation equates the marginal product of capital with the world’s real interest rate. When uncertainty is introduced, this equality holds only in terms of an expected value where the return of foreign and domestic capital is weighted by the marginal utility of consumption.
The shock et incorporates the effects of fluctuations in the terms of trade because output is a tradable commodity (see Greenwood (1983)). However, the model ignores the existence of nontraded goods and does not model separately importable and exportable commodities. Mendoza (1992) examines a model that relaxes these assumptions.
With these adjustment costs, the cost of changing the capital stock by a fixed amount increases with the speed of the desired adjustment, giving agents an incentive to undertake investment changes gradually. This prevents the model from exaggerating the variability of investment relative to what is observed in the data (see Mendoza (1991a) for details).
The world’s real interest rate is assumed to be fixed for simplicity. This reduces the model to the minimum framework in which to assess the performance of capital mobility indicators under uncertainty. Mendoza (1991a) finds that interest-rate shocks do not have significant implications for the model examined here under conditions of perfect capital mobility.
Implicit in this financial structure is the assumption that contracts with payment contingent on the realizations of the disturbances cannot be written. Impeding trade in these contingent claims limits the ability of agents to insure themselves completely against country-specific risks. However, Cole and Obstfeld (1991), Mendoza (1991b) and Baxter and Crucini (1992b) found that market incompleteness may not have drastic effects on competitive allocations. This financial structure also assumes that foreigners do not own domestic capital, although it is possible for domestic agents to borrow from world markets to finance investment projects.
In this utility function, the rate of time preference, exp[v(·)], increases with the level of past consumption in order to obtain a well-defined unique invariant limiting distribution of the state variables—as demonstrated by Epstein (1983). Obstfeld (1981) used the deterministic analog of this utility function, following Uzawa (1968), to obtain a well-defined steady state for foreign asset holdings in a small open economy. Epstein also showed that SCU is suitable for dynamic programming, that with it consumption in every period is a normal good, and that the conditions it requires restrain the variability of the rate of time preference so that major deviations from the standard time–separable setup are avoided
Labor supply is determined by a condition that equates the marginal product of labor with the marginal desutility of providing labor services, independently of the marginal utility of consumption. This implies that the labor supply choice can be separated from the dynamics of consumption in the dynamic programming problem described next.
This method is due to Bertsekas (1976) and was introduced to macroeconomic models by Sargent (1980). Greenwood, Hercowitz, and Huffman (1988) used it to simulate a closed-economy real business cycle model and Mendoza (1991a) used it to solve a small open economy model. The technique calculates exactly the unique invariant joint limiting distribution of the state variables using an algorithm that solves the functional equation problem for a discrete version of the state space (see Mendoza (1991a) for a detailed description).
Razin and Rose (1992) also argue that output variability increases with trade liberalization because of the specialization trends that follow from perfect mobility of goods.
The present value of the trade balance must be zero to satisfy the resource constraint. Hence the initial worsening of the trade balance is offset with several periods of improvement.