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The evidence presented in Click (1998) suggests that such shocks are indeed an important feature of the data. In a large cross-section of countries he finds that most permanent government spending is financed by conventional tax revenue. But transitory government spending (which has a high standard deviation in developing countries) is financed mainly by seigniorage.
See also Sargent and Smith (1988) on the irrelevance of open market operations in foreign currencies.
There is a well-established and growing literature on default risk. The early contributions include Eaton and Gersovitz (1981) and Aizenman (1989). More recent contributions include Kehoe and Perri (2002) and Kletzer and Wright (2000).
Useful surveys of the technical aspects of stochastic optimal control are contained in Chow (1979), Fleming and Rishel (1975), Malliaris and Brock (1982), Karatzas and Shreve (1991), and Duffie (1996). The seminal papers using this technique to analyze macroeconomic portfolio selection are Merton (1969, 1971) and Cox, Ingersoll and Ross (1985).
A nonzero drift would affect feasible choices for the inflation target. But because this does not affect the presence or transmission mechanism of a portfolio channel, we ignore it without loss of generality.
As we will see, this may, but need not, imply that financial markets are incomplete.
Introducing the endowment stream is not essential for the theoretical model, but it is important to make a link between the model and the data, as described in Section 3. The issue is that in practice the financial assets that we model in detail represent a smaller share of household income than non-financial sources.
Schmitt-Grohe and Uribe (2003) discuss computational reasons for adopting this device. Kollmann (2003) discusses calibration of the debt elasticity of interest rates based on international portfolio data.
Subsequent discontinuous exchange rate jumps are ruled out by arbitrage.
Note that Δh0 need not equal h0 — ho_, because the policy itself may in addition involve the purchase or sale of foreign exchange reserves against domestic money or bonds at the new exchange rate E0.
This formulation treats government issued and central bank issued domestic currency bonds as perfect substitutes, so that qt could represent either debt class. Note that qt could be negative and represent government claims on the private sector. In that case ht could also be negative. Given that the model makes no distinction between government and the central bank, we will refer to all policies, fiscal and monetary, as being carried out by government.
This result is consistent with the empirical results of Reinhart, Rogoff and Savastano (2003), who find that inflation is consistently more variable in countries with a high degree of liability dollarization, including government liability dollarization.
Recall that condition (18) ensures that household wealth will be continuous at the time of implementation of a new policy.
The two data sources are International Financial Statistics (IFS) and Banco de Mexico. The data series for
Below we construct a model consistent sample average of aggregate wealth a, but not its time series.
This is closely related to the problem of distinguishing fiscally dominant and monetary dominant policy regimes in the data, see Canzoneri, Cumby and Diba (2001).
If the real annual financial returns on Mexican government debt are multiplied by 0.241−1, the resulting figure equals roughly 2% of annual consumption, in line with our earlier assumption about the fraction of consumption financed by financial asset income.
Identifying the shock processes requires estimating continuous-time diffusion processes from a discrete sample. Aït-Sahalia (2002) shows that this can be quite complex in general settings, but Campbell, Lo and MacKinlay (1997, Ch. 9) show that geometric Brownian motion processes can be estimated in a straightforward fashion by maximum likelihood.