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I would like to thank participants and discussants to seminars at the Federal Reserve Bank of Minneapolis, La Pietra-Mondragone Workshop, Washington University in St. Louis, Bank of Italy, Federal Reserve Board, Federal Reserve New York, Federal Reserve San Francisco, University of Padova, Bank of Canada, North American Econometric Society 2009, EIEF, LUISS and to the Workshop in International Economics at the University of Minnesota. In particular, I have greatly benefited from discussions with Fabrizio Perri, Timothy Kehoe, Cristina Arellano, V.V. Chari, Patrick Kehoe, Victor Rios-Rull, Michele Boldrin, Enrique Mendoza and Martin Schneider. Any remaining errors are the authors’ responsibility.
For η ∈ (0; 1), the Pareto distribution has no finite first and second moment. This is of no consequence in the model. Low values for η give a distribution with a fat tail, which create beliefs that place a lot of mass on large realizations of
Combining (6) and (8) we see that focusing on Markov equilibria restricts us to equilibria with a balanced growth rate
As we will see, this is indeed equivalent to requiring that the equilibrium growth rate of aggregate capital is always non negative. The condition will also be interpreted as assuming that output costs, arising from financial autarky, cannot be so high as to reduce the household’s net return on capital below the international risk free rate.
In what follows it is understood that
Appendix A shows how the model with jumps is formally derived by solving (11) and (12) with an additional constraint
The process may not be deterministic, since households that default along the equilibrium path face idiosyncratic punishment durations. Idiosyncratic shocks are irrelevant for aggregation purposes.
Our parsimonious choice of the aggregate state S = w excludes the possibility of transitional dynamics to the balanced growth occurring up to the turning point, before which the aggregate state is constant
In a boom-bust equilibrium, the GDP at the turning point time
Fat tail distributions, used in extreme value theory, are defined as having the property that, for some constant c and η > 0,