Basic Small Country IRBC Model

Mendoza(1991)AER
- They use Canadian data.
- Basic model has no adjustment costs of capital stock.
- Trade Balance is not negatively correlated with output in case relative risk aversion is high (GAMMA = 2). In case of GAMMA = 1.001, the correlation becomes negative, but the number is small. Further, if including capital adjustment costs, the correlation of them can be close to the actual data.
- Savings is not highly correlated with investments, but if including capital adjustment costs, the correlation of them can be close to the actual data.

Benchmark Model
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In general, the benchmark model is capable of mimicking the ranking of variability of the actual aggregates, and it is also consistent with some of the coefficients of autocorrelation and correlation with domestic output. Of special interest is the fact that the model mimics the absence of comovement between GDP and foreign interest payments or the trade-balance:output ratio (TB/ Y). This contrasts with the less favorable results obtained in previous empirical studies of intertemporal-equilibrium models of the current account (e.g., Ahmed, 1986; Hercowitz, 1986b).

The low correlation between S and I in the benchmark model is not related to the degree of international capital mobility. Instead, it follows from the low degree of serial autocorrelation of the shocks used to calibrate the model. With RHO = 0.36, the productivity shocks are not persistent enough to cause sufficient divergence between the expected marginal productivity of capital and the world's real interest rate to produce a stronger correlation between S and I. If, for instance, RHO is increased to 0.99, the degree of correlation between savings and investment reaches 0.8. Thus, although the benchmark model cannot mimic simultaneously the stylized facts of GDP and the correlation between savings and investment, it does support the argument presented by Obstfeld (1986) and Finn (1990), claiming that the intensity of the comovement between S and I in economies with perfect capital mobility depends on the degree of persistence of the underlying technological disturbances.
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Adjustment Cost Model
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Perhaps the most significant result produced by these simulations is that the adjustment-cost model is capable of mimicking the two striking empirical regularities of open economies mentioned in the Introduction. Regardless of the value assigned to GAMMA, this model mimics the variability and GDP-correlation of the ratio of the trade balance to output, as well as the correlation between savings and investment. In fact, the comovement between S and I is slightly higher in both artificial economies than in the data, and this occurs without affecting the perfect international mobility of financial capital.

The introduction of moderate adjustment costs increases the persistence of the disturbances needed to calibrate the model, and with more permanent shocks investment tends to move closer together with savings, as Obstfeld (1986) suggested. Moreover, in line with the findings of Dooley et al. (1987), the perfect mobility of financial capital proves to be consistent not only with the correlation between S and I, but also with adjustment costs that prevent fast changes in physical capital.

The model mimics the variability and GDP correlation of TB/ Y because, in the presence of adjustment costs, the shocks that enable the model to mimic the stylized facts are expected to last long enough for the pro-borrowing effect, caused by an expected expansion of future output, to compensate for the pro-saving effect induced by a raise in contemporaneous output. These simulations suggest, therefore, that the intertemporal-equilibrium approach to the current account can be consistent with the empirical regularities of the business cycle.

The simulations also shed some light on a problem confronted by some empirical models of adjustment costs. As pointed out by Sargent (1978), these models generally produce reduced-form autoregressions in which highly persistent shocks cannot be distinguished from significant adjustment costs. Similarly, in the model studied here the variability of investment can be reduced by increasing the serial autocorrelation of the shocks, RHO, instead of introducing the adjustment costs. An increase in RHO reduces the probability of moving to the opposite state of productivity and lessens the chances of adjusting the capital stock, thereby reducing the variability of investment. However, the resulting persistence of the disturbances is too high and causes the model to exaggerate the actual moments. For instance, with GAMMA = 2 and PHI = 0, if RHO is set to 0.9 the variability of I falls to 5.4 percent, but the variability of GDP rises to 5 percent, and its serial autocorrelation is almost perfect. Thus, the simulations establish the relevance of adjustment costs relative to highly persistent shocks by showing that the latter are not consistent with the business cycle.
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Appendix
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The model studied here also differs from the standard real-business-cycle prototypein its use of an endogenous rate of time preference to determine a well-defined stationary equilibrium for the holdings of foreignassets. This approach was introduced by Obstfeld (1981), following the principles formulated by Hirofumi Uzawa (1968), to analyze current-account dynamics in a deterministic model of a small open economy.
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