A Redux of the Workhorse NOEM Model with Capital Accumulation and Incomplete Asset Markets

Abstract

I build a symmetric two-country model that incorporates nominal rigidities, local-currency pricing and monopolistic competition distorting the goods markets. The model is similar to the framework developed in Martinez-Garcia and Sondergaard (2008a, 2008b), but it also introduces frictions in the assets markets by restricting the financial assets available to two uncontingent nominal bonds in zero-net supply and by adding quadratic costs on international borrowing (see, e.g., Benigno and Thoenissen (2008) and Benigno (2009). The technical part of the paper contains three basic calculations. First, I derive the equilibrium conditions of the open economy model under local-currency pricing and incomplete asset markets. Second, I compute the zero-inflation (deterministic) steady state and discuss what happens with a non-zero net foreign asset position. Third, I derive the log-linearization of the equilibrium conditions around the deterministic steady state. The quantitative part of the paper aims to give a broad overview of the role that incomplete international asset markets can play in accounting for the persistence and volatility of the real exchange rate. I find that the simulation of the incomplete and complete asset markets models is almost indistinguishable whenever the business cycle is driven primarily by either non-persistent monetary or persistent productivity (but not permanent) shocks. In turn, asset market incompleteness has more sizeable wealth effects whenever the cycle is driven by persistent (but not permanent) investment-specific technology shocks, resulting in significantly lower real exchange rate volatility.