A small open economy model with transaction costs in foreign capital

Abstract

In this paper we develop a stochastic dynamic general equilibrium model for a small open economy in the real business cycle modeling tradition. Household preferences depend on private and public consumption and leisure. Production technology depends on public capital. Government finances its investment, consumption and transfer payments by means of a proportional income tax rate. Households buy and sell foreign assets in an international capital market with transaction costs and also receive transfer payments from abroad. We calibrate the model for the Greek economy. The volatility, persistence, and co-movement properties of the business cycle component of the data generated by the model are broadly consistent with the actual behavior of the corresponding actual data. We use the model to investigate the response of major macroeconomic variables to temporary and permanent changes in government policy variables, foreign transfers, and the rate on return of foreign assets. We find that increasing government consumption and domestic transfers financed through distorting taxation lowers capital, labor (in most cases) and output while it increases foreign asset holdings, both in the short and the long run. Increasing government investment financed by distorting taxation eventually increases capital and output and decreases labor. Finally transfers from abroad decrease capital, labor and output, while they increase consumption.