Equilibrium Indeterminacy in a Small Open Economy with Traded and Non-Traded Capital

Abstract

This paper presents the necessary conditions for equilibrium indeterminacy in a small open economy under partial capital mobility. In order to have meaningful transitional dynamics of consumption and capital, I assume that the economy uses two kinds of capital as inputs － traded capital and non-traded capital － and households can borrow from foreigners only with traded capital as collateral. Non-traded capital must be accumulated out of domestic savings, even with the free access to the world capital market. Benabib and Farmer (1994) argue that a representative agent model such as the standard RBC model requires a high degree of increasing returns to scale to cause indeterminacy in equilibrium path. Unlike the closed economy model of Benabib and Farmer (1994), equilibrium indeterminacy is shown to arise with a much weaker degree of increasing returns to scale in an open economy environment. This result implies that opening the capital market makes the small economy more vulnerable to the ‘animal spirits’ of investors. The fact that only the net returns to traded capital equal the world interest rate at all points in time plays an important role in determining the results.