Behaviour of model variables (with and without a country

country asymmetry)

In this section, we present the results of …rst-order dynamics of the model. To better see how the presence of the country asymmetry and global imbalances matter, we …rst report the results of the model in a symmetric case.

Figure3:3plots the case where the model is symmetrically parameterized such that = = 0:97. This …gure shows the …rst-order behaviour of the model

0 5 10 15 20 -0.05 0 0.05 0 5 10 15 20 -10 0 10 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 -0.5 0 0.5 1 0 5 10 15 20 -0.5 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 ε ε*

Figure 3.3: IRFs of the model to home (solid line) and foreign (dashed line) shocks: Symmetric case

0 5 10 15 20 -0.1 0 0.1 0 5 10 15 20 -15 -10 -5 0 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 -0.5 0 0.5 1 0 5 10 15 20 -0.5 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 0 5 10 15 20 0 0.5 1 ε ε*

Figure 3.4: IRFs of the model to home (solid line) and foreign (dashed line) shocks: Asymmetric case

after a1 percent positive shock to home (solid line) or/and foreign (dashed line) endowments. Endowments are shown in Panel (j). Panels (a) to (h) are thus respectively the response of the consumption di¤erential, home N F A (relative toy), home and foreign consumption, home and foreign asset returns, and home and foreign asset prices. Panel(i)shows responses of new-born’s consumption in the two countries. We use this to represent the case of a symmetric model even though in the literature, these models feature representative agents. Except for inclusion of new-born’s consumption, the dynamics of the model is similar to a standard model without overlapping generations.

Let us look at the solid lines …rst. In response to a positive shock to the home endowment, consumption in both country rises as shown in Panels (c)

and (d). With the shock decaying, consumption decrease gradually towards the steady state. With current consumption being higher than future consumption, expected future interest rates are driven down according to the Euler equations. That is r^1 and r^2 are equal and both below 0from the second period onwards as

seen in Panels (e) and (f). The sum of the discounted expected future interest rates, rn_{; is thus also negative which pushes up asset prices z^}

1 and z^2. Given

that the shock hits the home country, higher expected future dividend drives up the price of the home asset z^1 further, i.e. z^1 > z^2, as shown in Panels (g) and

(h). As there are capital gains, the higher price of the foreign equity implies a higher current rate of return to the foreign equity which explains the …rst period increase in r^2t in Panel (f). By the same token, r^1t will be also higher due to a

higher z^1. On top of this, a higher current dividend payment means ^r1t increase

even further, i.e. r^1t > r^2t or r^xt > 0. With gross external positions across

countries in the model, the rise in r^xt implies a wealth transfer from the home

country to the foreign country, i.e. a negative V AL e¤ect. This e¤ect is so big that it exceeds that of the initial trade surplus. So the net foreign asset position of the home country, w^t; declines, as shown in Panel (b). Lastly, as shown in

Panel (i), new-born’s consumption shows a persistent increase, consistent with Eq.(3:6).

Now let us look at the dashed lines which describe the model responses after a positive foreign shock. It is obvious that the dynamics are symmetric to above dynamics in the sense that the responses of home (foreign) variables now is just the responses of foreign (home) variables, which is easy to understand because

the home country in this case steps into the foreign country’s previous shoes. Now let us turn to the asymmetric case where < . Figure 3:4 depicts the corresponding dynamics. The panels represent responses of variables in the same sequence as in Figure 3:3.

We …nd that, except for w^t, the responses of variables does not change very

much when the asymmetry is introduced. They are qualitatively the same but with quantitative di¤erences re‡ecting the introduction of the country asymme- try. The symmetry between the responses to the two shocks (i.e. the solid and dashed lines) that exists in Figure 3:3therefore breaks down.

With preservation of the qualitative properties of the variable responses, im- portantly, as previously, a positive home shock still raises the rate of return of the home asset more than that of foreign asset. In terms of our previous notation, this implies 0 < _re1 < _re2. The sum of discounted expected future interest rates on impact is depressed and responds to home and foreign shocks to the same degree, i.e. 0> _sre1 = _sre2.

As forw^t, a positive home shock still involves a positive trade balance e¤ect

and a negative valuation e¤ect due to, as explained, the facts of r^xt > 0 and a

negative external gross position of the home equity by the home country. In addi- tion, under the asymmetric parameterization < , the home country features a large negative net external position. The attendant rise in ^r2 after the shock

also burdens the home country’s interest payments to the foreign country. A negative terms-of-trade e¤ect thus emerges, which reinforces the valuation e¤ect in worsening the net external balance. w^t (the solid line in Figure 3:4) declines

further in comparison to that in Figure 3:3. Following similar logic, a positive foreign shock involves a negative trade balance e¤ect and a positive valuation e¤ect in the home country. And because the shock hits the foreign country en- dowment, r^2t increases even more signi…cantly than in the last case. Given the

steady-state external net position in the home country, the total interest pay- ments rises substantially, i.e. a negative terms-of-trade e¤ect emerges again. w^t

(the dashed line in Figure 3:4) is lower than in the symmetric case (the dashed line in Figure 3:3).