Closing Small and "Sufficiently" Large Open Economies with Different Asset Structures
Abstract
There are two important dimensions that matter when we write down a model economy of a country that is open to international financial markets. The first one is its size, and the second one is its asset market structure. Small open economies are price takers so the analysis happens in partial equilibrium, while countries that are “sufficiently" large can affect international prices and the analysis happens in general equilibrium. The second important dimension is the asset market structure. If markets are complete there is full risk sharing, while if markets are incomplete there is not. In this paper I explore how these two dimensions—size and market structure—affect the conditions for the existence and the uniqueness of the equilibrium in economic models, and discuss how to achieve those conditions when they are not present. I finish by discussing how these implications change when a tax on the return to net foreign assets is introduced, generating endogenous incomplete markets.
Introduction
What is the difference between a small open economy and a “sufficiently” large open economy? If a country is small, demand and supply decisions in that economy have no bearing on prices for the rest of the world or any other country that they interact with (as long as that country is larger than they are). In other words, small open economies are price takers, and the analysis undertaken is in partial equilibrium. However, when we think about a country that is “sufficiently” large to affect world prices, things are different. In these cases, general equilibrium effects are important. Their demand and supply decisions affect the rest of the world, including any other country they interact with. Furthermore, the size of a country and its ability to repay its debts also has a bearing on the degree to which that country can share risk. These differences have implications for the existence and uniqueness of the equilibrium in a model economy.
To illustrate these differences from a theoretical standpoint, in this article I explore and analyze the conditions for the equilibrium in five different scenarios. I start with the small open economy setting with incomplete markets, followed by the small open economy setting with complete markets. I then move to the cases of sufficiently large economies with both incomplete and complete markets; I finish with the case of a sufficiently large economy with complete markets and a tax on the return to net foreign assets, which effectively generates endogenous incomplete markets.
I show how small open economy models with incomplete markets have a non-stationarity and discuss different alternatives already present in the literature to resolve this issue. Small open economy models with complete markets do not have this problem because consumption can be pinned down as a fraction of the rest of the world or another country’s consumption. Sufficiently large countries, however, have a non-stationarity that cannot be resolved by having complete markets. This is because the consumption of the other country (or of the rest of the world) cannot be taken as exogenous and consumption cannot be pinned down relative to the other country’s. In both the complete markets and the incomplete markets cases, only the growth rate of consumption is determined and not the level, implying that the equilibrium is dependent on initial conditions. Finally, I show that in the case of a sufficiently large economy with complete markets and a tax on the return to net foreign assets, initial conditions are not enough. Not only should the tax be zero in the long run, but one of the methods to restore stationarity in a small open economy model with incomplete markets should be used as well.
Citation
Paulina Restrepo-Echavarría, "Closing Small and "Sufficiently" Large Open Economies with Different Asset Structures," Federal Reserve Bank of St. Louis Review, Fourth Quarter 2024, Vol. 106, No. 13, pp. 1-8.
https://doi.org/10.20955/r.106.13
Editors in Chief
Michael Owyang and Juan Sanchez
This journal of scholarly research delves into monetary policy, macroeconomics, and more. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System. View the full archive (pre-2018).
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