This paper discusses the macroeconomic role of risk in a small open economy, using a stochastic CGE model of an open economy. The stochastic properties of the model derive from uncertainty about the rate of return to foreign bonds and to domestic capital. The return to domestic capital depends on labor productivity shocks and is not perfectly correlated with the return on foreign bonds. Households therefore have a diversification motive to adjust their portfolio so that the same stochastic discount factor applies to both bond returns and equity returns. The uncertain return on the portfolio generates a risk premium that depends on the level of wealth and affects the saving decisions of risk-averse households. Households choose their consumption of goods and leisure to optimally smooth consumption over time. The utility function is of the non-expected utility form, so that the smoothing incentive may differ from the diversification incentive. Because the return to capital is volatile, and potentially negative, households that issue debt to finance the purchase of equity run the risk of not being able to repay the debt. I assume that an insurance market for this risk does not exist, which implies that poor households are liquidity constrained.
Firms offer the same uncertain return to domestic and foreign investors alike. The uncertainty derives from correlated shocks to labor productivity. A favorable shock today increases the probability that labor productivity will be high tomorrow as well. This boosts the return to capital. Investors shift their portfolio towards equity. Depending on the tax policy of the government, other state variables may also influence firm decisions. The firm optimization problem is simple enough to allow for an analytic solution (conditional on the return process).
The government pursues a balanced-budget policy. Tax rates fluctuate randomly in response to fluctuations in tax receipts. Because of the small open economy assumption, saving and investment are not linked and the return to bonds is exogenous. The return to equity is endogenous, however, as a result of the assumption that all stock is held by domestic investors.
The remainder of this paper is subdivided as follows: Section 2 discusses the model of the firm and the stochastic return process on capital. Section 3 presents the household model and discusses the risk premium. The valuation of assets within complete and incomplete markets is discussed in Section 4. Section 5 specifies the budget restriction for the government and the closure rule, while Section 6 presents a simple model of foreign investors and foreign interest rates. Equilibrium conditions are discussed in Section 7. Calibration issues are discussed in Section 8 and computational results of the model are presented in Section 9. Section 10 concludes with a discussion of the items that are missing from this model, and what might be the best way to proceed.
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Endogenous Risk in Computable General Equilibrium Models
