Dynamics of Open Economy Models: What Is the Role of the Discount Factor?

This paper examines the dynamic implications of the use of an endogenous discount factor in small open economy models. We first present a stochastic dynamic model of a small open economy with an endogenous discount factor. Then, we examine the same model with a fixed discount factor. We calibrate both models for a representative small open economy and then simulate them to examine the moment implications to help understand the impact of the preference formulation on model dynamics. We study the quantitative responses of the model variables to shocks in technology and real interest rates. Our results suggest that while the use of an endogenous discount factor helps researchers to define a stable stochastic steady state, the dynamic implications of the two models can be quite similar depending on the parameters of the model.