How Uzawa Preferences Improve the Simulation Properties of the Small Open Economy

This paper compares a form of preferences introduced by Uzawa with additive preferences by simulating for a small open economy the optimal consumption response to permanent and temporary shocks to the world rate of interest. In simulations of permanent changes to the rate of interest, additive preferences suffer from the apparent disadvantage of requiring the rate of time preference to be changed exogenously. They also make optimal current account balances and foreign debt levels excessively sensitive to permanent and temporary changes in the world rate of interest. The simulations show that a linear specification of Uzawa preferences can have a similar pattern to simulations using additive preferences but have the advantage of yielding levels of current account deficits and foreign debt that do not exceed the actual levels observed in these variables for most economies. The paper includes a practical application using Uzawa preferences. This application calculates the impact on the prospective aging structure of Australia's population on the optimal rate of saving. The application shows that Uzawa preferences considerably reduce the optimal response of saving to the prospective aging of the Australian population