The Global Economy Model (GEM):

Theoretical Framework
+
Paolo Pesenti
Federal Reserve Bank of New York, NBER and CEPR
This draft: January 2008

The views expressed here are those of the author, and do not necessarily reect the position
of the International Monetary Fund, the Federal Reserve Bank of New York, the Federal Reserve
System, or any other institution with which the author is aliated.
Contents
1 Introduction 2
2 Peeking inside the box: model structure and basic notation 2
3 General considerations 3
3.1 Country size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.1.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.2 Growth trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.3 Prices and ination rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.3.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.4 Notational conventions and other formal aspects . . . . . . . . . . . . . . . . 5
4 The domestic macroeconomy in partial equilibrium 5
4.1 Final goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.1.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 Demand for intermediate goods . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.2.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
4.3 Supply of intermediate goods . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
4.3.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4.4 Price setting in the nontradables sector . . . . . . . . . . . . . . . . . . . . . 11
4.4.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
4.5 Price setting in the tradables sector . . . . . . . . . . . . . . . . . . . . . . . 13
4.6 Consumer preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
4.6.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
4.7 Budget constraint (forward-looking households) . . . . . . . . . . . . . . . . 15
4.7.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.8 Consumer optimization (forward-looking households) . . . . . . . . . . . . . . 17
4.8.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.9 Consumer optimization (liquidity-constrained households) . . . . . . . . . . . 20
4.9.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.10 Fiscal policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.10.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.11 Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.11.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
4.12 Market clearing in the domestic economy . . . . . . . . . . . . . . . . . . . . 23
5 World interdependencies in general equilibrium 24
5.1 Demand for imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
5.1.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
5.2 Price setting in the tradables sector and exchange rate pass-through . . . . . 26
5.2.1 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.3 Market clearing in the world economy . . . . . . . . . . . . . . . . . . . . . . 28
5.4 Measuring output and trade balance . . . . . . . . . . . . . . . . . . . . . . . 29
1
1 Introduction
This paper has two purposes. First, it provides a thorough exposition of the theoretical
framework underlying the Global Economy Model (GEM), as the model stands around
early 2008. Second, it discusses a number of variants and alternative features considered in
the GEM-related literature since Laxton and Pesenti (2003). For an updated survey of GEM
and other DSGE applications at the IMF the reader is referred to Botman et al (2007).
In what follows, each section starts with a formal description of the relevant equations,
and is followed by a presentation of modeling variants and options. When appropriate, the
section provides a more detailed discussion of how the building blocks of GEM relate to the
literature. It is worth emphasizing from the very beginning that the paper is meant to be
used as a technical reference on GEM and related models, with apologies for the somewhat
pedantic attention to details and formulas that stems directly from this premise.
The paper is organized as follows. Section 2 provides an intuitive presentation of the
structure of the model and introduces the reader to its basic notation. Section 3 discusses
general elements and formal aspects of GEM. Section 4 describes the country-specic build-
ing blocks of GEM, treating as exogenous the variables related to international trade in prod-
ucts and assets (a partial-equilibrium approach suitable to modeling small open economies).
Section 5 introduces international interdependencies and considers the full-edged general-
equilibrium version of the model. Consistent with the open nature of GEM as well as the
purpose of this contribution, there is no conclusion.
2 Peeking inside the box: model structure and basic
notation
Building on recent theoretical developments in international nance and monetary eco-
nomics, especially the New Open-Economy Macroeconomics literature since the seminal
contributions of Maurice Obstfeld and Kenneth Rogo (1995, 2000, 2002), GEM aims to
provide an optimizing intertemporal framework capable of addressing basic policy questions
involving international transmission of policy and structural shocks, while reproducing key
elements of macroeconomic interdependence among countries and regional blocs.
Like other recent dynamic, stochastic, general-equilibrium (DSGE) models, the design
of GEM combines the long-run properties of real business cycle models with short-run
Keynesian dynamics stemming from nominal rigidities and inertia in the ination process.
While obviously indebted to the classic Mundell-Fleming-Dornbusch tradition, GEM builds
on explicit microfoundations allowing for a tightly integrated treatment of positive elements
and welfare considerations.
A useful way to approaching GEM is by familiarizing with its broad characteristics and
notation with the help of a visual representation. Figure 1 illustrates the key macroeconomic
variables in a representative country.
Consider rst the households sector. Each household consumes a nal good (C in Figure
1), and supplies labor (/) to all domestic rms. Some households do not have access to capital
markets. They nance their consumption exclusively through disposable labor incomes. The
remaining households own the portfolio of domestic rms and the domestic capital stock
(1), which they rent to domestic rms. They also buy and sell two bonds: a domestic bond
denominated in domestic currency, and an international bond issued in zero net supply
worldwide. When households sell or purchase the international bond they pay a premium
2
to nancial intermediaries, whose size is a function of the aggregate net asset position of the
country. Labor and physical capital are immobile internationally. The market for capital is
competitive, and capital accumulation is subject to adjustment costs. In the labor market
wage contracts are subject to nominal rigidities.
On the production side, rms produce the nal goods, an array of dierentiated inter-
mediate goods, and provide intermediation services.
In each country there are two nal goods a consumption good () and an investment
good (1) produced by perfectly competitive rms. The consumption good is consumed
either by domestic households or by the government (G
c
). Similarly, demand for the in-
vestment good is split between private agents (1) and the public sector (G
1
). Final goods
are produced by using all available intermediate goods as inputs.
There are many varieties of intermediate goods, each produced by a single rm under
conditions of monopolistic competition. Each intermediate good is produced by using do-
mestic labor inputs and domestic capital. Intermediate goods are either nontraded () or
traded internationally (T). The nontraded intermediate goods can be purchased by the
government (G

) or used in the production of the nal goods (

). Domestic tradables
used by domestic rms are denoted Q, imports from all other country blocs are denoted '.
Imports are subject to short-term adjustment costs that temporarily lower the response of
demand to changes in relative prices. Prices of intermediate goods are subject to adjustment
costs (nominal price rigidities).
Finally, the government purchases the two national nal goods, as well as nontradable
services. As treasury, the government nances its expenditures with net taxes on the do-
mestic private sector. As central bank, the government manages the national short-term
nominal interest rate. Monetary policy is specied in terms of a credible commitment to
guarantee price stability by managing the domestic nominal short-term interest rate.
3 General considerations
3.1 Country size
The world economy consists of a set A of regional blocs (countries). The size of the world
economy is normalized to one. The size of each country H is denoted :
1
, with 0 < :
1
< 1
and

1
:
1
= 1 for H A. The country size measures the world share of private agents
who are resident in the country: both households and rms in country H are dened over
a continuum of mass :
1
.
3.1.1 Discussion
For applications focused on short- and medium-term analysis, the country size :
1
can be
treated as a constant parameter. This specication is problematic in simulation exercises
in which one or more countries grow for a prolonged period of time below (or above) the
common trend (the latter is dened in Section 3.2 below). In these cases, maintaining
the country size constant over time leads to an upward (downward) bias of the long-term
economic relevance of these countries in a global context. Also, since the number of product
varieties and labor inputs in each country is normalized to :
1
, constant country sizes imply
that the sectoral extensive margins (the number of rms and varieties in any given sector)
remain constant over time as well, and there is no labor immigration. For the time being,
the current version of GEM does not encompass endogenous rms entry and exit across
3
sectors and countries. A possible way to deal with these issues is to let :
1
be time-varying
and equal (for instance) to the size of G11 (or alternative measures of a countrys economy)
in country H relative to the world G11. The model-based notion of G11 is discussed later
in Section 5.4.
3.2 Growth trend
There is a common stochastic trend for the world economy (the variable T111), whose
gross rate of growth between time t and time t is denoted q
|,r
= T111
r
,T111
|
.
All quantity variables in each country are expressed in detrended terms, that is as ratios of
T111. The exception is labor eort /, bounded by endowment. In the long run q
|,|+1
converges to q
SS
and q
|,r
converges to q
r|
SS
, where q
SS
is a constant.
3.2.1 Discussion
Each (detrended) real variable is stationary, that is converges to a well-dened steady-state
level. This applies to all relative prices, including terms of trade and real exchange rates.
In the long term there is balanced growth (at the rate q) across countries and sectors. The
assumption is less restrictive than it appears, as it is always possible to engineer persistent
(albeit not permanent) deviations from balanced growth for an arbitrarily long period of
time. Variants of the model could be considered to account for unit roots in relative prices,
but they are not discussed here.
3.3 Prices and ination rates
As a convention throughout the model, nominal prices expressed in domestic currency are
denoted with uppercase variables, while relative prices are denoted with lowercase variables.
Without loss of generality, in each country the consumption good is the numeraire of the
economy and all national relative prices are expressed in terms of domestic consumption
units, that is relative to the Consumer Price Index (CPI). For instance, if 1
.
denotes the
nominal CPI and 1
J
the nominal price of one unit of the 1 good, j
J
= 1
J
,1
.
denotes the
price of one unit of 1 in terms of . Of course, by denition we have j
.
= 1.
Also we denote the (gross) CPI ination rate between time t and time t with
|,r
=
1
.,r
,1
.,|
. The ination rate in sector 1 is therefore equal to:

J|,r
=
j
J,r
j
J,|

|,r
(1)
In steady state the ination rate
|,|+1
converges to
SS
and
|,r
converges to
r|
SS
, where

SS
is a constant equal to the ination target of the government.
3.3.1 Discussion
GEM is coded up after transforming all prices in relative terms, so that nominal prices do
not appear in the model. Precisely for the same reason why all quantities are dened in
detrended terms, by normalizing all prices relative to the domestic nominal trend 1
.
we
avoid dealing with unit roots, either nominal or real, in quantitative simulations of the model
over very long time horizons. Since the ination rate
|,r
is part of the model solution, one
can always reconstruct the nominal path for the CPI level by arbitrarily setting the value of
1
.
at some initial time t = 0 and computing 1
.,|
= 1
.,0

0,|
. In the main text we typically
4
adopt the notation with relative (lowercase) prices. We only switch to the notation with
nominal (uppercase) variables when appropriate in order to simplify the exposition.
As observed above, all relative prices j converge to well-dened steady-state levels. If two
countries have dierent steady-state ination rates, reecting dierent policy preferences for
the domestic nominal anchor, in steady state the nominal exchange rate between the two
countries depreciates at a rate equal to the dierence between the two ination rates while
the CPI-based real exchange rate remains constant. We return on this point in Section 4.8.
Usually ination variables carry a double time index. In most applications time t is
measured in quarters, so that
|1,|
measures the quarterly ination rate at time t, (
|1,|
)
4
measures the annualized quarterly ination rate at time t, and
|4,|
measures the year-on-
year ination rate at time t. When there is no risk of confusion, we adopt the notation
|
as shorthand for quarterly ination
|1,|
.
3.4 Notational conventions and other formal aspects
The convention throughout the model is that variables which are not explicitly indexed
(to rms or households) are expressed in domestic per-capita terms. For instance,
|
=
(1,:)
_
s
0

|
(r)dr and /
|
= (1,:)
__
s
0
/
|
(:)d:
_
s
0
/
|
(/)d/
_
. Variables without time indexes
as well as variables with subscript oo are used interchangeably to denote steady-state levels.
For instance, q
SS
= q.
GEM allows for a rich menu of stochastic processes. As a general convention throughout
the model, when we state that variable A follows an autoregressive process, we mean that
the process for A is coded as:
A
|
= (1 `

) A
SS
`

A
|1
c
,|
(2)
where 0 < `

< 1, A
SS
is the steady-state value of A
|
, and c
,|
is an i.i.d. shock. If
variable A is strictly positive, a logarithmic transformation is considered:
lnA
|
= (1 `

) lnA
SS
`

lnA
|1
c
,|
(3)
Alternative specications can be introduced depending on the specic nature of the simu-
lation exercise.
It is worth emphasizing that GEM has been developed and coded up in non-linear
terms. This choice not only enhances the transparency of the model code relative to the
theoretical apparatus, but also allows for seamless higher-order extensions of the analysis
beyond the traditional rst-order approximations around the non-stochastic steady state.
This exibility is particularly relevant for welfare analyses involving at least second-order
expansions around the steady-state equilibrium. In one case below, however, we nd it
useful to focus the presentation on the linear approximations of the GEM equations, in
order to facilitate the comparison between our framework and similar analytical models.
4 The domestic macroeconomy in partial equilibrium
This section is devoted to the country-specic elements of the model that do not involve
international interactions. Thus, in what follows we consider a representative country under
the working assumption that trade-related variables are exogenous and determined outside
the equilibrium. For this reason, country-specic indexes play no role in this section. General
equilibrium considerations and a fuller notation involving country indexes are introduced in
Section 5.
5
4.1 Final goods
In each country there is a continuum of symmetric rms producing two nal goods, (the
consumption good) and 1 (the investment good). Both goods are produced under perfect
competition.
Consider rst the consumption sector. Each rm is indexed by r [0, :[. Firm rs
output at time t is denoted
|
(r). The consumption good is produced with the following
nested constant elasticity of substitution (CES) technology:

|
(r) = (1
.
)
1
z
.

.,|
(r)
1
1
z
.

1
z
.
.
[i
1
,
.
.
Q
.,|
(r)
1
1
,
.
(1 i
.
)
1
,
.
'
.,|
(r)
1
1
,
.
[
,
.
,
.
1

1
1
z
.

z
.
z
.
1
(4)
Three intermediate inputs are used in the production of the consumption good : a basket

.
of nontradable goods, a basket Q
.
of domestic tradable (import-competing) goods,
and a basket '
.
of imported goods. The elasticity of substitution between tradables and
nontradables is -
.
0, and the elasticity of substitution between domestic and imported
tradables is j
.
0. The weights of the three inputs are, respectively, 1
.
,
.
i
.
and

.
(1 i
.
) with 0 <
.
, i
.
< 1.
Firm r takes as given the prices of the three inputs and minimizes its costs j

.
(r)
j
Q
Q
.
(r) j
1.
'
.,|
(r) subject to the technological constraint (4). Cost minimization
implies that rm rs demands for intermediate inputs are:

.,|
(r) = (1
.
) j
:
.
,|

|
(r) (5)
Q
.,|
(r) =
.
i
.
j

.
Q,|
j

.
:
.
.,|

|
(r) (6)
'
.,|
(r) =
.
(1 i
.
) j

.
1.,|
j

.
:
.
.,|

|
(r) (7)
where j

, j
Q
and j
1.
are the relative prices of the inputs in terms of nal consumption
baskets, and j
.
is the cost-minimizing price of the composite basket of domestic and
foreign tradables, or:
j
.,|
=
_
i
.
j
1
.
Q,|
(1 i
.
) j
1
.
1.,|
_ 1
1,
.
(8)
The production technologies in the consumption and investment sectors can be quanti-
tatively dierent but their formal characterization is similar, with self-explanatory changes
in notation. For instance, a rm c [0, :[, that produces the investment good, demands
nontradable goods according to:

J,|
(c) = (1
J
) (j
,|
,j
J,|
)
:
1
1
|
(9)
4.1.1 Discussion
Note that j
1.
and j
1J
are sector-specic as they reect the dierent composition of
imports in the two sectors, while j

and j
Q
are identical across sectors. In Section 5.1
below we discuss the role of import adjustment costs and their eects on relative prices.
The weights
.
, i
.
,
J
and i
J
can be modeled as constant parameters or as autoregres-
sive processes. In the latter case, they can be interpreted as preference shifters, reecting
shifts in households consumption demand from tradables to nontradables, or from import-
competing goods to foreign imports.
6
The CES specication is notationally cumbersome but widely adopted in DSGE models
to allow for a exible parametrization of elasticities. Of course, when the elasticities are
equal to one the equations collapse to the traditional Cobb-Douglas specication. In most
applications the elasticities of substitution between import-competing goods and imports,
j
.
and j
J
, are likely to be larger than the elasticities of substitution between nontradables
and tradables, -
.
and -
J
. Note however that there are no theoretical restrictions on the
size of these elasticities.
4.2 Demand for intermediate goods
Intermediate inputs come in dierent varieties (brands) and are produced under conditions
of monopolistic competition. In each country there are two kinds of intermediate goods,
tradables and nontradables. Each kind is dened over a continuum of mass :. Without loss
of generality, we assume that each nontradable good is produced by a single domestic rm
indexed by : [0, :[, and each tradable good is produced by a rm / [0, :[.
Focusing rst on the basket
.
, this is a CES index of all domestic varieties of nontrad-
ables. Denoting as
.
(:, r) the demand by rm r of an intermediate good produced by
rm :, the basket
.
(r) is:

.,|
(r) =
_
_
1
:
_ 1
0
1
_
s
0

.,|
(:, r)
1
1
0
1
d:
_
0
1
0
1
1
(10)
where 0

1 denotes the elasticity of substitution among intermediate non-tradables.

Firm r takes as given the prices of the nontradable goods j(:) and minimizes its costs
_
s
0
j(:)
.,|
(:, r)d: subject to (10), obtaining:

.,|
(:, r) =
1
:
_
j
|
(:)
j
,|
_
0
1

.,|
(r) (11)
where j

(the Lagrange multiplier) is the cost-minimizing price of one unit of the non-
tradable basket, or:
j
,|
=
__
1
:
__
s
0
j
|
(:)
10
1
d:
_ 1
10
1
(12)
The basket
J
is similarly characterized. Aggregating across rms, and accounting for
public demand of nontradables here assumed to have the same composition as private
demand we obtain the total demand for good : as:
_
s
0

.,|
(:, r)dr
_
s
0

J,|
(:, c)dc G
,|
(:)
=
_
j
|
(:)
j
,|
_
0
1
(
.,|

J,|
G
,|
) =
_
j
|
(:)
j
,|
_
0
1

|
(13)
where
.,|
= (1,:)
_
s
0

.,|
(r)dr (and similar).
Following similar steps we can derive the domestic demand schedules for the intermediate
goods /:
_
s
0
Q
.,|
(/, r)dr
_
s
0
Q
J,|
(/, c)dc =
_
j
|
(/)
j
Q,|
_
0
J
Q
|
. (14)
Demand for imported intermediate goods will be characterized in Section 5.1 below.
7
4.2.1 Discussion
The elasticity of substitution 0, either in the nontradables or the tradables sector, can be
modeled as a constant parameter or as a time-varying stationary process.
In Section 5.2.1 we discuss how (13) changes when distribution services are considered.
4.3 Supply of intermediate goods
Each nontradable good : is produced with the following CES technology:

|
(:) = 7
,|
_
(1 c

)
1

1
/
|
(:)
1
1

1
c
1

1
|
(:)
1
1

1
_

1
1
(15)
Firm : uses labor /(:) and capital 1(:) to produce (:) units of its variety.

0 is the
elasticity of input substitution, and 7

is a stochastic process for productivity, common to

all producers of nontradables.
Following the notational convention regarding prices, we let :c
|
, n
|
and r
|
denote
marginal costs, wages and rental rates in consumption units. Firm : minimizes its costs
n
|
/
|
(:) r
|
1
|
(:) subject to (15). Cost minimization yields the marginal cost in nontrad-
ables production as:
:c
|
(:) =
1
7
,|
_
(1 c

) n
1
1
|
c

r
1
1
|
_ 1
1
1
(16)
and the capital-labor ratio is:
1
|
(:)
/
|
(:)
=
c

1 c

_
r
|
n
|
_

1
(17)
In each country, labor inputs are dierentiated and come in dierent varieties (skills).
Each input is associated to one household, dened over a continuum of mass equal to the
country size and indexed by , [0, :[. Each rm : uses a CES combination of all available
labor inputs:
/
|
(:) =
_
_
1
:
_ 1
;
1
_
s
0
/(:, ,)
1
1
;
1
d,
_
;
1
;
1
1
(18)
where /(:, ,) is the demand of labor input of type , by the producer of good : and c
J
1
is the elasticity of substitution among varieties of labor inputs.
Cost minimization implies that /(:, ,) is a function of the relative wage:
/
|
(:, ,) =
1
:
_
n
|
(,)
n
|
_
r
1
/
|
(:) (19)
where n(,) is the wage paid to labor input , and the wage index n is dened as:
n
|
=
__
1
:
__
s
0
n
|
(,)
1r
1
d,
_ 1
1;
1
(20)
Similar considerations hold for the production of tradables. We denote by T(/) the
supply of each intermediate tradable /. Using self-explanatory notation, we have:
T
|
(/) = 7
T,|
_
(1 c
T
)
1

J
/
|
(/)
1
1

J
c
1

J
T
1
|
(/)
1
1

J
_

J
1
(21)
8
where 7
T
is total factor productivity. Aggregating across rms, we obtain the total demand
for labor input , as:
_
s
0
/
|
(:, ,)d:
_
s
0
/
|
(/, ,)d/
=
_
n
|
(,)
n
|
_
r
1
1
:
__
s
0
/
|
(:)d:
_
s
0
/
|
(/)d/
_
=
_
n
|
(,)
n
|
_
r
1
/
|
(22)
where / is per-capita total labor in the economy.
4.3.1 Discussion
Recall that all variables are dened in detrended terms. The implicit assumption is that
in each country the eectiveness of labor eort / grows at the same rate as T111, so
that a shock 7 (either in the tradables or in the nontradables sector) is dened as a total
factor productivity deviation from the common world trend. The model allows for country-
specic changes in 7 that do not aect the long-run balanced-growth properties of the
model. Therefore, one can consider a scenario in which the level of 7 changes permanently,
or one in which 7 grows or falls for some time, but not a scenario in which 7 grows or falls
permanently in steady state. Variants of the model allow for the possibility of transitory
shocks to the eectiveness of labor or capital in addition to total factor productivity.
A variant of the model considered in Julliard et al (2006) introduces adjustment frictions
in the labor market. The adjustment terms reect the fact that it takes time for labor inputs
to be fully productive in production, so that from the viewpoint of national producers their
eective costs are higher in the short term than in steady state. Rewrite equation (15) as:

|
(:) = 7
,|
_
(1 c

)
1

1
/

|
(:)
1
1

1
c
1

1
|
(:)
1
1

1
_

1
1
(23)
where /

(:) is eective labor, dened as the product of two components:

/

|
(:) = /
|
(:) (1 I

[/
|
(:)[) (24)
In the expression above, /(:) is the same CES basket of dierentiated labor inputs as
dened in (18). However, now we assume that changes in labor are subject to rm-specic
adjustment costs. These costs are specied relative to the past observed level of labor
eort in the sector and are zero in steady state. Specically, I

[/(:)[ can be modeled as a

quadratic term:
I

[/
|
(:)[ =
c
J
2
_
/
|
(:)
/
,|1
1
_
2
(25)
where as usual /
,|1
= (1,:)
_
s
0
/
|1
(:)d:. In this case, expression (17) is replaced by
1
|
(:)
/

|
(:)
=
c

1 c

_
r
|
n
|
,(1 I
,|
(:) /
|
(:)I
0
,|
(:))
_

1
and the marginal cost :c(:) is given by:
:c
|
(:) =
1
7
,|
_
_
(1 c

)
_
n
|
1 I
,|
(:) /
|
(:)I
0
,|
(:)
_
1
1
c

r
1
1
|
_
_
1
1
1
(26)
9
The adjustment terms in the previous equation reect the fact that, if /
|
(:) diers from
/
,|1
, producers costs are temporarily higher to account for the losses of eciency associ-
ated with the change in labor inputs.
Another variant of GEM allows for heterogeneity in labor skills, to model situations in
which dierences between high- and low-skills workers may be relevant. As we discuss be-
low, there are two types of households, 1C-type households and 11-type households (these
indexes will be explained in Section 4.6 ). 11-type households represents a share (1 :
Jc
)
of domestic households and are indexed by , [0, : (1 :
Jc
)[. 1C-type households repre-
sent a share :
Jc
of domestic households and are indexed by , (: (1 :
Jc
) , :[. Suppose
each type of household supplies a dierent type of labor input, and each type comes in many
dierentiated varieties. In this case, (18) is replaced with:
/
|
(:) =
_
:
1
;
1
Jc
/
Jc,|
(:)
1
1
;
1
(1 :
Jc
)
1
;
1
/
JJ,|
(:)
1
1
;
1
_
;
1
;
1
1
(27)
where /
Jc
(:) is a basket of 1C-type labor inputs, /
JJ
(:) a basket of 11-type inputs, and
c
J
the elasticity of substitution between the two types. The two baskets are dened as:
/
JJ,|
(:) =
_
_
1
: (1 :
Jc
)
_ 1
;
11
_
s(1s
1C
)
0
/(:, ,)
1
1
;
11
d,
_
;
11
;
11
1
(28)
/
Jc,|
(:) =
_
_
1
: + :
Jc
_ 1
;
1C
_
s
s(1s
1C
)
/(:, ,)
1
1
;
1C
d,
_
;
1C
;
1C
1
(29)
where /(:, ,) is the demand of labor input , by the producer of good : and c
JJ
, c
Jc
1
are the elasticities of substitution among skills. Cost minimization implies that /(:, ,) is a
function of the relative wages:
/
|
(:, ,) =
_

_
1
:
_
n
|
(,)
n
JJ,|
_
r
11
_
n
JJ,|
n
|
_
r
1
/
|
(:) for 11 inputs
1
:
_
n
|
(,)
n
Jc,|
_
r
1C
_
n
Jc,|
n
|
_
r
1
/
|
(:) for 1C inputs
(30)
where the wage indexes n
Jc
, n
JJ
and n are dened as:
n
JJ,|
=
_
_
1
: (1 :
Jc
)
__
s(1s
1C
)
0
n
|
(,)
1r
11
d,
_ 1
1;
11
(31)
n
Jc,|
=
_
_
1
: + :
Jc
__
s
s(1s
1C
)
n
|
(,)
1r
1C
d,
_ 1
1;
1C
(32)
n
|
=
_
:
Jc
n
1r
1
Jc,|
(1 :
Jc
) n
1r
1
JJ,|
_ 1
1;
1
(33)
Similar considerations hold for the tradables sector. Aggregating across rms, we obtain
the total demand for 11-type labor input , as:
_
s(1s
1C
)
0
/
|
(:, ,)d:
_
s(1s
1C
)
0
/
|
(/, ,)d/ =
_
n
|
(,)
n
JJ,|
_
r
11
_
n
JJ,|
n
|
_
r
1
(1 :
Jc
) /
|
(34)
10
where once again / is per-capita total labor in the economy. Similarly, total demand for
1C-type labor input , is:
_
s
s(1s
1C
)
/
|
(:, ,)d:
_
s
s(1s
1C
)
/
|
(/, ,)d/ =
_
n
|
(,)
n
Jc,|
_
r
1C
_
n
Jc,|
n
|
_
r
1
:
Jc
/
|
(35)
The elasticities c
J
, c
JJ
and c
Jc
can be modeled as constants or as time-varying autore-
gressive processes.
4.4 Price setting in the nontradables sector
Consider now prot maximization in the intermediate nontradables sector. The key element
here is the presence of nominal rigidities. They are modeled as costs to nominal price
adjustment measured in terms of total prots foregone, building on Rotemberg (1982) and
Ireland (2001). To illustrate as clearly as possible the role of nominal inertias, we nd it
useful to cast the analysis rst in terms of nominal prices, and later move back to our usual
notation involving relative prices.
Each rm : takes into account the demand (13) for its product and sets its nominal price
1
|
(:) to maximize the present discounted value of prots. The adjustment cost is denoted
G
1,|
[1
|
(:), 1
|1
(:)[ and is a function of both current and lagged prices. The benchmark
parameterization we adopt allows the model to reproduce realistic nominal dynamics:
G
1,|
(:) =
c
1
2
_
1
|
(:),1
|1
(:)

,|1
1
_
2
(36)
The adjustment cost is related to changes of the nominal price of nontradable : relative to
the lagged ination rate in the nontradables sector
,|1
. Underlying this specication is
the notion that rms should not be penalized when their price hikes are indexed to some
(publicly observable) measures of aggregate or sectoral ination.
The price-setting problem is then characterized as:
max
1t(n)
T1J1t
1
.t
E
|
1

r=|
1
|,r
q
|,r
[1
r
(:) 'C
r
(:)[
_
1
r
(:)
1
,r
_
0
1

r
(1 G
1,r
(:)) (37)
where 1
|,r
(with 1
|,|
= 1) is the appropriate nominal discount rate, to be dened below in
eq. (66). As real variables are detrended, eq. (37) includes the rate of growth of the global
trend between t and t.
The rst order condition is:
0 =
_
1 0

_
1
|
(:) 'C
|
(:)
1
|
(:)
__ _
1
|
(:)
1
,|
_
0
1
(1 G
1,|
(:))
[1
|
(:) 'C
|
(:)[
_
1
|
(:)
1
,|
_
0
1
0G
1,|
01
|
(:)
E
|
1
|,|+1
q
|,|+1
[1
|+1
(:) 'C
|+1
(:)[
_
1
|+1
(:)
1
,|+1
_
0
1

|+1

|
0G
1,|+1
01
|
(:)
(38)
where:
0G
1,|
01
|
(:)
= c
1
_
1
|
(:),1
|1
(:)

,|1
1
_
1

,|1
1
1
|1
(:)
(39)
0G
1,|+1
01
|
(:)
= c
1
_
1
|+1
(:),1
|
(:)

,|
1
_
1
|+1
(:),1
|
(:)

,|
1
1
|
(:)
(40)
11
Since marginal costs are symmetric across nontradables producers, say 'C
|
(:) = 'C
|
,
rms : charge the same equilibrium price 1(:) = 1

. The rst order condition can therefore

be simplied as:
0 = [1
|
(1 0

) 0

'C
|
[ (1 G
1,|
(:)) [1
|
'C
|
[
0G
1,|
01
|
(:)
1
|

E
|
1
|,|+1
q
|,|+1
[1
|+1
'C
|+1
[

|+1

|
0G
1,|+1
01
|
(:)
1
|
(41)
There right hand side of the previous equation consists of three expressions in curly brack-
ets. When prices are fully exible (G
1
= 0), only the rst expression matters and the
optimization problem collapses to the standard markup rule:
1
|
=
0

1
'C
|
(42)
where the gross markup is a negative function of the elasticity of input substitution. De-
viations from markup pricing occur if rms are penalized for modifying their prices in the
short term. The speed of adjustment in response to shocks depends on the trade-o be-
tween current costs (second expression in curly brackets) and future expected costs (third
expression), making the price-setting process forward-looking.
We can now return to the standard notation in terms of relative prices: the optimization
problem can be written as:
max
t(n)
T111
|
E
|
1

r=|
1
|,r
q
|,r

|,r
[j
r
(:) :c
r
(:)[
_
j
r
(:)
j
,r
_
0
1

r
(1 I
1,r
(:)) (43)
where the adjustment costs I are now expressed as a function of relative prices:
I
1,|
(:) =
c
1
2
_

|
j
|
(:),j
|1
(:)

,|1
1
_
2
(44)
Note that I
1,|
= G
1,|
, j
|
(:)0I
1,|
,0j
|
(:) = 1
|
(:)0G
1,|
,01
|
(:) and j
|
(:)0I
1,|+1
,0j
|
(:)
= 1
|
(:)0G
1,|+1
,01
|
(:). The rst order condition is then:
0 = (1 I
1,|
(:)) [j
|
(:) (1 0

) 0

:c
|
(:)[ [j
|
(:) :c
|
(:)[
0I
1,|
0j
|
(:)
j
|
(:)
E
|
1
|,|+1

|,|+1
q
|,|+1
[j
|+1
(:) :c
|+1
(:)[

|+1

|
0I
1,|+1
0j
|
(:)
j
|
(:) (45)
4.4.1 Discussion
Note that when 0 is very large, the rst order condition is approximately solved by j
|
(:) -
:c
|
(:) regardless of how sizable c
1
is. This implies that in a competitive economy (large
0

) prices must move in tandem with the shocks aecting marginal costs, even though such
exibility entails large adjustment costs. Instead, if price setters have strong monopoly
power (0

is close to one, its minimum value), they can charge a high average markup over
marginal costs. In this case, when marginal costs increase due to cyclical conditions, rms
nd it optimal to maintain relatively stable prices and absorb the change in production
costs through a markup squeeze. In other words, when 0

is small, rms are able to keep

their prices well above marginal costs and accommodate changes in demand through supply
adjustments, without corresponding changes in prices. Other things being equal, an increase
in 0

reduces rms ability to use markup uctuations as a shock absorber.

12
It can be useful to express the pricing equation above as a rst-order approximation
around the steady state where I
1,|
= 0I
1,|
,0j
|
(:) = 0I
1,|+1
,0j
|
(:) = 0,
|
=

|1
=
|+1
= , 1
|,|+1

|+1
q
|,|+1
= 1,(1 r) and j(:) = 0

, (0

1) :c(:). Also
for simplicity consider the case in which there is zero growth in steady state or q = 1, so
that 1,(1 r) = ,. Dening j
|
= :c
|
(:),j
|
(:), we can rewrite (45) as:
0 = (1 0

j
|
) (1 I
1,|
(:)) (1 j
|
)
0I
1,|
0j
|
(:)
j
|
(:)
E
|
1
|,|+1
q
|,|+1

|,|+1
(1 j
|+1
)

|+1

|
0I
1,|+1
0j
|
(:)
j
|
(:) (46)
Now linearize in the neighborhood of the steady state:
0 = 0

dj
|

1
0

c
1
_
d
|
d
|1

_
E
|
,
1
0

c
1
_
d
|+1
d
|

_
(47)
Dene
|
= d
|
, and j
|
= dj
|
,j

. Obtain:
(0

1) j
|
=
1
0

c
1
(
|

|1
)
1
0

c
1
E
|
, (
|+1

|
) (48)
which can be rewritten as a log-linear Phillips curve with full indexation, an expression that
relates changes in ination to expected changes in ination and real marginal costs:
^
|
= j
|
,E
|
^
|+1
=
(0

1) 0

c
1
(49)
Similar considerations apply to the tradables sector.
Notice that markup/monopoly power in our setup (0) aects directly the slope of the
Phillips curve . The important implication is that a reduction of monopoly power in GEM
(higher 0) makes the Phillips curve steeper and reduces the sacrice ratio faced by the
economy. Similar considerations apply to an increase in price exibility (lower c
1
).
Variants of the model can exploit alternative assumptions about the degree of indexation
and ination inertia in the model, simply by modifying the denominator of the term in
brackets in (36) or (44). For instance, a model in which:
I
1,|
(:) =
c
1
2
_

|
j
|
(:),j
|1
(:)

o
,|1

1o
|
1
_
2
(50)
implies weighted indexation with respect to past sectoral ination and current economy-wide
ination, and the resulting Phillips curve is characterized by asymmetries between forward-
and backward-looking components of the ination process:

|
= c
|1
(1 c)
|
j
|
,E
|
(
|+1
c
|
(1 c)
|+1
) =
(0

1) 0

c
1
(51)
4.5 Price setting in the tradables sector
In this section we only consider optimal price setting for domestic rms selling in the domes-
tic market, and we abstract from the role of the distribution sector. Later we consider the
price-setting problem faced by exporters and consider a variant of the model encompassing
distribution services.
13
The analysis is similar to the nontradables sector above. Adopting a self-explanatory
notation, the price-setting problem of rm / at time t can be characterized as follows:
max
t(|)
T111
|
E
|
1

r=|
1
|,r

|,r
q
|,r
[j
r
(/) :c
r
(/)[
_
j
r
(/)
j
Q,r
_
0
J
Q
r
(1 I
1Q,r
(/)) (52)
and the rst-order condition in a symmetric equilibrium with j(/) = j
Q
is:
0 = (1 I
1Q,|
(/)) [j
|
(/) (1 0
T
) 0
T
:c
|
(/)[ [j
|
(/) :c
|
(/)[
0I
1Q,|
0j
|
(/)
j
|
(/)
E
|
1
|,|+1

|,|+1
q
|,|+1
[j
|+1
(/) :c
|+1
(/)[
Q
|+1
Q
|
0I
1Q,|+1
0j
|
(/)
j
|
(/) (53)
4.6 Consumer preferences
In each country there is a continuum of households indexed by , [0, :[, the same index
of labor inputs. Some households have access to capital markets, some do not. The latter
nance their consumption by relying exclusively on their labor incomes. We refer to the rst
type as Ricardian or forward-looking (11). We refer to the second type as non-Ricardian
or liquidity-constrained (1C). The two types of households can also be heterogeneous in
the labor market, as discussed above.
For each household ,, we denote with
|
(,) the lifetime expected utility and specify its
preferences as:

|
(,) = T111
|
E
|
1

r=|
,
|,r
q
1c
|,r
n
r
( C
r
(,), /
r
(,) ) (54)
where the instantaneous felicity is a function of (detrended) consumption C and labor eort
/:
n
|
( C
|
(,), /
|
(,) ) =
7
I
1 o
[C
|
(,) /
c
C
,|1
q
|1,|

7
\
1
(/
|
(,) /
|
/
,|1
)
1+
(1 /
|
)

[
1c
(55)
In the expressions above ,
|,r
is the discount rate between time t and time t, possibly
time-varying and dierent across countries. In steady state ,
|,r
converges to ,
r|
SS
where
,
SS
is a constant.
The term q
1c
|,r
in (54) implies that the disutility of labor eort increases with the
common trend, an assumption required to guarantee balanced growth. The implicit as-
sumption is that technological progress associated with home production activities follows
the same trend as the eectiveness of labor in manufacturing production. The restriction
|i:
r!1
,
|,r
q
1c
|,r
< 1 is imposed to ensure that utility is bounded.
The parameter o in (55), which aects the curvature of consumption utility, is the
reciprocal of the elasticity of intertemporal substitution. The parameter , which aects the
curvature of labor disutility, is the reciprocal of the Frisch elasticity of labor supply.
There is habit persistence in consumption with coecient 0 < /
c
< 1. The term C
,|1
in (55) is past per-capita consumption of household ,s peers, (i.e., either forward-looking or
liquidity-constrained agents). Similarly, there is habit persistence in leisure with coecient
0 < /
|
< 1. Households preferences are therefore symmetric within their respective cate-
gories but, because of dierent reference groups in habit formation, they are not symmetric
across categories.
14
The marginal utilities of consumption and leisure are:
0n
|
(,)
0C
|
(,)
= 7
I
[C
|
(,) /
c
C
,|1
q
|1,|

7
\
1
(/
|
(,) /
|
/
,|1
)
1+
(1 /
|
)

[
c
(56)

0n
|
(,)
0/
|
(,)
= 7
I
[C
|
(,) /
c
C
,|1
q
|1,|

7
\
1
(/
|
(,) /
|
/
,|1
)
1+
(1 /
|
)

[
c
7
\
(
/
|
(,) /
|
/
,|1
1 /
|
)

(57)
and the marginal rate of substitution is:
'1o
|
(,) =
0n
|
(,),0/
|
(,)
0n
|
(,),0C
|
(,)
= 7
\
(
/
|
(,) /
|
/
,|1
1 /
|
)

(58)
4.6.1 Discussion
The specication of the utility function builds on Greenwood, Human and Hercowitz
(1988). The main reason underlying the choice of this parameterization relatively to alterna-
tive options (such as additive separability or Cobb-Douglas aggregators) is that it generates
relatively high volatility in consumption and counter-cyclical trade balances, consistent with
empirical stylized facts. This is because hours worked are determined exclusively by the real
wage (see (71) below after accounting for (58)), leading to a direct link between uctuations
in labor eort and consumption growth.
The terms 7
I
and 7
\
can be modeled as positive parameters or autoregressive processes.
Note that 7
\
is normalized so that in a steady state with /
|
(,) = /
,|1
the marginal rate
of substitution is independent of habit persistence
4.7 Budget constraint (forward-looking households)
The individual ow budget constraint for Ricardian agent , [0, (1 :
Jc
) :[ is:
1
|
(,) -
|
1

|
(,) _ (1 i
|1
)
1
|1
(,)

|1,|
q
|1,|
(1 i

|1
) [1 I
1,|1
[
-
|
1

|1
(,)

|1,|
q
|1,|
(1 t
1
) r
|
1
|
(,) (1 t
J
) n
|
(,)/
|
(,) ( 1 I
V,|
(,) )
C
|
(,) j
J,|
1
|
(,) 1
|
(,) TT
|
(,) (59)
Households hold two nominal bonds, one denominated in domestic currency and one
denominated in an international currency. We will refer to the country issuing the interna-
tional currency as the center. In terms of our notation, 1
|
(,) is holdings of the domestic
bond by household ,, expressed in terms of domestic consumption units, 1

|
(,) is holdings
of the international bond, expressed in terms of center consumption units, and -
|
is the
CPI-based real exchange rate, expressed as the price of one center consumption basket in
terms of domestic consumption. If the domestic currency is also the international currency
- is equal to 1. Below, when we introduce explicit country indexes, -
1,
is the price of
one consumption basket in country J in terms of country Hs consumption baskets, and
similarly -
1,
is the bilateral real exchange rate of country H relative to the center.
The short-term nominal rates i
|
and i

|
are paid at the beginning of period t 1 and
are known at time t. The two rates are directly controlled by their respective national
governments, so that i

is the onshore rate in the center country. The spread between

onshore rate paid in the center country and the oshore rate received by domestic investors
is denoted I
1
. Only the center-currency bond is traded internationally and is in zero net
15
supply worldwide. The domestic bond is in zero net supply at the domestic level (although
later we consider a model variant encompassing public debt).
Agents who take a position in the international bond market must deal with nancial
intermediaries who charge a transaction fee I
1
on sales/purchases of the international bond.
The presence of the nancial friction I
1
guarantees that international net asset positions
follow a stationary process and the economies converge asymptotically to a well-dened
steady state. This transaction cost is a function of the average net asset position of the
whole economy. Specically, we adopt the following functional form:
1 I
1,|
= (1 c
11
oxp(c
12
[-
|
1

|
,G11
|
/

J1JS
[) 1
oxp(c
12
[-
|
1

|
,G11
|
/

J1JS
[) 1
7
1,|
)
,

|1,|
,
|1,|
(60)
where 0 _ c
11
_ 1, c
12
0, and -
|
1

= (1,:) -
|
_
s(1s
1C
)
0
1

(,)d, represents the per-

capita net asset position of the country in consumption units. The term /

J1JS
is the
desired net asset position of the country expressed as a ratio of G11. This variable mea-
sures the degree of international exposure that nancial intermediaries consider appropriate
for the economy, based on their assessment of the global economic outlook.
To understand the role played by I
1
, suppose rst that /

J1JS
= 7
1
= 0 and ,

= ,.
In this case, when the net asset position of the country is equal to its desired level of
zero, it must be the case that I
1
= 0 and the return on the international bond is equal
to 1 i

. If the country is a net creditor worldwide I

1
rises above zero, implying that
the countrys households lose an increasing fraction of their international bond returns to
nancial intermediaries. When holdings of the international bond go to innity, the return
on the international bond approaches (1 i

) (1 c
11
). By the same token, if the country
is a net debtor worldwide I
1
falls from zero to c
11
, implying that households pay an
increasing intermediation premium on their international debt. When net borrowing goes
to innity, the cost of borrowing approaches (1 i

) (1 c
11
). In nonlinear applications of
GEM the parameter c
12
controls the atness of the I
1
function: if c
12
= 0 then I
1
= 0
regardless of the net asset position; if c
12
tends to innity then 1 I
1
= (1 c
11
) for any
arbitrarily small net lending position, and 1 I
1
= (1 c
11
) for any arbitrarily small net
borrowing position. An appropriate parameterization allows the model to generate realistic
dynamics for net asset positions and current account.
Consider now the other components of (60). The term /

J1JS
can be positive or negative.
The above considerations are still valid after reinterpreting the concepts of net creditor or
net borrower in terms of deviations from the desired levels.
The variable 7
1,|
can be modeled as a stochastic process with zero mean in steady state,
provided that uctuations in 7
1
are not large enough to push I
1
above 1. In our framework,
uncertainty in international nancial intermediation plays the same role that uncovered
interest parity shocks or risk-premium uctuations play in similar open-economy models.
Finally, when rates of time preference diverge across countries and ,

,= ,, the transac-
tion cost is appropriately modied to account for asymmetries in real interest rates across
countries, as in Faruqee et al. (2007)..
Lets consider now the remaining components in the budget constraint. Households ac-
cumulate physical capital which they rent to domestic rms at the after-tax rate r (1 t
1
).
Gross investment before depreciation is denoted 1. The law of motion of capital is:
1
|+1
(,)q
|,|+1
= (1 c) 1
|
(,) I
1,|
(,)1
|
(,) 0 < c _ 1 (61)
where c is the country-specic depreciation rate of capital. Capital accumulation is subject
to adjustment costs: I
1
(.) is an increasing, concave, and twice-continuously dierentiable
16
function of the investment/capital ratio 1
|
(,),1
|
(,) with two properties entailing no adjust-
ment costs in steady state: I
1
(c q 1) = c q 1 and I
0
1
(c q 1) = 1. The specic
functional form we adopt is quadratic and encompasses inertia in investment:
I
1,|
(,) =
1
|
(,)
1
|
(,)
(1 7
1,|
)
c
11
2
_
1
|
(,)
1
|
(,)
(c q 1)
_
2

c
12
2
_
1
|
(,)
1
|
(,)

1
|1
1
|1
_
2
(62)
where c
11
, c
12
_ 0, 7
1,|
is a transitory shock (modeled as a negative adjustment cost) and
q is the steady-state growth rate.
Labor incomes n/ are taxed at the rate t
J
. Each 11-type household is the monopolistic
supplier of a specic labor input and sets the nominal wage for its labor input , accounting
for its demand /(,) = (n(,),n)
r
1
/. There is sluggish wage adjustment due to resource
costs that are measured in terms of the total wage bill. The adjustment cost is denoted
I
VJJ
(for Wage Forward-Looking) and its specication is the analog of (44) above:
I
VJJ,|
(,) =
c
VJJ
2
_

|
n
|
(,),n
|1
(,)

V,|1
1
_
2
(63)
where
V
is the wage ination rate.
Ricardian households own all domestic rms and there is no international trade in claims
on rms prots. The variable 1 includes all dividends accruing to shareholders, plus all
revenue from nominal and real adjustment rebated in a lump-sum way to all Ricardian
households, plus revenue from nancial intermediation which is assumed to be provided by
domestic rms exclusively. A formal denition of 1 is given below in equation (119).
Finally, agents pay lump-sum (non-distortionary) net taxes TT denominated in con-
sumption units.
4.7.1 Discussion
In GEM it is assumed that all intermediation rms are owned by the countrys residents, and
that their revenue is rebated to domestic households in a lump-sum fashion. A simple variant
of the model in which intermediation rms are owned by foreign residents leaves the basic
results virtually unchanged. There are no intermediation costs for center residents entering
the international bond market, that is, there is no dierence between onshore and oshore
center interest rates. Note that the choice of currency denomination of the international
bond is arbitrary, and any available country currency is viable.
Both desired (/

J1JS
) and actual (-1

,G11) net asset positions converge over the long

term to their steady-state value /

J,SS
.
4.8 Consumer optimization (forward-looking households)
The representative Ricardian household chooses bond holdings, capital and consumption
paths, and sets wages to maximize its expected lifetime utility (54) subject to (59) and (61),
taking into account (22) (or (34) if there are dierent types of labor).
For expositional convenience, it is worthwhile to write explicitly the maximization prob-
17
lem of agent , [0, (1 :
Jc
) :[ in terms of the following Lagrangian:
max
ct(),1t(),1t(),1

t
(),1t+1(),ut()
T111
|
E
|
1

r=|
,
|,r
q
1c
|,r
n
_
C
r
(,) , n
r
(,)
r
1
n
r
1
r
/
r
_
j
r
(,) ( 1
r
(,) -
r
1

r
(,)
(1 i
r1
)1
r1
(,)

r1,r
q
r1,r

(1 i

r1
)(1 I
1,r1
)-
r
1

r1
(,)

r1,r
q
r1,r
(1 t
J
) n
r
(,)
1r
1
n
r
1
r
/
r
(1 I
V,r
[n
r
(,), n
r1
(,)[)
(1 t
1
) r
r
1
r
(,) C
r
(,) j
J,r
1
r
(,) 1
r
(,) TT
r
(,) )
`
r
(,) ( 1
r+1
(,)q
r,r+1
(1 c) 1
r
(,) I
1,r
[1
r
(,),1
r
(,)[ 1
r
(,) ) (64)
where j and ` are the multipliers associated with, respectively, the budget constraint and
the capital accumulation process.
The rst order conditions with respect to C
|
(,) and 1
|
(,) yield:
j
|
(,) = 0n
|
(,),0C
|
(,) = `
|
(,)I
0
1,|
(,),j
J,|
(65)
In a symmetric setup, 0n
|
(,),0C
|
(,) is the same across Ricardian agents ,. Their stochastic
discount rate and pricing kernel is therefore the variable 1
|,r
, which is dened as:
1
|,r
= ,
|,r
q
1c
|,r
j
r
j
|
1

|,r
1
q
|,r
(66)
Accounting for the above expressions, the rst order conditions with respect to 1
|
(,) and
1

|
(,) are, respectively:
1 = (1 i
|
) E
|
1
|,|+1
(67)
1 = (1 i

|
) (1 I
1,|
) E
|
(1
|,|+1
^
|,|+1
) (68)
where ^ denotes the rate of nominal exchange rate depreciation against the US, or:
^
|,r
=
-
r
-
|

|,r

|,|
(69)
The rst order condition with respect to 1
|+1
(,) is:
j
J,|
I
0
1,|
(,)
E
|
q
|,|+1
= E
|
1
|,|+1

|,|+1
q
|,|+1
( (1 t
1
) r
|+1

j
J,|+1
I
0
1,|+1
(,)
[1 c I
1,|+1
(,) I
0
1,|+1
(,)
1
|+1
(,)
1
|+1
(,)
[ ) (70)
Expression (70) links capital accumulation to the behavior of the after-tax price of capital
(1 t
1
) r. In a non-stochastic steady state 1 (1 t
1
) r,j
J
is equal to the sum of the
natural real rate q
c
,, and the rate of capital depreciation c.
Finally, taking the rst order condition with respect to n(,), the Ricardian household
wage rate is set according to:
c
J
'1o
|
(,)
1
n
|
(,)
= (c
J
1) [1 I
VJJ,|
(,)[ (1 t
J
)
0I
VJJ,|
(,)
0n
|
(,)
n
|
(,) (1 t
J
)
E
|
1
|,|+1

|,|+1
q
|,|+1
n
|+1
(,)
n
|
(,)
(n
|+1
(,),n
|+1
)
r
1
(n
|
(,),n
|
)
r
1
/
|+1
/
|
0I
VJJ,|+1
(,)
0n
|
(,)
n
|
(,) (1 t
J
) (71)
where '1o has been dened in (58) above. The interpretation of (71) is similar to (112)
above. In a non-stochastic steady state the real wage n(,) is equal to the marginal rate of
substitution between consumption and leisure, '1o = n
|
,n
c
, augmented by the markup
c
J
, (c
J
1) which reects monopoly power in the labor market. For an analysis of wage
rigidities in open-economy general equilibrium models see e.g. Corsetti and Pesenti (2001).
18
4.8.1 Discussion
In a non-stochastic steady state (67) implies (1 i
SS
) ,
SS
= q
c
SS
,,
SS
: recall that
SS
is the (gross steady-state quarterly) ination rate, (1 i
SS
) ,
SS
is the equilibrium real
interest rate, q
SS
is the (gross steady-state quarterly) rate of growth of the world economy,
1,,
SS
is the rate of time preference, and q
c
SS
,,
SS
is the steady-state natural real interest
rate of the economy. International dierences in natural rates can arise from asymmetric
rates of time preference. The nancial friction I
1
in (60) is appropriately adjusted to take
into account these asymmetries.
Expressions (67) and (68) yield the risk-adjusted uncovered interest parity, recalling that
the return on international bond holdings is modied to account for the costs of intermedi-
ation I
1
. In steady state the interest dierential (1 i
SS
) ,[(1 i

SS
) (1 I
1,SS
)[ is equal
to the steady-state nominal depreciation rate of the currency vis-a-vis the US, and relative
purchasing power parity holds.
Note that the expectation operator on the left hand side of (70) is needed as shocks to
the trend q
|,|+1
are not part of the information set at time t. This is because variables are
expressed as deviations from the current trend. An alternative specication which expresses
variables as deviations from the lagged trend would make little dierence.
When the two types of households also represent dierent types of labor inputs with
dierent elasticities, the rst order condition (71) is replaced by:
c
JJ
'1o
|
(,)
1
n
|
(,)
= (c
JJ
1) [1 I
VJJ,|
(,)[ (1 t
J
)
0I
VJJ,|
(,)
0n
|
(,)
n
|
(,) (1 t
J
)
E
|
1
|,|+1

|,|+1
q
|,|+1
n
|+1
(,)
n
|
(,)
(n
JJ,|+1
,n
|+1
)
r
1
(n
JJ,|
,n
|
)
r
1
/
JJ,|+1
/
JJ,|
0I
VJJ,|+1
(,)
0n
|
(,)
n
|
(,) (1 t
J
)
(72)
A variant of the model considers the role of money. Dene as /the stock of real money
balances held by household ,. The budget constraint (59) becomes:
/
|
(,) 1
|
(,) -
|
1

|
(,) _ /
|1
(,) (1 i
|1
)
1
|1
(,)

|1,|
q
|1,|
(1 i

|1
) [1 I
1,|1
[
-
|
1

|1
(,)

|1,|
q
|1,|
(1 t
1
) r
|
1
|
(,) (1 t
J
) n
|
(,)/
|
(,) ( 1 I
V,|
(,) )
C
|
(,) [1 I
S,|
(,)[ j
J,|
1
|
(,) 1
|
(,) TT
|
(,) (73)
Consumption spending is subject to a proportional transaction cost I
S
that depends on
the households money velocity , where:

|
(,) =
C
|
(,)
/
|
(,)
(74)
A suggested functional form for the transaction cost (implying a satiation point for the
demand of real balances) is:
I
S
(
|
) = c
S1

|

c
S2

|
2 (c
S1
c
S2
)
1/2
(75)
Agents optimally choose their stock of real money holdings / so that at the margin
shopping costs measured in terms of foregone consumption are equal to the benets from
investing in yield-bearing assets. The rst order condition with respect to /
|
(,) is:
1 I
0
S,|
(,)
2
|
(,) = E
|
1
|,|+1
(76)
19
which denes real money balances / as a positive function of consumption and a negative
function of the nominal interest rate. Other equations of the model need to be modied
appropriately to account for the presence of money. For instance, the asset pricing kernel is
now equal to:
1
|,r
= ,
|,r
q
1c
|,r
j
r
j
|
1

|,r
1
q
|,r
1 I
S,|
(,) I
0
S,|
(,)
|
(,)
1 I
S,r
(,) I
0
S,r
(,)
r
(,)
(77)
and the government budget constraint is modied so that seigniorage revenue is rebated in
a lump-sum fashion through net transfers.
4.9 Consumer optimization (liquidity-constrained households)
As liquidity-constrained households have no access to capital markets, their optimal choices
are conned to labor supply. Similar to the Ricardian households, they can optimally set
their wages to exploit their market power. Also similar to the Ricardian households, they
face adjustment costs for their wages. These costs are denoted I
VJc,|
(for Wage Liquidity
Constrained) and are similar to (63). Dierent from the Ricardian households, however,
their optimal choices are purely static and do not entail forward-looking components.
The maximization problem of agent , ((1 :
Jc
) :, :[ can be written in terms of the
following static Lagrangian:
max
ct(),ut()
n ( C
|
(,), n
r
1
|
(,)n
r
1
|
/
|
) j
|
(,) [ C
|
(,) TT
|
(,)
(1 t
J
) n
|
(,)
1r
1
n
r
1
|
/
|
(1 I
VJc,|
(,) [ (78)
It is assumed that redistributive policies TT rebate to 1C-type households the income losses
associated with wage adjustment, so that their consumption level is:
C
|
(,) = (1 t
J
) n
|
(,)/
|
(,) (79)
The rst order conditions with respect to C(,) and n(,) determines partial adjustment of
wages:
c
J
'1o
|
(,)
1
n
|
(,)
= (1 t
J
) [(c
J
1) ( 1 I
VJc,|
(,) )
0I
VJc,|
(,)
0n
|
(,)
n
|
(,) [ (80)
Denoting n
JJ
the wage rate n(,) that solves (71), and n
Jc
the wage rate n(,) that
solves (80), equation (20) determines the wage rate for the whole economy as:
n
1r
1
|
= :
Jc
n
1r
1
Jc,|
(1 :
Jc
) n
1r
1
JJ,|
(81)
4.9.1 Discussion
When two types of labor inputs are considered, equation (80) is replaced by:
c
Jc
'1o
|
(,)
1
n
|
(,)
= (1 t
J
) [(c
Jc
1) ( 1 I
VJc,|
(,) )
0I
VJc,|
(,)
0n
|
(,)
n
|
(,) [ (82)
4.10 Fiscal policy
Public spending falls on nontradable goods, both nal and intermediate. In per-capita terms,
G
c
is government consumption, G
1
is government investment, and G

denotes public pur-

chases of intermediate nontradables. There are four sources of (net) tax revenue: taxes on
20
capital income t
1
, taxes on labor income t
J
, import taris tar, and lump-sum taxes net
of transfers to households TT. In the benchmark version of GEM the government follows a
balanced budget rule:
0 = G
|
G
1J\,|
(83)
where:
G
|
= G
c,|
j
J,|
G
1,|
j
,|
G
,|
(84)
and G
1J\
is aggregate government revenue, to be dened below in Section 5.3.
4.10.1 Discussion
Although GEM has not been designed to analyze scal policy issues in detail, variants of
the model can be designed to provide a satisfactory quantitative assessment of budgetary
dynamics. In what follows we consider a possible extension in this direction, following
Faruqee et al (2007,2008).
The government nances the excess of public expenditure over net taxes by issuing debt
denominated in nominal currency, denoted 1 in per-capita terms. All national debt is held
exclusively by domestic (Ricardian) agents. The budget constraint of the government is:
1
|
_ (1 i
|1
)
1
|1

|1,|
q
|1,|
G
|
G
1J\,|
(85)
Dene now the average tax rate for the economy t as:
t
|
= G
1J\,|
,G11
|
(86)
Similarly, dene the decit-to-GDP ratio as:
111
|
G11
|
=
_
1
|

1
|1

|1,|
q
|1,|
_
,G11
|
(87)
From (85), in steady state we have:
1
SS
G11
SS
=

SS
q
SS

SS
q
SS
(1 i
SS
)
_
G
SS
G11
SS
t
SS
_
=

SS
q
SS

SS
q
SS
1
111
SS
G11
SS
(88)
The previous equations dene the relations between debt-to-GDP, average tax rate, and
decit-to-GDP ratio which are sustainable in the long term. In what follows we treat the
long-run debt-to-GDP ratio as a policy parameter set by the government, and let t
SS
and
111
SS
,G11
SS
be determined by (88).
The government is assumed to control lump-sum taxes, trade policy parameters, t and
t
1
directly, while t
J
is endogenously determined. A possible specication for the scal rule
for t is:
t
|
= (t
|1
t
|
E
|
t
|+1
) ,8 c
T.1
(
1
|
G11
|
c
T.2
/
T.1,|
(1 c
T.2
)
1
|1
G11
|1
)
c
T.3
_
111
|
G11
|

111
SS
G11
SS
_
c
T.4
_
G
|
G11
|

G
SS
G11
SS
_
(89)
where /
T.1
is the targeted debt-to-GDP ratio, a variable that converges to 1
SS
,G11
SS
in
steady state. The tax rate is a smoothed function of past and expected future rates, adjusted
upward when the current debt-to-GDP ratio is above the average of its current target and its
21
past observed level, when the current decit-to-GDP ratio is above its sustainable steady-
state level, and when current government spending as a share of GDP is above its long-run
level.
By construction, public debt is exclusively held by domestic agents, and the net asset
position of the country is independent of the extent of public borrowing. This feature of
the model is of course highly unrealistic. A way to enhance the realism of the simulations
is by introducing a link between the desired net asset position of country H and the debt
to GDP ratios in the world economy as follows:
/
1
J1JS,|
= /
1
JJIT
c
1
J1
1
1
|
G11
1
|


6=1
c
,1
J2
1

|
G11

|
(90)
According to the previous expression, /
1
J1JS
is equal to a country-specic constant, /
1
JJIT
,
adjusted to account for changes in the debt-to-GDP ratios in either the domestic economy
(1
1
,G11
1
) or in the other countries in the world (1

,G11

).
This specication provides a plausible (albeit judgmental) link between debt imbalances
and net asset positions. When the national debt-to-GDP ratio increases, domestic agents
reduce the share of foreign securities in their portfolios by selling the international bond
to foreigners. By the same token, if the debt-to-GDP ratio increases in the center country,
international investors would require a higher return on center securities, leading to a higher
share of center assets in their portfolios or a reduction of net borrowing from the center.
Of course, our approach should be viewed only as a crude approximation to the actual de-
terminants of cross-country spreads and interest rate premia in response to macroeconomic
imbalances, whose endogenization should be eventually incorporated in a self-contained
model. It remains unclear, however, whether the nal benets of such a framework signi-
cantly outstrip the costs of incorporating the large amount of complications from which we
abstract here.
Quantitatively, one could take /

J1JS
as a free variable and estimate the c
J1
and c
J2
parameters on the basis of empirical evidence on the link between net asset positions and
debt levels. Alternatively, one could rely on cross-fertilization with respect to alternative
theoretical models able to shed light on the structural determinants of these parameters.
In Faruqee et al (2007), for instance, the calibration of (90) has relied on results based on
the Global Fiscal Model, an overlapping-generation multi-country model developed at the
International Monetary Fund.
4.11 Monetary policy
The government controls the short-term rate i
|
. Monetary policy is specied in terms of
annualized interest rate rules. The specication of the interest rule is likely to change
according to the nature of the simulation exercise. A benchmark specication is:
(1 i
|
)
4
= .
I
(1 i
|1
)
4
(1 .
I
)
_
1 i
ntu|
|
_
4
.
1
E
|
(
|1,|+3
H
|1,|+3
) (91)
The current interest rate i
|
is an average of the lagged rate i
|1
and the current neutral
rate i
ntu|
|
, dened as:
1 i
ntu|
|
=
H
0.25
|4,|
(q
|1,|
)
c
,
|1,|
(92)
where H
|r,|r+4
is the year-on-year gross CPI ination target (either explicit or implicit)
prevailing at time t for the four-quarter period between t t and t t 4. This average is
22
adjusted to account for the expected ination gap three quarters in the future. In a steady
state when all constant targets are reached it must be the case that the nominal interest rate
is equal to the neutral level, equal to the product of the equilibrium natural real interest
rate q
c
,, times the ination target:
1 i
SS
= 1 i
ntu|
SS
=
H
0.25
SS
q
c
SS
,
SS
=

SS
q
c
SS
,
SS
. (93)
4.11.1 Discussion
The rule (91) could be modied to include policy responses to a set of other variables (such
as measures of the output gap level or growth, the exchange rate, the current account etc.)
expressed as deviations from their targets. For an extension to price-level path targeting,
the reader is referred to Laxton, NDiaye and Pesenti (2006). For an introduction to optimal
monetary policy in open economies see e.g. Corsetti and Pesenti (2005).
4.12 Market clearing in the domestic economy
Maintaining international variables exogenous for the time being, the model is closed by
imposing the following resource constraints and market clearing conditions.
In each country, the domestic resource constraints for capital and labor are, respectively:
_
s(1s
1C
)
0
1
|
(,)d, _
_
s
0
1
|
(:)d:
_
s
0
1
|
(/)d/ (94)
and:
/
|
(,) _
_
s
0
/
|
(:, ,)d:
_
s
0
/
|
(/, ,)d/ (95)
The resource constraint for the nontradable good :
1
is:

|
(:) _
_
s
0

.,|
(:, r)dr
_
s
0

J,|
(:, c)dc G
,|
(:) (96)
while the tradable / can be used by domestic rms or imported by foreign rms (see below).
The nal good can be used for private or public consumption:
_
s
0

|
(r)dr _
_
s
0
C
|
(,)d, :G
c,|
(97)
and similarly for the investment good 1:
_
s
0
1
|
(c)dc _
_
(1s
1C
)s
0
1
|
(,)d, :G
1,|
(98)
Market clearing in the domestic bond market requires:
_
s(1s
1C
)
0
1
|
(,)d, = :1
|
(99)
where 1
|
= 0 in the benchmark model (see discussion above for the treatment of public
debt 1
|
0).
23
5 World interdependencies in general equilibrium
So far all trade-related variables have been taken as exogenous. Now we close the model
by considering a multi-country general-equilibrium setting. The notation becomes slightly
more complicated, as explicit country indexes must be introduced. We will refer to H as the
home country and to J ,= H as one of the remaining foreign countries. When a double
country index is considered in the case of bilateral trade variables, the rst index refers to
the importing (destination) country and the second index to the exporting (source) country.
Multi-country applications of GEM can be found e.g. in Faruqee et al (2007, 2008).
5.1 Demand for imports
The derivation of the foreign demand schedule for good / is analytically more complex but,
as we show in (108) at the end of this section, it shares the same functional form as (13) and
(14) above, thus can be written as a function of the relative price of good / (with elasticity
0
T
) and total foreign demand for imports.
We focus rst on import demand in the consumption good sector of country H. Denote
the representative rm in the consumption sector as r
1
[0, :
1
[. Its imports '
1
.
(r
1
) are
a CES function of baskets of goods imported from the other countries, or:
'
1
.,|
(r
1
)
1
1
,
1
.
=

6=1
_
/
1,
.
_ 1
,
1
.
_
'
1,
.,|
_
r
1
_
_
1 I
1,
1.,|
_
r
1
_
_ _
1
1
,
1
.
(100)
where:
0 _ /
1,
_ 1,

6=1
/
1,
= 1 (101)
In (100) above j
1
.
is country Hs elasticity of substitution across exporters: the higher is
j
1
.
, the easier it is for rm r
1
to replace imports from one country with imports from an-
other. The parameters /
1,
.
determine the composition of the import basket across countries.
'
1,
.
(r
1
) denotes imports from country J by rm r
1
located in country H.
The response of import volumes to changes in demand as well as their price elasticities are
typically estimated to be smaller in the short term than in the long run. To model realistic
imports dynamics, such as the delayed and sluggish adjustment to changes in relative prices
typically referred to as the J curve, we assume that bilateral imports are subject to bilateral
adjustment costs I
1,
1.
. These costs are specied in terms of import shares relative to rm
r
1
s output. They are zero in steady state. Specically, GEM adopts the parameterization:
I
1,
1.,|
[
'
1,
.,|
(r
1
)

1
|
(r
1
)
,
'
1,
.,|1

1
|1
[ =
c
1,
1.
2
__
'
1,
.,|
(r
1
),
1
|
(r
1
)
_
,
_
'
1,
.,|1
,
1
|1
_
1
_
2
_
1
__
'
1,
.,|
(r
1
),
1
|
(r
1
)
_
,
_
'
1,
.,|1
,
1
|1
_
1
_
2
_
(102)
with c
1,
1.
_ 0. The specication is such that I
1,
1.
[1[ = 0, I
1,
1.
[[ = c
1,
1.
,2, and
I
1,
1.
[0[ = I
1,
1.
[2[ = c
1,
1.
,4. Alternative parameterizations (for instance, quadratic) could
be considered, although the suggested one has proven to be useful in non-linear simulation
exercises with relatively large shocks.
Denoting j
1,
1
the price in country H of a basket of intermediate inputs imported from
J, rm r
1
minimizes its costs

6=1
j
1,
1
'
1,
.
(r
1
) subject to (100). Cost minimization
24
implies:
'
1,
.,|
(r
1
)
_
1 I
1,
1.,|
(r
1
)
_
_
1 I
1,
1.,|
(r
1
) '
1,
.,|
(r
1
)I
01,
1.,|
(r
1
)
_

1
.
= /
1,
.
_
j
1,
1,|
j
1
1.,|
(r
1
)
_

1
.
'
1
.,|
(r
1
) (103)
where I
01,
1.
(r
1
) is the rst derivative of I
1,
1.
(r
1
) with respect to '
1,
.
(r
1
) and the
cost-minimizing import price index j
1
1.
(r
1
) is the Lagrangian multiplier:
j
1
1.,|
(r
1
) =
_
_

6=1
/
1,
_
j
1,
1,|
1 I
1,
1.,|
(r
1
) '
1,
.,|
(r
1
)I
01,
1.,|
(r
1
)
_
1
1
.
_
_
1
1,
1
.
(104)
In principle, the import price j
1
1.
(r
1
) is rm-specic, as it depends on rm r
1
s import
shares. To the extent that all rms r
1
are symmetric within the consumption sector, how-
ever, there will be a unique import price j
1
1.
. It follows that j
1
1.
'
1
.
=

6=1
j
1,
1
'
1,
.
(1
I
1,
1.
),(1 I
1,
1.
'
1,
.
I
01,
1.
).
Consider now the basket '
1,
.
(r
1
) in some detail. In analogy with (10) above, it is a
CES index of all varieties of tradable intermediate goods produced by rms /

operating in
country J and exported to country H. Denoting as '
1,
.
_
/

, r
1
_
the demand by rm r
1
of an intermediate good produced by rm /

, the basket '

1,
.
_
r
1
_
is:
'
1,
.,|
(r
1
) =
_
_
1
:

_ 1
0
J
J
_
s
J
0
'
1,
.,|
_
/

, r
1
_1
1
0
J
J
d/

_
0
J
J
0
J
J
1
(105)
where 0

T
1 is the elasticity of substitution among intermediate tradables, the same
elasticity entering (14) in country J.
The cost-minimizing rm r
1
takes as given the prices of the imported goods j
1
(/

)
and determines its demand of good /

according to:
'
1,
.,|
(/

, r
1
) =
1
:

_
j
1
|
(/

)
j
1,
1,|
_
0
J
J
'
1,
.,|
(r
1
) (106)
where '
1,
.,|
(r
1
) has been dened in (103) and j
1,
1
is:
j
1,
1,|
=
_
_
1
:

__
s
J
0
j
1
|
_
/

_
10
J
J
d/

_ 1
10
J
J
(107)
The import demand schedules in the investment good sector can be derived in perfect
analogy with the analysis above. As a last step, we can derive country Js demand schedule
for country Hs intermediate good /
1
, that is, the analog of (14). Aggregating across rms
(and paying attention to the order of the country indexes) we obtain:
_
s
J
0
'
,1
.,|
(/
1
, r

)dr

_
s
J
0
'
,1
J,|
(/
1
, c

)dc

=
:

:
1
_
j

|
(/
1
)
j
,1
1,|
_
0
1
J
_
'
,1
.,|
'
,1
J,|
_
(108)
25
5.1.1 Discussion
Import adjustment costs I
1,
1.
and I
1,
1J
are treated in GEM as expenditures associated
with intermediation activities (transportation, distribution, training, etc.) Thus, they show
up somewhere else in the economy as revenue for the rms that provide these services,
and as dividend incomes for the households who own these rms. Below, we include these
components in the denition of 1.
Variants of the model can include trade in commodities, parts, raw materials and other
upstream intermediate goods. The reader is referred to Laxton and Pesenti (2003) for a
detailed algebraic treatment.
5.2 Price setting in the tradables sector and exchange rate pass-
through
In Section 4.5 above we characterized the optimal price set by a rm producing tradable
intermediate goods for the local market. We now reconsider the price-setting problem in the
tradables sector from the vantage point of the rm /
1
located in country H and exporting
to all other countries J ,= H. We also introduce the distinction between import prices at
the national level and at the border level. National import prices j

(/
1
) are paid by rms
located in country J to purchase one unit of the variety /
1
. These are the prices that enter
equations such as (103) above. Border import prices are indexed with a bar (e.g. j

(/
1
)).
These are the prices set by the exporting rm /
1
. The dierence between the two prices
stems from trade barriers such as taris. Below we consider a more general specication
of the model in which the gap between the two prices reects distribution costs and retail
margins. In terms of our notation, we have:
j

|
(/
1
) =
_
1 tar
,1
_
j

|
(/
1
) (109)
where tar
,1
is a proportional tari duty imposed by country J over its imports from
country H.
To the extent that dierent country blocs represent segmented markets in the global
economy, each rm /
1
in country H has to set dierent prices for the domestic market and
all other export markets. Since the rm faces the same marginal costs regardless of the scale
of production in each market, the dierent price-setting problems are independent of each
other.
Exports are invoiced (and prices are set) in the currency of the destination market.
Accounting for (108), the price-setting problems of rm / in country H at time t can then
be characterized as follows:
max

J
t
(|
1
)
T111
|
E
|
1

r=|
1
1
|,r

1
|,r
q
|,r
[-
1,
r
j

r
(/
1
) :c
1
r
(/
1
)[
+
:

:
1
_
_
1 tar
,1
_
j

r
(/
1
)
j
,1
1,r
_
0
1
J
_
'
,1
.,r
'
,1
J,r
__
1 I
,1
11,r
(/)
_
(110)
where j
,1
1
is the price of the basket of country Js imports from country H, and '
,1
.

'
,1
J
is country Js aggregate imports from country H. The term -
1,
is the bilateral
real exchange rate between country H and country J (an increase in -
1,
represents a
real depreciation of country Hs currency against country J). The term I
1,
11
(/
1
) denotes
26
adjustment costs related to changes of the price of good /
1
in country J. These costs are
the analogs of (44) above:
I
,1
11,|
(/
1
) =
c
,1
11
2
_

|
j

|
(/
1
),j

|1
(/
1
)

,1
1,|1
1
_
2
(111)
where
1
is the ination rate for bilateral imports prices. Despite its fastidiousness, the
notation above is straightforward and the equations are self-explanatory.
Accounting for rms symmetry (j

(/
1
) = j
,1
1
and
_
1 tar
,1
|
_
j

(/
1
) = j
,1
1
in
equilibrium), prot maximization yields:
0 =
_
1 I
,1
11,|
(/
1
)
__
-
1,
|
j

|
(/
1
)
_
1 0
1
T
_
0
1
T
:c
1
|
(/
1
)
_

_
-
1,
|
j

|
(/
1
) :c
1
|
(/
1
)
_
0I
,1
11,|
0j

|
(/
1
)
j

|
(/
1
) E
|
1
1
|,|+1

1
|,|+1
q
|,|+1
+
_
-
1,
|+1
j

|+1
(/
1
) :c
1
|+1
(/
1
)
_
_
'
,1
.,|+1
'
,1
J,|+1
'
,1
.,|
'
,1
J,|
_
0I
,1
11,|+1
0j

|
(/
1
)
j

|
(/
1
) (112)
If adjustment costs in the export market are relatively large, the prices of country Hs
goods in the foreign markets are characterized by signicant stickiness in local currency.
In this case, the degree to which short-term exchange rate movements (and other shocks
to marginal costs in country H) aect import prices in country J is rather small as in
Chari, Kehoe and McGrattan (2002). If instead the c
,1
11
coecients are small, expression
(112) collapses to a markup rule, and exchange rate pass-through is full:
-
1,
|
j

|
(/
1
) = -
1,
|
j
,1
1,|
=
0
1
T
0
1
T
1
:c
1
|
(113)
If rm /
1
faces small adjustment costs in all sales markets, both domestic and foreign, the
law of one price holds at the border level:
j
1
Q,|
= -
1,
|
j
,1
1,|
=
0
1
T
0
1
T
1
:c
1
|
(114)
5.2.1 Discussion
In the previous paragraph, low exchange rate pass-through is the result of nominal price
stickiness in export prices. There is no need, however, to limit our analysis of the deter-
minants of pass-through to the role of nominal rigidities. As an example of an alternative
approach, the variant of GEM studied in Laxton and Pesenti (2003) and based on work by
Corsetti and Dedola (2005) considers the role of the distribution sector. In this section we
briey summarize this extension and its implications for export prices.
Suppose that rms producing the nal goods and 1 in country J do not import
intermediate tradables directly from the foreign producers. Instead, rms in the distribution
sector purchase tradables abroad and distribute them to the rms producing the nal good.
The distribution technology is Leontief: to make one unit of an intermediate good available
to downstream producers, rms in the distribution sector require j _ 0 units of the non-
tradables basket . Thus, total demand for nontradables (13) in country J is appropriately
modied as
_
j

|
(:

),j

,|
_
0
J
1
_

.,|

J,|
G

,|
j

16=
('
,1
.,|
'
,1
J,|
_
.
27
Firms in the distribution sector are perfectly competitive. Because of distribution costs,
there is a wedge between producer (border) and consumer (retail) prices even in the absence
of taris and trade barriers. It follows that:
j

|
(/
1
) =
_
1 tar
,1
_
j

|
(/
1
) j

,|
(115)
From the vantage point of rm /
1
exporting to country J, the price-setting equation (112)
then becomes:
0 =
_
1 I
,1
11,|
(/
1
)
_
_
-
1,
|
j

r
(/
1
)(1 0
1
T
)
-
1,
|
j

,|
1 tar
,1
0
1
T
:c
1
|
(/
1
)
_

_
-
1,
|
j

|
(/
1
) :c
1
|
(/
1
)
_
0I
,1
11,|
0j

|
(/
1
)
(j

r
(/
1
)
j

,|
1 tar
,1
) E
|
1
1
|,|+1

1
|,|+1
q
|,|+1
+
_
-
1,
|+1
j

|+1
(/
1
) :c
1
|+1
(/
1
)
_
_
'
,1
.,|+1
'
,1
J,|+1
'
,1
.,|
'
,1
J,|
_
0I
,1
11,|+1
0j

|
(/
1
)
(j

r
(/
1
)
j

,|
1 tar
,1
)
(116)
The key implication of the presence of a distribution sector is that, even in the absence
of adjustment costs, pass-through is no longer full. In fact, when he c
,1
11
coecients are
small, the above expression collapses to a double-markup rule:
-
1,
|
j

|
(/
1
) = -
1,
|
j
,1
1,|
=
0
1
T
0
1
T
1
:c
1
|

j

0
1
T
1
-
1,
|
j

,|
1 tar
,1
(117)
-
1,
|
j

|
(/
1
) = -
1,
|
j
,1
1,|
=
0
1
T
0
1
T
1
:c
1
|
_
1 tar
,1
_

0
1
T
1
-
1,
|
j

,|
(118)
5.3 Market clearing in the world economy
All prots and intermediation revenue accrue to Ricardian households:
_
s
1
(1s
1
1C
)
0
1
1
|
(,
1
)d,
1
=
_
s
1
(1s
1
1C
)
0
(1 i

|1
)I
1
1,|1
-
1,
|
1
1
|1
(,
1
)

|1,|
q
|1,|
d,
1

_
s
1
(1s
1
1C
)
0
I
1
VJJ,|
(,
1
)
_
1 t
1
J,|
_
n
1
|
(,
1
)d,
1

_
s
1
s
1
(1s
1
1C
)
I
1
VJc,|
(,
1
)
_
1 t
1
J,|
_
n
1
|
(,
1
)d,
1

_
s
1
0
_
j
1
|
(:
1
) :c
1
|
(:
1
)

(
_
s
1
0

1
.,|
(:
1
, r
1
)dr
1

_
s
1
0

1
J,|
(:
1
, c
1
)dc
1
G
1
,|
(:
1
))d:
1

_
s
1
0
_
j
1
|
(/
1
) :c
1
|
(/
1
)

(
_
s
1
0
Q
1
.,|
(/
1
, r
1
)dr
1

_
s
1
0
Q
1
J,|
(/
1
, c
1
)dc
1
)d/
1

6=1
_
s
1
0
[-
1,
|
j

|
(/
1
) :c
1
|
(/
1
)[(
_
s
J
0
'
,1
.,|
(/
1
, r

)dr

_
s
J
0
'
,1
J,|
(/
1
, c

)dc

)d/
1

6=1
_
s
1
0
_
'
1,
.
(r
1
)I
01,
1.,|
(r
1
)
1 I
1,
1.,|
(r
1
) '
1,
.
I
01,
1.,|
(r
1
)
_
j
1,
1
'
1,
.
(r
1
)dr
1

6=1
_
s
1
0
_
'
1,
J
I
01,
1J,|
(c
1
)
1 I
1,
1J,|
(c
1
) '
1,
J
I
01,
1J,|
(c
1
)
_
j
1,
1
'
1,
J
(c
1
)dc
1
(119)
where -
1,
is the bilateral real exchange rate between country H and the center country.
28
It may be helpful to go through the single elements on the right hand side. The rst
expression (integral) is revenue associated with nancial intermediation in the bond market.
The second and third expressions are revenue associated with wage adjustment by either
forward-looking or liquidity-constrained agents. Note that revenue associated with price
adjustment is not included here, as it is a cost for some rms and a revenue for others.
The fourth expression is monopoly prots in the nontradables sector (if entry costs were
considered, they would appear here as negative items osetting these prots). The fth
expression is domestic monopoly prots in the tradables sector. The sixth expression is
export prots.
The last two expressions in (119) are revenue associated with import adjustment, both
in the consumption sector and in the investment sector. The sum of these last components
is referred to as 1'11J (for import adjustment) in what follows.
The tradable good /
1
can be used by domestic rms or imported by foreign rms:
T
|
_
/
1
_
_
_
s
1
0
Q
.,|
(/
1
, r
1
)dr
1

_
s
1
0
Q
J,|
(/
1
, c
1
)dc
1

6=1
_
_
s
J
0
'
,1
.,|
(/
1
, r

)dr

_
s
J
0
'
,1
J,|
(/
1
, c

)dc

_
(120)
Market clearing in the international bond market requires:

_
s
J
(1s
J
1C
)
0
1

|
(,

)d,

= 0. (121)
Finally, government revenue is given by:
G
1
1J\,|
=
1
:
1
_
_
s
1
0
TT
1
|
(,)d, t
1
1
r
1
|
_
s
1
(1s
1
1C
)
0
1
1
|
(,)d, t
1
J
_
s
1
0
n
1
|
(,)/
1
|
(,)d,
_

1
:
1

6=1
tar
1,
|
_
s
J
0
j
1
|
(/

)
_
'
1,
.,|
(/

) '
1,
J,|
(/

_
)d/

(122)
Together with the appropriate transversality conditions, this concludes the description of
the equilibrium.
5.4 Measuring output and trade balance
GEM codes all quantity variables in per-capita terms. For the vast majority of the equations
above the aggregation is straightforward. In this section we focus on the two most important
macrovariables in the model, gross domestic product and the current account.
Dene rst per-capita net nancial wealth in country H as:
1
1
|
=
1
:
1
(1 i

|1
) [1 I
1,|1
[
_
s
1(1s
1
1C
)
0
-
1,
|
1
1
|1
(,
1
)

|1,|
q
|1,|
d,
1
(123)
Aggregating the budget constraints across private and public agents after imposing the
appropriate transversality conditions, the law of motion for nancial wealth is:
E
|
1
1
|,|+1

1
|,|+1
q
|,|+1
1
1
|+1
= 1
1
|
I
1
1,|1
_
1 i

|1
_
-
1,
|
1
1
|1

|1,|
q
|1,|
j
1
,|

1
|
j
1
T,|
T
1
|

6=1
_
j
1
1,|
j
1,
1,|
__
'
1,
.,|
'
1,
J,|
_
1'11J
1
|
C
1
|
j
1
J,|
1
1
|
G
1
|
(124)
29
where the total value of tradables is dened as:
j
1
T,|
T
1
|
= j
1
Q,|
_
Q
1
.,|
Q
1
J,|
_

6=1
:

:
1
-
1,
|
j
,1
1,|
_
'
,1
.,|
'
,1
J,|
_
(125)
Recall that the variable 1'11J is the sum of the last two terms in (119).
Expression (125) can be written as:
Cl111
1
|
= -
1,
|
_
1
1
|

1
1
|1

|1,|
q
|1,|
_
= 11
1
|
T11
1
|
(126)
The left hand side of (126) is country Hs current account in domestic consumption units.
The rst term on the right hand side is net factor payments from the rest of the world to
country H:
11
1
|
=
i

|1
-
1,
|
1
1
|1

|1,|
q
|1,|
(127)
T11 is the trade balance or net exports:
T11
1
|
= 1A
1
|
1'
1
|
(128)
where total exports 1A are evaluated at border prices:
1A
1
|
= j
1
T,|
T
1
|
j
1
Q,|
_
Q
1
.,|
Q
1
J,|
_
(129)
and, similarly, total imports 1' are evaluated at border prices:
1'
1
|
=

6=1
j
1,
1,|
_
'
1,
.,|
'
1,
J,|
_
(130)
Using the denition above, the model-based Gross Domestic Product (in consumption
units) is:
G11
1
|
=
1
|
j
1
J,|
1
1
|
j
1
,|
G
1
,|
T11
1
|
= j
1
,|

1
|
j
1
T,|
T
1
|


6=1
_
j
1
1,|
j
1,
1,|
__
'
1,
.,|
'
1,
J,|
_
1'11J
1
|
(131)
Note that there is a discrepancy between GDP measured according to national accounting
standards (goods output), and GDP measured as manufacturing output. This discrepancy
reects the portion of the revenue from sales of goods associated with making imports
available to downstream users, such as costs incurred with imports adjustment and wedges
between border- and market-prices of imported goods.
30
References
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and Persistent Real Exchange Rates?, Review of Economic Studies 69 (3), pp.533-63.
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[9] Ireland, P., 2001. Sticky-price models of the business cycle: specication and stability.
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[10] Juillard M., P. Karam, D. Laxton and P. Pesenti, 2006, Welfare-Based Monetary
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Rules: An Open-Economy Scenario Analysis, Journal of the Japanese and Interna-
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[12] Laxton D., and P. Pesenti, 2003, Monetary Rules for Small, Open, Emerging
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[13] Obstfeld M., and K. Rogo, 1995, Exchange Rate Dynamics Redux, Journal of Po-
litical Economy 103, pp. 624-660.
[14] Obstfeld M., and K. Rogo, 2000, New Directions for Stochastic Open Economy
Models, Journal of International Economics 50 (1), pp. 117-153.
[15] Obstfeld M., and K. Rogo, 2002, Global Implications of Self-Oriented National Mon-
etary Rules, Quarterly Journal of Economics 117, pp. 503-36.
[16] Rotemberg, J., 1982. Sticky prices in the United States. Journal of Political Economy
90, 1187-1211.
31
Figure 1: The Structure of the Model
I
E
G
I
G
N
K
C G
c
A
N
T
Q M
Abroad
L
32