DS Class 2008 (EDocFind - Com)

International Macroeconomics
Devereux and Sutherland (2006) method - some applications
May 16, 2008

Devereux and Sutherland method
Intro and motivation
Financial transmission on shocks
Financial channels of international shocks’transmission

risk sharing
consumption smoothing
Transmission literature usually based on DSGE models with

either
complete mkts
trade in only one asset
Drawbacks (I)
Models with complete mkts

asset holdings automatically deliver wealth transfers that
guarantee full insurance
consumption smoothing channel shut down
nfa/current account de…cits play no active role in shocks’
transmission
u 0 (ct? )
absent taste shocks complete mkts imply rert = u 0 (c t )
according to the empirical literature on RS measurament, this

is counterfactual
Drawbacks (II)
Models with trade in one asset

gross and net foreign assets positions coincide
Lane and Milesi-Ferretti (2001, 2006): large gross portfolio
holdings
what are the important macro determinants of size and
composition of gross portfolio positions?
gross assets and liabilities can have important e¤ect on macro
dynamics
Incomplete mkts and more than one asset
Should allow for
analyze the role of current account de…cits/surpluses in

shaping international shocks’transmission
analyze the implications of gross portfolio holdings

Incomplete mkts and more than one asset - issues
1 With complete mkts it is possible to solve for the real macro

allocation/dynamics independently of portfolio allocation
2 With incomplete mkts we have to solve jointly for macro
outcomes and portfolios
3 In a non-stochastic Steady State portfolio is indeterminate
4 The same applies in a …rst order approximation to the model
5 In principle it is infeasible to apply standard approximation
methods to incomplete mkts models
Devereux and Sutherland method - key aspects
At 1rst order of approximation only a solution for the Stedy

State portfolio is required to analyze dynamics
Time variations in portfolio shares are irrelevant for …rst order

responses of macro variables
Characterize SS portfolio by a system of

2nd order approximation to portfolio selection condition
1rts order approximation to the rest of the model
interdependent as excess returns used for portfolio selection
depend on GE model and macro outcomes depend on chosen
portfolio
DS solve this system to yield a closed form solution for
portfolio holdings
Basic framework
Basic model - goods and utility
Two countries, H and F, specialized in the production of

di¤erent goods, YH and YF , at prices PH and PF?
Consumption is a bundle of H and F goods
Prices of H and F consumption bundle P and P ?
∞
U = Et ∑ βτ t
[u (Cτ ) + υ (.)]
τ =t
Basic framework
Basic model - assets
Assume n assets
Asset holdings of H households α1 , ..., αn - denominated in
units of H consumption good
H households wealth
n
Wt = ∑ αi ,t
i =1
r are endogenous gross returns
r 0 = [r1t , ...rnt ]
Basic framework
H agents budget constraint
n n
Wt = ∑ αi ,t = ∑ αi ,t 1 rit + Yt Ct
i =1 i =1
where Yt = PH YH /P
De…ne excess returns on the n-th asset as rix = (ri rn ) )
0 = [(r
rxt rnt ) , ..., (rn rnt )] and
1t 1t
αt0 = [α1t , ..., αn 1t ]

Basic framework
H agents budget constraint
H hhs bc can be written as
n n 1
Wt = ∑ αi ,t = ∑ αi ,t 1 rit + rnt Wt 1 + Yt Ct =
i =1 i =1
= αt0 1 rit + rnt Wt 1 + Yt Ct
F agents bc is
1 ? 1 ?0
W = α rit + rnt Wt? + Yt Ct
Q t Q t 1 1
Basic framework
Optimality conditions
∞
max . : U = Et
fct ,αi g
∑ βτ t
[u (Cτ ) + υ (.)]
τ =t
n n 1
st : Wt = ∑ αi ,t = ∑ αi ,t 1 rit + rnt Wt 1 + Yt Ct
i =1 i =1
u 0 (Ct ) = βEt fu 0 (Ct +1 ) rit +1 g =

= βEt fu 0 (Ct +1 ) rnt +1 g , 8i = 1, ... (n 1)
Qt 1 u 0 (Ct? ) = βEt Qt +11 u 0 Ct?+1 rit +1 =
= βEt Qt +11 u 0 Ct?+1 rnt +1
αit + αit? = 0, 8i = 1, ... (n 1)
Basic framework
Indeterminacy problem
Non-stochastic SS
u 0 (Ct +1 ) u 0 (Ct +1 )
1 = βEt rit +1 = βEt rnt +1 )
u 0 (Ct ) u 0 (Ct )
) r1SS = r1SS = (1/β)
First order approximation (assume u CRRA)
ρCt = ρEt fCt +1 g + Et fr1t +1 g = ρEt fCt +1 g + Et fr2t +1 g

) Et fr1t +1 g = Et fr2t +1 g
DS procedure
DS assumptions and notation
Shocks are AR(1) with variance/covariance matrix Σ - time

invariant
Innovations symmetrically distributed in interval [ ε, +ε]
Assume symmetric non-stochastic SS with zero wealth:

W̄ = W̄ ? = 0
1
CRRA utility u (Ct ) = (1 ρ) (Ct )1 ρ
W t W̄
De…ne Ŵt = C̄
and r̂xt = r̂it r̂nt
ᾱ
α̃ = βȲ
DS procedure
Basic principle
Goal: approximate the model at 1rst order around X̄ and α̃
DS show that only a solution for α̃ is required to analyze

dynamics
In a …rst order approximation to the non-portfolio part of the

model the only aspect of the portfolio allocation that appears
is α̃
1
Ŵt = Ŵt 1 + α̃0 r̂xt + Yt Ct
β
DS procedure
Basic principle
Normal perturbation methodology: specify an approximation

point and solve for approximate behaviour of variables around
that point
DS procedure reverses this principle: leave α̃ unspeci…ed,
derive it endogenously after having approximated the rest of
the system
Can be thought of as a …xed point problem (iterative
algorithm)
1 approximate non portfolio equations at 1rst order for a given α̃
2 do implied linear decision rules satisfy (second order) portfolio
choice equations?
DS develop closed form solution for α̃ given the (1rst order)
equations for the rest of the model
DS procedure
Portfolio equations
Take 2nd order approximation of Euler Equations for H and F

Subtract them
Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) = 0
Sum them
1 2 1
Et fr̂xt +1 g = Et r̂xt +1 + ρ Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )
2 2
Characterize equilibrium portfolio and expected excess returns

DS procedure
Exploiting approximation properties
Up to 1rst order approximation

Et fr1t +1 g = Et fr2t +1 g ) Et frxt +1 g = 0
Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )

= Covt Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )
Σ time invariant ) second order (one-period-ahead)

moments are time invariant
Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )

= Cov Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )
DS procedure
The procedure in practice (1)

Solve the 1rst order approximation to the non-portfolio
equations of the model by treating α̃0 as given
Et frxt +1 g = 0 ) ξ t +1 = α̃0 rxt +1 is a zero mean i.i.d random
variable
1
Ŵt = Ŵt 1 + ξ t + Yt Ct
β
Full model linearized to 1rst order
st + 1 s
A1 = A2 t + A3 xt + Bξ t
Et c t + 1 ct
st +1 = F1 xt + F2 st + F3 ξ t
ct = P1 xt + P2 st + P3 ξ t
DS procedure
Derive α̃0 as the one that satis…es 2nd order approximation of

portfolio equations
Extract r̂xt +1 vector from the solution
r̂xt +1 = R1 ξ t +1 + R2 εt +1
Recall ξ is endogenous
ξ xt +1 = α̃0 rxt +1
Combining the equations above
α̃0 R2
r̂xt +1 = R1 + R2 εt +1
1 α̃0 R1
DS procedure
Extract from the solution
st + 1
Ĉt +1 Ĉt +1 Q̂t +1 /ρ = D1 ξ t +1 + D2 εt +1 + D3
xt
α̃0 R2 st + 1
D1 + D2 ε t + 1 + D3
1 α̃0 R1 xt
Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) =

0
α̃ R2
Et D1 + D2 εt +1 r̂xt +1 = R̃ΣD̃ 0
1 α̃0 R1
DS procedure
Derive α̃0 as portfolio holdings satisfying
Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) = R̃ΣD̃ 0 = 0
Closed form solution for α̃0 in terms of vectors derived from

linear solver
1
α̃ = R2 ΣD20 R10 D1 R2 ΣR20 R2 ΣD20
An example
Model setup
One good, H and F country
u (Ct ) = 1
(1 ρ ) (Ct )1 ρ
log Yt = ζ Y log Yt 1 + εt,Y , log Yt? = ζ Y log Yt? 1

?
+ εt,Y
σ2Y 0
Var =
0 σ2Y
Two bonds. H bc:
Wt = αB ,t + αB? ,t = αB ,t 1 rBt + αB? ,t ?
1 rBt + Yt Ct
An example
Model setup
De…ne RB and RB? to be the nominal payo¤s of the bonds
?
rBt = RB ,t Pt 1 /Pt and rBt = RB? ,t Pt? 1 /Pt?
LOP ) P = SP ? ) Q = 1
Money demands
Mt = Pt Yt and Mt? = Pt? Yt?
Monetary shocks - uncorrelated, variance σ2M
log Mt = ζ M log Mt 1 + εt,M , log Mt? = ζ M log Mt? 1

?
+ εt,M
An example
Focs and resource constraint
n o n o
(Ct ) ρ
= βEt (Ct +1 ) ρ
rBt +1 = βEt (Ct +1 ) ρ ?
rBt +1
n o n o
ρ ρ
(Ct? ) ρ
= βEt Ct?+1 rBt +1 = βEt Ct?+1 ?
rBt +1
Ct + Ct? = Yt + Yt?
Two assets and four shocks ) incomplete asset mkts

An example
First order approximation - excess returns
r̂Bt = R̂Bt + P̂t P̂t ? = R̂ ? + P̂ ?

r̂Bt P̂t?
1 Bt t 1
Et fr̂Bt ? g = 0 ) (R
r̂Bt ? )=
RBt
1 Bt
Et 1 (Pt ) Pt 1 Et 1 (Pt ) + Pt? 1
?
(r̂Bt ? ) = R̂
r̂Bt ? + P̂
R̂Bt P̂t P̂t? + P̂t? =
Bt t 1 1
= Et 1 P̂t P̂t 1 Et 1 P̂t? + P̂t? 1 + P̂t 1 P̂t P̂t? 1 + P̂t?
) r̂xt = Et 1 P̂t Et 1 P̂t? P̂t + P̂t?

An example
First order approximation - excess returns
De…ne PtE 1 = Et 1 P̂t PtE ?1 = Et 1 P̂t?
) r̂xt = PtE 1 P̂t PtE ?1 P̂t?
The realized excess return is given by the di¤erence between

H and F price surprise
An example
First order approximation - expectational equations
ρ (Ct ) = ρEt (Ct +1 ) + Et (rBt +1 )
ρ (Ct? ) = ρEt Ct?+1 + Et rBt

?
+1
?
De…ne Et (rBt +1 ) = Et rBt E
+1 = r̂t
PtE = Et P̂t +1
PtE ? = Et P̂t?+1
An example
First order approximation - non-expectational equations
Ĉt + Ĉt? = Ŷt + Ŷt?
Ŵt = (1/β) Ŵt 1 + Ŷt Ĉt + ξ t
M̂t = P̂t + Ŷt
M̂t? = P̂t? + Ŷt?
r̂xt = P̂tE 1 P̂t P̂tE ?1 P̂t?

An example
Variables
Endogenous states = [P̂tE , P̂tE ? , Ŵt , r̂tE ]
Jumps = [Ĉt , Ĉt? , P̂t , P̂t? , r x̂t ]
Exogenous states = [Ŷt , Ŷt? , M̂t , M̂t? , ξ t ]

An example
Steady State Portfolio
Extract appropriate rows from the solution to the (1rst order)

system
1
α̃ = R2 ΣD20 R10 D1 R2 ΣR20 R2 ΣD20
σ2Y
α̃B = α̃B? =
2 (σ2M + σ2Y ) (1 βζ Y )
H households sell the bond in their own currency and buy the
bond in the foreign currency
An example
Why are foreign bonds a good hedge?
M̂t = P̂t + Ŷt ) negative shock to domestic output rises the

domestic price level
Countercyclical price level
r̂xt = P̂tE 1 P̂t P̂tE ?1 P̂t? ) real excess returns fall
When domestic output is low, foreign bonds yield more

An example
Optimal portfolio dependance on variances
σ2Y
α̃B = α̃B? =
2 (σ2M + σ2Y ) (1 βζ Y )
Demand for foreign currency denominated bonds is increasing

in output variance
decreasing in monetary shocks’variance
Although prices are fully ‡exible, monetary volatility is costly

because it reduces the usefulness of nominal bonds as a
risk-sharing instrument
An example
Matrix from the linearized system
PP: Recursive equilibrium law of motion for x(t) on x(t-1):

00 0 0
00 0 0
00 1 0
00 0 0
Not stationary!
An example
Impulse responses - H endowment shock
H techn shock F techn shock

1 1
0.5 0.5
0 0
20 40 60 80 100 20 40 60 80 100
H monetary shock F monetary shock

1 1
0.5 0.5
0 0
20 40 60 80 100 20 40 60 80 100
An example

H consumption F consumption H price
1 1 1
0.5 0.5 0.5
0 0 0
-0.5 -0.5 -0.5
-1 -1 -1
20 40 60 80 100 20 40 60 80 100 20 40 60 80 100
F price return differential

1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
20 40 60 80 100 20 40 60 80 100
An example
H expected price F expected price

1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
20 40 60 80 100 20 40 60 80 100
wealth expected returns

10
0.2
5
0.1
0 0
-0.1
-5
-0.2
-10
20 40 60 80 100 20 40 60 80 100
An example

nominal exchange rate
1
0.5
-0.5
-1
10 20 30 40 50 60 70 80 90 100
real exchange rate

1
0.5
-0.5
-1
10 20 30 40 50 60 70 80 90 100
An example
Impulse responses - H monetary shock
H techn shock F techn shock

1 1
0.5 0.5
0 0
20 40 60 80 100 20 40 60 80 100
H monetary shock F monetary shock

1 1
0.5 0.5
0 0
20 40 60 80 100 20 40 60 80 100
An example
H consumption F consumption H price

1 1 1
0.5 0.5 0.5
0 0 0
-0.5 -0.5 -0.5
-1 -1 -1
20 40 60 80 100 20 40 60 80 100 20 40 60 80 100
F price return differential

1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
20 40 60 80 100 20 40 60 80 100
An example
H expected price F expected price

1 1
0.5 0.5
0 0
-0.5 -0.5
-1 -1
20 40 60 80 100 20 40 60 80 100
wealth expected returns

10
0.2
5
0.1
0 0
-0.1
-5
-0.2
-10
20 40 60 80 100 20 40 60 80 100
An example

nominal exchange rate
1
0.5
-0.5
-1
10 20 30 40 50 60 70 80 90 100
real exchange rate

1
0.5
-0.5
-1
10 20 30 40 50 60 70 80 90 100
Some issues about DS method
When are asset markets (e¤ectively) complete?
Focus on 1rst order approximation: is it su¢ cient to have as

many assets as shocks?
Characteristics of assets available matter
Endowment economies, YH , YF shocks, H and F equities )

(up to 1rst order) full risk sharing
Endowment economies, YH , YF shocks, H equity and H bond

) incomplete mkts
Order of approximation matters

Some issues about DS method
Other issues
The model is non-stationary
stationarity inducing features
gross asset holdings vary wrt non-stationary model and across

di¤erent parametrization of stationarity features
Can retrieve closed form solution for shares only if model fairly
simple

DS Class 2008 (EDocFind - Com)

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International Macroeconomics

Devereux and Sutherland (2006) method - some applications

May 16, 2008

Financial transmission on shocks

Financial channels of international shocks’transmission

Transmission literature usually based on DSGE models with

Models with complete mkts

according to the empirical literature on RS measurament, this

Models with trade in one asset

Incomplete mkts and more than one asset

Should allow for

analyze the role of current account de…cits/surpluses in

analyze the implications of gross portfolio holdings

Incomplete mkts and more than one asset - issues

1 With complete mkts it is possible to solve for the real macro

Devereux and Sutherland method - key aspects

At 1rst order of approximation only a solution for the Stedy

Time variations in portfolio shares are irrelevant for …rst order

Characterize SS portfolio by a system of

Basic model - goods and utility

Two countries, H and F, specialized in the production of

Consumption is a bundle of H and F goods

Prices of H and F consumption bundle P and P ?

Basic model - assets

r are endogenous gross returns

H agents budget constraint

De…ne excess returns on the n-th asset as rix = (ri rn ) )

αt0 = [α1t , ..., αn 1t ]

H agents budget constraint

H hhs bc can be written as

u 0 (Ct ) = βEt fu 0 (Ct +1 ) rit +1 g =

First order approximation (assume u CRRA)

ρCt = ρEt fCt +1 g + Et fr1t +1 g = ρEt fCt +1 g + Et fr2t +1 g

DS assumptions and notation

Shocks are AR(1) with variance/covariance matrix Σ - time

Innovations symmetrically distributed in interval [ ε, +ε]

Assume symmetric non-stochastic SS with zero wealth:

Goal: approximate the model at 1rst order around X̄ and α̃

DS show that only a solution for α̃ is required to analyze

In a …rst order approximation to the non-portfolio part of the

Normal perturbation methodology: specify an approximation

Take 2nd order approximation of Euler Equations for H and F

Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) = 0

Characterize equilibrium portfolio and expected excess returns

Exploiting approximation properties

Up to 1rst order approximation

Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )

Σ time invariant ) second order (one-period-ahead)

Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 )

The procedure in practice (1)

The procedure in practice (2)

Derive α̃0 as the one that satis…es 2nd order approximation of

Combining the equations above

The procedure in practice (2)

Extract from the solution

Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) =

The procedure in practice (2)

Derive α̃0 as portfolio holdings satisfying

Et Ĉt +1 Ĉt +1 Q̂t +1 /ρ (r̂xt +1 ) = R̃ΣD̃ 0 = 0

Closed form solution for α̃0 in terms of vectors derived from

One good, H and F country

log Yt = ζ Y log Yt 1 + εt,Y , log Yt? = ζ Y log Yt? 1