A small open economy model with transaction costs in foreign capital

In this paper we develop a stochastic dynamic general equilibrium model for a small open economy in the real business cycle modeling tradition. Househ old preferences depend on private and public consumption and leisure. Produ ction technology depends on public capital. Government finances its investm ent, consumption and transfer payments by means of a proportional income ta x rate. Households buy and sell foreign assets in an international capital market with transaction costs and also receive transfer payments from abroa d. We calibrate the model for the Greek economy. The volatility, persistenc e, and co-movement properties of the business cycle component of the data g enerated by the model are broadly consistent with the actual behavior of th e corresponding actual data. We use the model to investigate the response o f major macroeconomic variables to temporary and permanent changes in gover nment policy variables, foreign transfers, and the rate on return of foreig n assets. We find that increasing government consumption and domestic trans fers financed through distorting taxation lowers capital, labor (in most ca ses) and output while it increases foreign asset holdings, both in the shor t and the long run. Increasing government investment financed by distorting taxation eventually increases capital and output and decreases labor. Fina lly transfers from abroad decrease capital, labor and output, while they in crease consumption. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification. El; E3; E6; F3.