PRECAUTIONARY SAVINGS IN SMALL OPEN ECONOMIES

Abstract

Emerging markets are more volatile and face different types of shocks, in size and nature, compared to their developed counterparts. Accurate identification of the stochastic properties of shocks is difficult. We show evidence suggesting that uncertainty about the underlying stochastic process is present in commodity prices. In addition, we build a dynamic stochastic general equilibrium model with informational frictions, which explicitly considers uncertainty about the nature of shocks. When formulating expectations, the economy assigns some probability to the shocks being temporary even if they are actually permanent. Parameter instability in the stochastic process implies that optimal saving levels (debt holdings) should be higher (lower) compared to a process with fixed parameters. Imperfect information about the nature of shocks matters when commodity GDP shares are high. Thus, economic policies based on misperception of the underlying regime can lead to substantial over/under saving with important associated costs. Later, I introduce the first example of a particular class of preferences characterized by a negative third derivative and a constant and invariant coefficient of relative prudence in the sense of Kimball (1990). This particular feature enables us to isolate the effect of risk aversion on precautionary savings. Furthermore, I use this particular class of preferences to assess the effects of volatility, risk aversion, interest rates and intertemporal distortions on precautionary savings in finite and infinite horizon models of a small open economy. The effects of risk aversion, intertemporal distortions and interest rates on average assets holdings are qualitatively identical as the ones observed for CES preferences. Using an infinite horizon model I can evaluate the effects of persistence and volatility of shocks on precautionary savings and verify that these are qualitatively identical to the ones observed with CES preferences.