Hypothetical scenario: Let’s say I have an open economy DSGE model where the export/import ratio is approximately one in all periods (i.e, trade is balanced is zero in all periods), will the dynamics of the model resemble that of a closed economy model following external shocks? I want to do this experiment but maybe the answer is obvious.
That depends on the type of model. If there is only one good, then the answer is obvious. If differentiated goods are imported/exported, then even balance trade may be associated with significant effects deriving from openness.
Dear Prof. Pfeifer, may I confirm your statement. If there is only one good, then the answer is obvious that an open economy model is essentially a closed economy model if the export/import ratio is one, right?
Also if I may ask, using differentiated goods is the standard, right? Or more broadly, what decides the choice between a single good or a differentiated goods model for analysis? Simplicity and tractability vs. realism?
If you are exporting the same good you are importing, then balanced trade is equivalent to a closed economy. You are neither importing nor exporting the good. Of course, that is usually not a good description of reality. Countries export different goods than they import and there is often some pricing power involved, at least for non-commodity type goods.
Many thanks for the explanation! May I kindly ask one more clarification about differentiated goods model. Like NK models where there are intermediate good producers that produces differentiated goods and a final good producer that aggregates those goods like Smet and Wouters is what you mean by differentiated goods model, right? And by single good models, you mean like RBC models, right?
No, there are RBC-type models with more than one type of good. It’s about domestic and foreign goods not being perfect substitutes in some regard, either at the stage of intermediates or at the final good level. There are for example two-good models where agents consume an aggregate of domestic and foreign goods.