Exchange rate and recursive preferences

Dear forum members,

I am trying to build a very simple toy model with 2 countries, recursive preferences and complete markets. The economy of each country is similar to what is common with recursive preferences (e.g., Caldara et al., 2012), and I just allow households to trade a complete set of state-contingent claims.

As mentioned in Gourio et al. (2013), for example, the complete markets assumption implies that the exchange rate follows

q(+1)/q = ms/m

where “ms” and “m” are the stochastic discount factors for the foreign (MSt,t+1) and domestic (Mt,t+1) country, respectively.

My code runs if both countries are in autarky (i.e., if I arbitrarily set q=1 for all t), but when I add the exchange rate equation I get two errors:

  1. I have 13 forward-looking variables but only 12 eigenvalues > 1 in modulus;
  2. the model_diagnostics option tells me there is 1 colinear relationship between the variables and the equations

I’m new to Dynare so I am having trouble figuring out what is wrong with the code. Any help or feedback you could provide would be really appreciated.

toymodel.mod (3.37 KB)