I am trying to figure out what might have gone wrong and how to deal with it. It is a two sector NK model (oil and non-oil). “model 3” is a simpler version, which looks fine to me. The non-stationary IRFs ( C and CNO, and others) pop up when I add the external sector, including international crude oil price shock (“model 4”). I read few resources on this forum, but still not sure where the problem could be coming from. Setting period =1000+ still shows the same. Thanks.
What determines the world interest rate in your model? It seems that interest rate permanently changes, requiring other variables to also permanently change.
Thanks a lot @jpfeifer . Quite strange, as I noticed that in the previous file, the IRF for world interest rate returns to SS. World interest rate was initially determined through FOC for foreign bond. But I have just changed that and set it as a constant as in CLOSING SMALL OPEN ECONOMY MODELS. Although I am seeing some slight improvements, the IRF for C and CNO still have issues.
model4_external_base2.mod (15.6 KB)
You should try to understand why there is a unit root in the capital stocks. For some reason, there is a permanent shift from investment to consumption.
@jpfeifer Thanks. The unit root in appears up when investment subsidy (omegga) to the oil sector (which is the main point of the research) appears in the budget constraint. When I set omegga to zero or remove it from the model, everything is fine.
Maybe it’s a feature of the model. The additional resources from the subsidy are used to finance permanent consumption?
Thanks for you reply. Consumption is function of Y, G, Tb and (subsidized) investment. Subsidy therefore create more consumption space. My interpretation was what, since subsidy works as a distortion its introduction shifts the economy to a new SS.
That may be. But the fundamental question is why a temporary shock has this permanent effect.
Thanks a lot. I started again from scratches and reviewed the way subsidy enters the model. I finally noticed that I incorrectly mixed some real and nominal concepts (thanks to your feedback below). Now everything works fine.