IRF not returning to SS

Stochastic simulations
1

Hi,
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.

model3_rigid.mod (10.1 KB)
model4_external_base.mod (15.4 KB)

2

What determines the world interest rate in your model? It seems that interest rate permanently changes, requiring other variables to also permanently change.

3

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)

4

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.

1 Like
5

@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.

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image1144×670 30.6 KB

7

Maybe it’s a feature of the model. The additional resources from the subsidy are used to finance permanent consumption?

8

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.

9

That may be. But the fundamental question is why a temporary shock has this permanent effect.

10

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.