Master Thesis - Humboldt-Universität zu Berlin

of Christiano, Eichenbaum and Evans (2005); Lubik and Schorfheide (2005)
built up a small-scale two-country model. They are the pioneers in estimating
their open economy models using Bayesian techniques.
Following these advances in estimating the DSGE closed economy, Walque,
Smets and Wouter (2005) launched a new initiative to estimate large scale
models using over 20 shocks and time series in their model. Their theoretical
setup explaining the international sector is successful in accounting for
the role of the elasticity of substitution between domestic and foreign goods;
current account is derived from the intertemporal decision, as the difference
between savings and investment,and interest rate parity is modeled by introducing
a stochastic component. This mirrors the imperfections in the
international capital market and recoils on the capital account flows, and
thereby on the current account through the balance of payments identity.
The linkage between current account, international risk premiums, and exchange
rate has been the subject of investigation for some of the authors’
contemporaries. Mainly, the correlation between net foreign assets and the
exchange rate through the intermediation of a risk premium in Bergin (2006)
and Adolfson, Laséen, Lindé, and Villani (2005) is strongly supported by the
data. An extensive body of research has provided evidence that fluctuations
in fiscal policy seem to matter for the business cycle. In our contribution, we
use a benchmark model where government issues no debt, which is consistent
with Bergin (2005),and follows Baxter and King (1993) specifications.
Another simplification used in our theoretical model is to assume increasing
public debt (e.g. Trabant and Uhlig (2006)).
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