Closing the Small Open Economy Model: A Demographic Approach

Abstract

Closing the small open economy model has been a stumbling block in studying the dynamic evolution of such models. The typical procedure of equating the after‐tax return on traded bonds to the rate of time preference involves imposing an arbitrary and constraining knife‐edge condition. This paper replaces the infinitely lived representative agent framework with a plausible demographic structure. This yields a well‐behaved macrodynamic equilibrium without imposing any knife‐edge conditions. The equilibrium dynamics generated by the Rectangular survival function, characteristic of the Samuelson–Diamond model, closely track those corresponding to an empirically estimated survival function. However, the Blanchard survival function tracks the data poorly in terms of absolute levels, while the closeness of its relative dynamics (following a structural change) depends on the source of the structural change.