substitution. For σ > 1 the marginal utility of consumption in retirement exceeds the marginal
utility of consumption during work and vice versa. Especially the case σ<1 has the interesting
consequence that workers prefer consumption during working life. Intuitively this phenomenon
can be related to the preference for income smoothing implied by a low intertemporal elasticity of
substitution. Effectively this increases the rate of time preference of workers.
Total financial wealth At consists of three types of assets, government bonds Bt domestic equity
qtKt , where qt is the share price and Kt are units of real capital owned by the household.
Households can also store wealth in the form of internationally traded bonds Ft issued by private
agents in both countries.
At =qtKt+Bt+Ft. (19)
Imperfect international capital mobility is introduced via a trading friction for internationally
traded bonds expressed as a function which captures the cost for the domestic household of
undertaking positions in the international capital market. As borrower, the household is charged a
premium on the foreign interest rate and as lender he receives a remuneration which is below the
foreign interest rate. Effectively this implies that uncovered interest parity does not hold between
the domestic and the foreign economy where the spread between the domestic and foreign interest
rate depends on whether the home country is a borrower or a lender in the market for international
bonds. We specify the interest differential as a linear function of the net foreign asset position of
the respective country
rtF
( Ff )
= rt - Ψ Y- I, ψ ≥ 0
к γt )
(20)
The corporate sector in each region operates under perfect competition. Output is produced with a
constant returns to scale Cobb Douglas production function
Yt =F(Kt,Lt)Γt = Kt1-αLαt Γt
(21)
where Γt is an exogenous shock to technology. Capital stock changes according to the rate of
fixed capital formation J t and the rate of geometric depreciation
Kt =Jt+(1-δ)Kt-1.
(22)
Total investment expenditures are equal to investment purchases plus the cost of installation. The
unit installation costs are assumed to be a linear function of the investment to capital ratio with a
parameter φ. Total investment expenditure is therefore given by
It
= Jt
(K-)1
к t ))
(23)
The corporate sector in country i maximises the net present value of its cash flow
76
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