Why Global and Local Solutions of Open-Economy Models with Incomplete Markets Differ and Why it Matters

Global and local methods used to study open-economy incomplete-markets models yield different cyclical moments, impulse responses, spectral densities and precautionary savings. Endowment and RBC model solutions obtained with first-order, higher-order, and risky-steady-state local methods are compared with fixed-point-iteration global solutions. Analytic and numerical results show that the differences are due to the near-unit-root nature of net foreign assets under incomplete markets and inaccuracies of local methods in computing their autocorrelation. In a Sudden Stops model, quasi-linear methods that handle occasionally binding constraints understate the size of credit constraint multipliers, financial premia and macroeconomic responses.