UIP in two country model

[mghazias]

Hi Everyone;

I have a colinearity problem in a simple two country model. I have removed all the rigidities and extra features of the model and yet the problem is there.
Problematic equations are interest rate equations in two country and UIP equation connecting the two variable.
Please help, I have spent endless time on this and really frustrated.
Do appreciate your advices.
Thanks

P.S. it produces a LATEX file that you can see all equations.

[jpfeifer]

Try narrowing down the problem even further. Get rid of the adjustment costs and the exogenous processes except for 1.

One a more constructive level: Are you sure that you can determine the single prices in the respective countries? I only know those model written down in terms of inflation instead of the price levels. Moreover, could you post a LaTeX-file detailing how you derived equation 41 and 42 from the household's optimization problem and the setup?

[mghazias]

I will narrow it down further,

I am following this work:

[url]
http://www.federalreserve.gov/pubs/ifdp ... pendix.pdf
[/url]

and

[url]
http://www.sciencedirect.com/science/ar ... 611000365#
[/url]

I derived UIP from household optimization, it didn't work, then followed above papers and some others.
Actually there are different ways to make bond position stationary. portfolio cost, endogenous discount factor, debt elastic interest rate etc. I used the debt elastic model for no reason as it is shown they all do the same work.

I will post a pdf file soon.

Thanks a lot JP.

[jpfeifer]

The stationarity of assets is not the problem. If you look at equations 79 and 80 in the Appendix, you can see my point. What is treated as a variable is the relative prices, not the individual prices.

[mghazias]

About equations 79 and 80, I think I have done the same,

But about individual prices and inflation, I am coming to this conclusion that I must use inflation in budget constraint, but, I will need two more equations. Should I use taylor rule equation (or some monetary policy equation) for that?

[jpfeifer]

That should depend on your model. Start with the easiest version possible to see which equations are missing.