Welfare implications when closing small open economy models

This paper establishes that the closing method matters when the small open economy model is used for welfare analysis. The differences stem from the impact of the closing method on debt dynamics. When the ad-hoc parameters are set so that the current account volatility is controlled for across models, the welfare properties of versions with portfolio adjustment costs (PAC) and debt elastic interest rates (DEIR) are significantly different from the version with an endogenous discount factor (EDF). Nevertheless, this outcome is an artifact of an unrealistically dispersed distribution of the net foreign assets under PAC and DEIR, and can disappear under alternative calibrations of the ad-hoc parameters. In this sense, a seemingly innocuous application of PAC and DEIR versions may imply spurious results regarding welfare especially if a highly volatile economy is studied. Under commonly used functional forms, the spuriousness of welfare implications is found to be more radical under DEIR than PAC.