Description

This paper builds a quantitative model to assess the optimal allocation of resources in an economy that is subject to a volatile source of income such as commodity exports, and with imperfect access to international financial markets. In this context the government faces a trade-off between smoothing expenditures and accumulating assets for precautionary motives, as well as saving in riskfree assets and investing in physical capital. The features of the model and the solution method allow for a detailed exploration of the trade-offs involved, particularly those related to volatility and uncertainty. The analysis sheds light about optimal saving and spending in stochastic environments, and best responses to large shocks and to permanent changes in stochastic processes.