Devaluation and investment in an optimizing model of the small open economy

We analyze the impact of devaluation on sectoral investment, aggregate investment, and real output in a fully articulated, optimizing model of a small open economy where installed capital is sector-specific and new capital goods are constructed by combining nontraded inputs with non-competitive imported machines. Investment falls when the intertemporal elasticity of substitution and the share of domestically produced capital goods are not implausibly large, This result is robust to a wide range of parameter values and to the possibility that saving-investment decisions are made by heterogeneous agents instead of a representative agent. (C) 2001 Elsevier Science B.V. All rights reserved.