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10

future profits by the probability that the price will still be effective in that period. Thus the representative home firm seeks to maximize

= t z p z V t ) ( m a x ) ( s=t

γ stζ t,sπs (z)

(18)

whereζ t,s is the domestic discount factor between period t and period s, defined as

ζ t,s = Π

t j=s

(1+ i j )1 , where i the domestic nominal interest rate. The result is the following

pricing rule

pt (z) = (

θ θ 1

)

s=t s=t s W s s t t s s W s s t t s P C P C ζ γ ζ γ ) ( ( 1 ) ( ( 1 , , )θ wt ) θ

(19)

All firms in a country are symmetric and every firm that changes its price in any given period chooses the same price and output consistently with (19). The structure of price setting implies that each period a fraction of 1γ of firms sets a new price and the remaining

fraction keeps their price unchanged.

D. The Initial Steady State

In the policy exercises which we carry out below, we log-linearize the model around a symmetric steady state. We consider the special case in which initial net foreign assets are zero ( D0 = 0 ). Under this assumption we have, using the zero subscript to denote the initial

steady state

y0 = C0 = [(

1τ 1+τ I 0 C 0

)(

θ 1 θ

)]

1 ν +1

(20)

III. PARAMETERIZATION

The benchmark parameterization of the model mostly follows Betts and Devereux (2000). The elasticity of substitution between differentiated goods θ is set to 11. The discount factor β is assumed equal to 0.94, implying a steady-state interest rate of about 6 percent. The consumption elasticity of money demand 1/ε is set to 1. The disutility parameter ν is assumed to be unitary. The countries are assumed to be of equal size, implying n=0.5. The price rigidity parameter is set at γ=0.5. Initial income and consumption tax rates of respectively 20

a n d 8 p e r c e n t a r e a s s u m e d ) 0 8 . 0 ; 2 . 0 ( 0 0 = = C I τ τ . O u r g o a l i s t o p r e s e n t s i m p l e n u m e r i c a l

examples in order to illustrate the theoretical mechanisms underpinning the domestic and international impact of tax reforms. We therefore do not calibrate the model to any particular

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