17Stabilization policies in open economies.docx

17Stabilization policies in open economies.docx

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17Stabilizationpoliciesinopeneconomies

STABILIZATIONPOLICIESINOPENECONOMIES

RICHARDC.MARSTON*

UniversityofPennsylvaniaandNationalBureauofEconomicResearch

Contents

1.Introduction

2.Stabilizationpolicyintheinsulareconomy

2.1.Amodeloftradeandoutput

2.2.Flexibleexchangerates

2.3.Fixedexchangerates

2.4.Modificationsofthemodel

3.CapitalmobilityandtheMundell-Flemingpropositions

3.1.Amodelwithinternationallymobilecapital

3.2.Stabilizationpolicyunderfixedexchangerates

3.3.Stabilizationpolicyunderflexibleexchangerates

3.4.Therelativeeffectivenessofpoliciesandotherissues

4.Flexiblewagesandthemonetaryapproach

4.1.Amodelwithflexiblewages

4.2.Effectsofadevaluationwithflexiblewages

4.3.Effectsofmonetaryandfiscalpolicywithflexiblewages

5.Theroleofpolicyinthenewclassicalmacroeconomics

5.1.Amodelofanopeneconomyunderrationalexpectations

5.2.Changesinthemoneysupply

5.3.Policyrules

6.Exchangerateregimes

6.1.Domesticdisturbances

6.2.Foreigndisturbancesandinsulation

6.3.Optimalforeignexchangeintervention

References

*TheauthorwouldliketothankJoshuaAizenman,RichardHerring,HowardKaufold,StephenTurnovsky,CharlesWyploszandthetwodiscussantsofthepaper,RichardCooperandMohsinKhan,andotherparticipantsataPrincetonUniversityConferenceinMay1982fortheirhelpfulcommentsonanearlierdraft.Jean-FrancoisDreyfusprovidedexcellentresearchassistance.FinancialsupportbasprovidedbyaGermanMarshallFundFellowshipandagrantfromtheNationalScienceFoundation（SES-8006414）

HandbookofInternationalEconomics,col.II,editedbyR.W.JonesandP.B.Kenen

EIsevierSciencePublishersB.K..,1985

1.Introduction

Themodernopeneconomyisnottheonefoundinmostmacroeconomictextbooks,aneconomythatoccasionallyimportsBordeauxwinebutwhichproducesmostofwhatitconsumesatpricesdetermineddomestically.Itisratheraneconomyintegratedwiththoseabroadthroughcommodityandfinanciallinkageswhichlimitthescopefornationalstabilizationpolicy.Howthathappensisthesubjectofthischapter.

ManyofourideasaboutstabilizationpolicycanbetracedtowhatMcKinnon（1981）callsthe"insulareconomy"whichwediscussinSection2.Insuchaneconomy,whichwastheparadigmmostcommoninthe1950sandearlier,internationalcapitalmobilityislowornon-existent,moneysuppliesarecon-trolledbythenationalauthoritiesandpricelinkagesacrosscountriesarelimited.（Chapter13ofthisHandbookdescribesthiseconomyindetail.）Theliteratureonstabilizationsincethe1950shasmodifiedthisparadigminseveralessentialways.Thefinalproductmightnotberecognizedbyitsoriginalcraftsmen.

Itisusefultoclassifytheseprogressivemodificationsintothreecategories.

（1）Capitalmobility.Mundell（1963）andFleming（1962）showedtheimportanceofinternationalfinanciallinkagesindeterminingtheeffectsofstabilizationpolicy.TheirworkwillbethefocusofSection3,butthepropositionsassociatedwithMundellandFlemingwillbere-examinedinthelightofrecentportfoliobalancetheoriesoftheassetmarkets.

（2）Wageandpriceflexibility.Manyrecentstudies,includingthoseassociatedwiththemonetaryapproachtothebalanceofpaymentsandwiththenewclassicaleconomics,havereplacedtherigidwageassumptionofMundellandFlemingwithvariousformsofwageflexibility.InSection4weintroducewageflexibilityintotheMundell-Flemingmodelandshowhowmuchdifferencethismakesindeterminingtheeffectivenessofgovernmentpolicy.Whenwagesareflexible,wealtheffectsbecomeofprimaryimportancewiththeaccumulationofwealthmovingtheeconomyfromshort-runequilibriumtoalong-runsteadystate.WeillustratethiswealthaccumulationprocessusingDornbusch's（1973）versionofthemonetaryapproachtodevaluation.

（3）Rationalexpectationsandthenaturalratehypothesis.Nostudyofstabilizationpolicyiscompletewithoutthe"newclassicalmacroeconomics".Thisliteraturecombinesthelong-runwageandpriceflexibilityoftheclassicalmodelwithanexplicittreatmentofexpectationsthatincludesassumptionsabouttheavailabilityofinformationwhicharecrucialindeterminingtheeffectivenessofstabilizationpolicy.InSection5were-examinestandardpropositionsaboutpolicyusingrationalexpectationsandastochasticsupplyfunction;inSection6weusethesamemodeltore-examinethechoicebetweenexchangerateregimesandtheinsulatingpropertiesofflexiblerates.

Throughoutthechapter,onegeneralmodelisusedtointerpretdevelopmentsintheliterature,withthemodelbeingprogressivelymodifiedtoincludeinternationalfinanciallinkages,wageflexibilityandstochasticfeatures.Itfocusesonasinglenationaleconomy,althoughaforeigneconomyisaddedlaterinthechapter.Thiseconomyisassumedtoproduceitsown（composite）goodandtoissueitsowninterest-bearingbond.Inlimitingcasescommodityarbitragepegsthepriceofthegoodatpurchasingpowerparityandfinancialarbitragepegstheinterestrateat（uncovered）interestparity.Thechapterwillshowhowstabilizationpolicyisaffectedbyeachoftheselinkages.

Achapterwhichtreatssuchabroadrangeofissuesmustdrawthelinesomewhere.Wedonotattempttodiscusstheliteratureonnon-tradedgoodsorbonds.Nordowediscussindetailthedynamicresponsestopolicychangesthathavebeenadominantfeatureofsomerecentmodels.（Chapters15and18ofthisHandbookanalyzethisliterature.）Evenso,ourgeneralmodelwillberequiredtospanawiderangeofrecentdevelopments.Asingleunifyingframeworkwillservetoplacethesedevelopmentsinaclearperspective.

2.Stabilizationpolicyintheinsulareconomy

Thebalanceofpaymentsandexchangerateplayverydifferentrolesinstabilizationpolicydependinguponwhetherornotthereiscapitalmobility.Webegintheanalysisofstabilizationpolicyusingamodelwithoutanycapitalaccount.ThisisthemodelofHarberger（1950）,Tinbergen（1952）,Tsiang（1961）,andaboveallMeade（1951）,whichdominatedtheliteratureoninternationalmonetaryeconomicsuntilthe1960s.

Themodelvariesfromonestudytoanother,butanumberofcharacteristicsaretypicalofmostofthestudies.First,themodelis"Keynesian"inthatnominalgagesarefixed,atleastoverthetimehorizonrelevantforpolicy.Second,themoneysupplyisregardedasapolicyinstrumentunderthecompletecontroloftheauthorities.（Alternatively,theinterestratemaybecontrolledbytheauthorities.）Allbalanceofpaymentsflowsaresterilizedbyopenmarketsalesorpurchasesofsecuritiesorbyotherpolicyactions.Third,thefinancialsectorissimplifiedconsiderablybytheimmobilityofcapital.Usually,portfolioscontainonlyoneassetotherthanmoney,andthemarketforthatassetistreatedonlyimplicitly.Finally,expectationsareignored.

Weintroducebelowamodelofasmallcountrythatillustratesallofthesecharacteristics.Thecountryissmallinthatitdoesnotsignificantlyaffectforeignvariablessuchasthepriceofforeignoutput.Nestwesummarizesomeofthemainconclusionsaboutstabilizationpolicythatcanbederivedfromthismodel.Someoftheseconclusionsareverysensitivetotheprecisespecificationofthemodel,soweconcludethesectionbydiscussingmodificationsofthemodel.

2.1.Amodeloftradeandoutput

Sincethismodelisastandardoneinmostrespects,thedescriptionwillbebrief.Themodelconsistsofsixequations:

（2.1）-（2.6）

Eq.（2.1）describesthedemandforoutputinthehomecountry;itmustequalexpenditurebydomesticresidehts（Z）,andthegovernment（G0）plusthetradebalance（B）,allmeasuredinunitsofdomesticoutput.Expenditurebyresidents（2.2）isafunctionofincome（Y）,theinterestrate（r）,andtherealwealthofdomesticresidents;realwealthisthesum（A）ofmoneyanddomesticbondsdeflatedbythedomesticprice（P）,Thetrade（2.3）isafunctionofdomesticexpenditure,foreignexpenditure（Zf）,andthetermsoftrade,definedasp/pfX,wherepandpfarethepricesofdomesticandforeigngoods,respectively,andXisthedomesticcurrencypriceofforeigncurrency.Thetradebalanceisassumedtobenegativelyrelatedtothetermstrade（BP＜0），whichisthecaseiftheMarshall-Lernerconditionissatisfied.

Theaggregatesupplycurve（2.4）describestheresponseofoutput（income）toanincreaseinthepriceofthedomesticgood,holdingconstantthenominalwage（W）.Somemodelsofthistypefixthepriceofthegooditself,butnotmuchisgainedbythisfurthersimplificationofthemodel.Thedemandfunctionformoney（2.5）hasastandardformfamiliarfrommodelsoftheclosedeconomy.Therestrictiononthewealthelasticityincludestwolimitingcases;thedemandformoneycanbeindependentofwealth,asinthequantitytheory,orcanbehomogeneousofdegreeoneinwealth,asinsomeassetmodels.Eq.（2.6）isabalanceofpaymentsequationdescribingtheaccumulationofforeignexchangereserves（Fm）.

Thefourequationsjointlydeterminefourvariables:

thedomesticprice,output,interestrateandeitherforeignexchangereservesortheexchangerate,dependingupontheexchangerateregime.Webeginbydescribingtheflexibleexchangerateregime.

2.2.Flexibleexchangerates

Withcapitalimmobile,theexchangerateisdeterminedentirelybyflowconditions,asindicatedbythebalanceofpaymentseq.（2.6）.Sincethebalanceofpaymentsconsistsofthetradeaccountonly,theexchangeratemustadjusttokeepthetradebalanceatzero:

（2.3’）

Thisleadstoverystrongc