Dynamic Adjustment in an Open Economy with Flexible Exchange Rates

A constantly recurring topic in international finance since the early sixties has been investigation of the potential impact and effectiveness of monetary and/or fiscal stimulus for different exchange rate regimes. In this paper we reexamine these issues using a relatively simple dynamic model of an open economy which is well integrated with the rest of the world and has a flexible exchange rate. The model is designed to analyze the effects of monetary and fiscal policy over an intermediate length period in which flow equilibria are reached in both goods and asset markets. Our "equilibria" may, however, involve continuing stock disequilibria, and to the extent that they do our analysis is intermediate-run in nature.' In some ways, the model presented in this paper occupies a center ground between standard open economy Keynesian models, on the one hand, and open economy monetary approach models on the other. Like the former, aggregate demand plays a major role in determining the level of real income and its dynamic behavior in our model. Like the latter our model assumes a high degree of capital mobility and extensive integration of domestic goods markets with those of the rest-of-the-world. Thus the domestic interest rate is closely linked to the foreign rate, while goods prices and the exchange rate move to achieve purchasing power parity as an equilibrium condition. This endogenous adjustment of the domestic price level distinguishes our model from the standard Keynesian one in which prices are generally exogenous. The endogeneity of real income both in the short-run and in equilibrium