Fiscal Policy and the Current Account in a Small Open Economy
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This paper analyses the macroeconomic effects of fiscal policy in a small open economy in a flexible exchange rate regime. The key result is that the effects of fiscal policy depend on the size of the elasticity of substitution between traded and nontraded goods. In particular, the sign of the current account response to fiscal policy depends on the interplay between the intertemporal elasticity of aggregate consumption and the elasticity of substitution between traded and nontraded goods. The paper also shows that only permanent fiscal expansions generate current account imbalances while temporary fiscal expansions do not affect the current account.Keywords:
Small open economy
Open economy
Elasticity
Consumption
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Using quarterly data for the 2000—2017 period, fiscal and monetary policy effects upon the real exchange rate (RER), the current account balance and output (GDP) in Ukraine are estimated with the SVAR model. It is found that the budget surplus is a factor behind both an improvement in the current account and the business cycle, arguing in favor of fiscal discipline as a stabilization tool. On the other side, there is weak evidence that the monetary hangover measured as a deviation of the monetary aggregate M2 from its equilibrium trend contributes to an improvement in the current account as well, but at the cost of significant output losses with 4 to 6 quarter lags. Similar outcomes are brought about by the RER depreciation above trend, with a simultaneous drop in output on impact combined with the current account surplus. Both money supply and RER effects could be explained by crowding out of investments in the nontradable sector by the export activities, as it is implied by the familiar dependent economy model. As there is an increase in the money supply in response to economic boom, it rejects criticisms about artificial money shortages in Ukraine. Our results provide support to the so-called «45o rule» of a direct link between output and the current account, although with a significant time lag. А favourable current account effect upon output is achieved in the long run either, with an opposite restrictionary effect being observed on impact. While there is no causality running from the money supply to the budget balance, a strong link between the budget deficit and expansionary monetary stance is observed.Everything seems to be that an increase in GDP is an effective factor in improving the current account balance over the long term, while a favorable feedback also appears with a significant time lag (in the short term, it is quite the opposite, that is, improving the current account balance worsens the cyclical GDP position). However, the decomposition of the remnants does not allow asserting the importance of causality «catÞyt» та «ytÞcat». It is obvious that changes in the balance of the current account depend largely on the state of external markets, and the cyclical GDP dynamics ─ on internal factors, which relate primarily to the exchange rate and the monetary "sway" (the effect of the budget balance is less significant).
Money supply
Depreciation (economics)
Output gap
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Exchange-rate flexibility
Exchange-rate pass-through
Currency substitution
Open economy
Small open economy
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This thesis analyses the effects of certain real shocks on the nominal and real exchange rates.
The first chapter analyses the impact and long run effects of an open market operation when domestic and foreign assets are imperfect substitutes. The nominal exchange rate overshoots its long run value. The real exchange rate depreciates on impact but appreciates in the long run.
The second chapter analyses the effects of monetary disinflation when the government budget constraint is introduced. It is shown that when a cut in the rate of monetary growth is accompanied by a cut in government expenditure we could have a jump depreciation of the real exchange rate.
But the costs in terms of output foregone are identical to those in the literature.
The third chapter shows that under plausible assumptions an expansionary balanced budget fiscal policy leads to current account surpluses rather than deficits.
The fourth (and final) chapter exmaines empirically the effects of a foreign real interest shock on the real exchange rate for the UK.
Disinflation
Depreciation (economics)
International Fisher effect
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We develop a two‐country, optimising, sticky prices and sticky wages model of real exchange rate determination in the new open macroeconomics tradition to analyse the interaction between supply‐side behaviour, market structure and the real exchange rate. For a UK‐euro area calibration, supply‐side improvements to total factor productivity (TFP) or the degree of monopolistic competition in the goods and labour markets result in a depreciation of the real exchange rate. When TFP increases in the traded goods sector, a depreciation of the terms of trade offsets the appreciation of the relative price of non‐traded goods, contrasting with the Balassa‐Samuelson proposition.
Depreciation (economics)
Monopolistic competition
Relative price
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This paper provides a complete analytical characterization of the positive and normative effects of alternative exchange rate regimes in a simple two-country sticky-price dynamic general equilibrium model with money, technology, and government spending shocks. A central question addressed is whether fixing the exchange rate prevents macroeconomic adjustment in relative prices from occurring, in face of shocks. In the model, the exchange rate regime has implications for both the volatility and mean of macroeconomic aggregates. But the effects of the exchange rate regime depend upon both the stance of monetary policy and the way in which the exchange rate is pegged. With a passive monetary policy, a cooperative pegged exchange rate regime has no implications for macroeconomic volatility, relative to a floating regime, but implies a higher mean level of employment, capital stock, and real GDP. When monetary policy is determined optimally however, a fixed exchange rate regime leads to higher employment volatility and a lower mean level of employment and real GDP. Therefore, whether fixing the exchange rate involves a welfare cost depends critically upon the flexibility of monetary policy in responding to macroeconomic shocks.
Exchange-rate flexibility
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Balance of Payments
Open economy
Constant (computer programming)
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Now that we have reviewed the impact and steady-state effects of various disturbances, we are ready to show how the economy travels from the one to the other and how its behavior over time is affected by the exchange-rate regime. We shall not do so however, for all of the disturbances studied in Chapters 4 and 5. Instead, we shall select examples that illustrate clearly the processes at work under the two exchange-rate regimes.
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As shown in Chapter 1, most emerging-market and developing economies maintain some type of officially determined exchange rate regime. Accordingly, the benchmark model of Part 2 was built on the assumption of a fixed exchange rate. However, as also shown in Chapter 1, a substantial number of emerging-market economies – and a few developing economies as well – operate exchange rate regimes that are best described as managed or free floats. To examine how the economy behaves in the short run under this alternative exchange rate regime, in this chapter we will revisit the benchmark model of Part 2 and investigate how it would need to be modified to describe an economy with floating exchange rates. This extension will not only allow us to study the macroeconomics of some important emerging economies but will also give us a frame of reference for analyzing optimal exchange rate regimes in Chapter 18.
Benchmark (surveying)
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This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific “r*” shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates ‘does all the work’ of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*’s are unobserved but are correlated across countries.
Depreciation (economics)
International Fisher effect
Liberian dollar
Taylor rule
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This paper proposes an equilibrium theory of nominal exchange rates, which offers a new perspective on various issues in open economy macroeconomics. The nominal exchange rate and portfolio choices are jointly determined in equilibrium, thus providing a new approach to overcoming the indeterminacy results in Kareken and Wallace (1981). The distinctive features of this theory are that the nominal exchange rate is determined in international financial markets, that the risk premium and UIP deviations are fully endogenous equilibrium objects and that the real exchange rate inherits its properties from the nominal exchange rate. In terms of policy, this novel theory implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma, because it loses not only monetary policy independence but also fiscal policy independence.
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