Financial Policies in an Open Economy

The large number of countries now pursuing flexible rates justifies another look at the small-country case under such an exchange rate regime. The Metzlerian (1951) macro-model, which was opened up to world trade by Mundell (1961b), provides an elegant framework for the analysis. That model remains the workhorse for much of the research on both fixed and flexible exchange rates for economies that have capital and commodity mobility with the rest of the world (McKinnon and Oates, 1966; Johnson, 1969; Frenkel, 1971; Dornbusch, 1973; Mussa, 1974; Parkin, 1974; Boyer, 1975). Recent research in related areas, in particular the disaggregation of commodities into traded and non-traded goods, permits a number of simplifications of that basic framework without restricting its generality. These simplifications allow greater attention to be paid to some aspects of the model that have been criticized in the past, notably the specification of the capital account (Willett and Forte, 1969). To meet these criticisms the model presented here has a portfolio balance conception of the asset markets. Within such a context it is possible to consider an element that has been neglected in the analysis of flexible exchange rates: the effects of the capital gains or losses from a change in the exchange rate. These capital gains, which assumed great importance recently because of large foreign currency borrowing, depend crucially upon the currency composition of domestic portfolios immediately before any exogenous shock. With the incorporation of capital gains into the portfolio balance model, the equilibrium is none the less uniquely dependent upon the values of the system parameters so long as the economy is not a substantial debtor in foreign currency-denominated market instruments (Tower, 1972). However, the popular assumption that the money market equilibrium condition is independent of the exchange rate is justified only when the economy's net holdings of foreign currency market instruments is zero. Section II analyses the effects of financial policies under flexible exchange rates. A simple diagrammatic apparatus is developed there in order to portray these results. Section III introduces the fixed exchange rate version of the model and shows how this exchange rate regime can be incorporated into the diagram used above. Financial policies under this exchange rate regime are considered in Section IV, where a comparison is made of their potency under alternative exchange rate regimes. Section V provides a conclusion. The conclusions of this analysis can be stated very briefly. The traditional results concerning the relative potency of financial policies in non-traded goods and traded bonds under alternative exchange rate regimes (Fleming, 1962; Mundell, 1963) continue to hold. In particular, it is demonstrated that the conclusion that fiscal policy has no effect on the price level under flexible exchange rates depends on the economy's having a zero net position in

Business · Economics · Financial system · Banking stability, regulation, efficiency · Economic Theory and Policy · Finance · Global Financial Crisis and Policies

• Optimal Foreign Exchange Market Intervention

  Russell S Boyer•Journal of Political Economy•1978

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• Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates

  Open Access•Robert A Mundell•The Canadian Journal of Economics…•1963

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• Wealth, Saving, and the Rate of Interest

  Lloyd A Metzler•Journal of Political Economy•1951

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