Monetary Expansion and Aggregate Supply in a Small, Open Economy

Bibliographic Data

ID9725485
AuthorsBetty C Daniel (0000-0002-7843-1594, corresponding author)
Year1982
Volume49
Issue195
Pages267
Publication date1982-08-01
Open AccessNo
TypeARTICLE
VenueEconomica (JOURNAL)
Journal identifiersISSN: 0013-0427 • E-ISSN: 1468-0335
PublisherJSTOR (PUBLISHER)
DOI10.2307/2553627
OpenAlexW1980764805
LanguageEN
References cited6

This analysis considers the dynamic effects of an unanticipated monetary shock on the exchange rate, the wage rate, the price level and the level of output in a small, open economy. The analysis explicitly recognizes different speeds of adjustment in asset and goods markets following Dornbusch's work on exchange rate dynamics (1976a, b). Wages and prices are assumed to be sticky relative to exchange rates. The distinguishing feature of the adjustment path derived in this analysis, compared to that in Dornbusch (1976a), is the dominant role played by labour supply, obtained by respecifying labour supply consistent with recent theory. Labour supply is assumed to increase with the current real wage and the real interest rate and to decrease with the expected rate of change of the real wage.' Dornbusch finds that an unanticipated monetary expansion immediately depreciates the exchange rate, creating excess demand for domestic goods. He uses two descriptions of labour supply. In one version labour supply and output are fixed, whereas in another labour supply is infinitely elastic, making output demand-determined. Thus, following the depreciation, output either rises or stays constant; the exchange rate must overshoot only if output does not rise. With the specification of labour supply used in this paper, an increase in the exchange rate reduces the purchasing power of labour's current wage and reduces the current relative to the future real wage, contracting labour supply and output. The short-run effects of monetary expansion in the face of wage and price stickiness are negative. The positive response of output, which is typical of Keynesian demand-determined models, does not appear. Since output falls, the exchange rate must overshoot, and the overshooting is larger than in the versions explored by Dornbusch. The adjustment path following monetary expansion is characterized by rising wages and prices, which contribute to a rising real wage for labour as it returns to its previous long-run level, increasing output. As prices rise, the rate of inflation falls. Thus, the adjustment path is characterized by falling inflation and rising output. This analysis is significant as a contribution towards integrating modern labour market theory with exchange rate and balance of payments work. As demonstrated here, replacing the assumption that labour supply passively responds to labour demand with modern labour market theory can substantially alter the conclusions. This paper is organized as follows. The next section contains a presentation of the model, including a discussion of endogenous expectations, goods and labour markets, asset markets, and solutions of the system. Section II contains

Aggregate (composite) · Aggregate demand · Aggregate supply · Economics · Monetary economics · Monetary policy · Economic Theory and Policy · Global Financial Crisis and Policies · Monetary Policy and Economic Impact

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