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Monetary and Fiscal Policy in a Small Open Economy
Copyright © IFAC Dynamic Modelling Warsaw. Poland. 1980
MONETARY AND FISCAL POLICY IN A SMALL OPEN ECONOMY G. Chiesa Conjederazione Generale dell'/ndustria Italiana and LU/SS University, Viale dell'Astronomia, 30 EUR 00144 Rome, Italy
AbstracL. This paper presents an aggregate model of the Italian economy, discusses its properties, simulation results and the implications on the main macroeconomic variables of different reaction functions of the monetary authority. The main features of the model are: (a) specification in continuous time; (b) specification of the dynamics of the model as a disequilibrium process; (c) estimation procedure: full information maximum - likelihood technique with restrictions on parameters within and across the equations. The model specifies the real and financial sectors, their interactions and those with the rest of the world. The specification is based on the more recent theoretical work on the behaviour of small open economies, and it recognizes the implications of the size and degree of openness of the economy on price behaviour and assets substitutability. The main empirical findings are the relevant impact of financial variables on the economic activity and the type of adjustment process which works mainly through quantity adjustment with strong and rapid impact on the balance of payments. Keywords. Disequilibrium; model; stochastic; differential equations; simulation; monetary; fiscal policy. of monetary policy within a framework which allows for the spillover of the disequiliINTRODUCTION brium of financial assets into real domestic and financial markets. This paper presents the results of a model of the Italian economy and discusses its The model is specified in continuous time as properties. Although the model is highly aga system of non-linear differential equations, gregated, it links together the real, finanthus giving explicit recognition to the poscial and foreign sectors. The specification sibility that at any point in time the econodraws on the recent theoretical work in monemy might be out of equilibrium. tary economics directed to the analysis of small open economies 1/; according to this This approach also provides a consistent approach the law of one price in the ·intertreatment of stock and flow variables and sanational markets is assumed to hold in long tisfies the objective of dealing with the run equilibrium. adjustment process of the economy without imposing any a priori constraint on the mean Particular attention has been given to the per- time lag. formance of the model under dynamic simulation and to its stability conditions in the analysis The specification treatment of the dynamic of the interaction between financial and real structure of the economy and the estimation markets. The hypothesis of instantaneous adprocedure 2/ of a model which includes market justment of markets to the equilibrium position identities~ a budget constraint and the reachas been relaxed, it has explicitly recognized tion function of the authorities also allow the possibility that the divergency between more accurate simulation exercises and therethe effective and the equilibrium value of fore the model is particularly useful for the demand for commodities and financial assets purpose of ana1yzing the effects of changes affects the level of prices and quantities in in economic policy variables. the other markets. The analysis is particularly relevant for the objective of evaluating Although the period of estimation includes the empirical relevance of the various approayears of exchange rate flexibility, the model ches to the balance of payments and it provides as it stands does not endogenize the exchange the information which one needs in order to rate. It is taken as an exogenous policy assess the intermediate quantitative targets variable under the assumption that the authority determine a target level of lira I am greatly indebted to A. Markandya, P. on the foreign exchange market and use their Savona, C. R. Wymer for helpful comments. instruments to achieve this target. l/See for instance the collection of essays on the approach to the balance of payments edited by J. Frenkel and H. Johnson (1976). 253
2/The model has been estimated simultaneously using a full information maximum likelihood method developed by C.R. Wymer (1972).
254
G. Chiesa
balance of payments and stocks of financial The paper is set out as follows: Section I assets is an integral part of the model. discusses the structure of the model, Section 11 presents the empirical results, and Section 111 In the present work the balance of trade can discusses its dynamic simulation. It analyses the relationship between the behaviour of be identified, in the long run, as the excess the monetary authority and the adjustment of supply o£ goods on the real market and the the system to changes in the exogenous variacapital movement as the excess supply of dobles and the effects of different monetary mestic financial assets. rules on the level of outpu~, private expenditure and balance of payments. On_the other hand, no prior assumption has been made on the speed of adjustment of the various markets so that the model does not prevent any effect of domestic policy on I. OVERVIEW OF THE MODEL prices and level of domestic activity other than their long. run final effect on the Macroeconomic modelling applied to open ecobalance of payments. nomies can be easily referred to two main approaches: one of structural form in line In.order to clarify the line followed in the with US modelling which tends to neglect specification, it is worth mentioning here the implication of the openness of the systhat output is in the short run defined by tem on the behaviour and adjustment of the aggregate demand relative prices (domestic markets. The other of reduced form type and foreign); on the other hand, the explicit which embodies the proposition brought about consideration of feedbacks from the gap betby the monetary theory related to open ecoween the actual and the equilibrium value of nomies, that the law of one price must domidemand onto prices and quantities (imports nate on the international real and financial and exports) traces the effect of the dismarkets. The growing integration of markets equilibrium of the real market onto the tends to support such propositions and to balance of trade and prices and therefore its deny that the specifications which exclude effects on the level of output at any point them can be of any use in analyzing the in time. relation between financial, and real domestic markets with the foreign one. The assumption of non-instantaneous adjustment of the system also allows for the effect The second approach which derives from the of the gap between the desired and actual line of thought known as the "monetary apholding of financial assets to affect the proach to the balance of payments" has equilibrium solution of other markets. It originated empirical work which implicitly affects the flow of expenditure over income assumes instantaneous adjustment of real and the capital flows with the foreign secand financial markets and identifies the tor; the latter acting as the adjustment balance of payments as the adjustment mechamechanism through which the monetary nism of the money market. i/ disequilibrium is eliminated. On the one hand, such assumptions are bound to give inconsistency to the empirical estimates, THE STRUCTURE OF THE MODEL whilst on the other they prevent the' analysis from giving any information on what is more The model specifies real and financial relevant to the approach to which they refer. sectors of the Italian economy and their What is needed is a greater knowledge of the in- interactions with the rest of the world. It teraction among markets out of equilibrium and incorporates market identities and a budget the implication on the balance of payments of constraint, and explicitly recognizes the the adjustment process which tends to fill the reaction of the monetary authority to the gap between actual and desired stock of wealth behaviour of the economy, emphasizing the and financial assets. 4/ The specification relevance of the balance of payments on the proposed here attempts-to deal with this probformulation of its interest rate target. lem. It borrows from the monetarist approach the identification of the external accounts as The specification of the model is related to the adjustment mechanism through which an open the behaviour of the following economic economy reaches the equilibrium of flow variaagents: bles on the real market and that of stocks on financial markets. The link between the (a) the private sector ~~~~~~~~~~~~~~~~~~~~~~~~(b)the rest of the world
3/T. Courchene, and K. Singh, (1975), H. A. Genberg (1976). 4/The relation stocKs-flows and the interpretation of real and monetary flows with the external market as consequences of wealth and portfolio adjustment is emphasized by H. Johnson in several works, see for example, H. Johnson (1976).
(c)
the monetary and fiscal authority.
The private sector produces a homogeneous stream of goods which are either traded in international markets or absorbed domes-
255
M)netary and Fiscal Policy in a Small Open Economy
tically. 5/ The private sector uses income from production and borrowing from domestic and foreign financial markets in order to purchase domestic and foreign goods and assets.
TABLE 2 Specification of the Model ~i10g
(E/E) + d210g Af / Af)
(1)
~rd - D log P})
A
log E = log (eo YD e -
The monetary and fiscal authority is defined as the aggregation of the government and the banking sector. Such aggregation has been chosen on the basis of the high degree of control that the Bank of Italy exercises on the banking system as far as domestic and foreign markets are concerned. The approach followed in the specification is consistent with the hypothesis that demand and supply for goods, financial assets, liabilities and prices react at any point in time to any divergence between actual and desired values; the latter being specified with respect to the behaviour of economic agents.
A
1\
D log E =
A
log Af
B log (ao YD 2)
log YD
log (Y - Tax/P + Tr/P)
log Af
10gCM/P + B/P + F/P) 1\
D log X =o(~log (X/X) - ~log (E + G) (E + Gr~eA,t ~
1\
log X
(Pw /P~
log (Xo Wd A
D log I =rl(; log (1/1) + /\
)
'" (V/V)
~,log
(3)
log (~ eA'Lt (P/Pm)"" S)
log I TABLE 1. Variables of the Model
(2)
1\
log (Vo S)
log V Endogenous
S = E + X+ G Output and expenditure variables D log y =~1log E X I Y V
P
Pt
Private domestic demand for goods Real exports of goods and services Real imports of goods and services Gross domestic product Inventories of goods and work in progress Gross domestic product implicit price deflator Price of goods traded internationally
Financial Variables Domestic banks advances to private sector B Government bonds held by the private sector F Net stock of foreign assets held by domestic residents rd Average market yield on government bonds Tax = Tax receipts valued in money terms M Domestic money stock (M2)
A
"
+ 0(& log V/v A A2.t f}5 log Y = log (S - /34 e (P /Pm) S)
DV
(Y /y)
Y + I - S
( 4)
(5)
D log P = o(~ log (p/P) '" + "fa log (E + G) t (6) (E + G)i1,A, A
log (Po Pw eA"t)
log P
AD
Exogenous
Pm Pw
Wd G rw AICS tr t
Unit value of imported goods Unit value of world manufactured exports Total exports of developed countries Government expenditure on current goods and services Foreign interest rate Special credit institutions loans to the private sector Transfer payments Time
l/A1though in the price sector different price behaviour for traded and non~traded goods is specified, the constant share of traded and non-traded output on the average_has suggested to neglect the effect of their relative prices on the system.
D log Pt =
'"
log (Pto Pw)
log Pt
D rd =~~(rd - rd) +~14log PmI PxX 1\
rd
(8)
rw +~~(D log P - D log Pw) 1\
A
D log AD = ~1' log ( (AD/P) / AD/P ) +,(nlog V/V +~1llog
log
(PmI) PS
ADh
(9)
= log (Ao S e-
Bfrd
)
A
D log B
=I(l~
log ( (B/P) /B/P ) 131
1\ )\
log ( B/P) = log (bo Y e D log F
=~(rw +«~(D
/3 1 (rd
(10)
- D log P)
log P - D log Pw) - rd)
A
+(1110g (M/P)/(M/P)
(11)
~'
256
G. Chiesa
A log (M/P) D log Tax
~~d
log (Mo Y e r ) =d~3log
A
(Tax/Tax)
log Tix = log {to (Y
(12)
P)~
DM = (PtX - PmI) + (PG + Tr - Tax) +
(13)
DAD - DB - DF + DAICS Aspects of Sectors This section highlights key aspects and sectors of the model in order to give the reader more insight into the model than may be gleaned from a simple listing of equations. Domestic Private Absorption The demand for goods and services of the domestic private sector is assumed to adjust towards a desired level determined by disposable income and interest rate. The adjustment is also assumed to be affected by disequilibrium holdings of financial assets, the last representing a generalization of the real money balance effect on expenditure within a model in which financial assets are not just money. 6/ It is worth pointing out here that the specification of the interaction between financial and real markets is not only consistent with a structure which including assets other than money allows them to absorb disequilibrium of money holdings 7/ but also it has been found relevant in defIning the dynamic properties of the model. When, consistently with the propos~t~on embodied in the theoretical and empirical analysis of monetarist type 8/ the strict monetary disequilibrium is Introduced although the estimates show that it has relevant and significant impact on expenditure, the dynamic simulation of such specification and the variable path in response to changes in policy variables have led to reject iL on the grounds of the lack of stability of the model. Such evidence integrated with the significant effect of disequilibrum money holdings into the demand for domestic and foreign financial assets allows one to say that the excess of money balances produces a readjustment of the financial portfolio and only because this 6/The effect of hoarding and dishoarding of money balances onto expenditure has been developed by A. Marty (1964) and taken up by R. Dornbusch (1973) in a model in which money is th~ only asset. 7//This is emphasized by F.H.Hahn (1977)in his criticism to the monetary approach to the balance of payments. a/See P.D. Jonson (1976); B. Aghle~i and C. Kodriguez (1979).
causes a non equilibrium holdings of the total financial assets it affects the real market. The empirical evidence seems therefore to confirm for Italy the thesis that in order to control domestic absorption the intermediate target of the monetary policy has to be defined in terms of liquid assets rather than its strictly monetary component 9/; given the relation between expenditure output and balance of trade one can also say that the intermediate target declared by the Italian authorities (CTI) 10/ is the appropriate one in controlling the balance of trade as compared with DCE, domestic component of the money supply. On the other hand it is worth emphasizing that although the channels through which the financial assets are domestically created have the same impact on the level of the intermediate target, this does not hold as far as the final goal is concerned, suggesting that the level of the monetary target cannot be defined independently of its composition: government deficit and bank credit. The direct and induced effects of the public deficit on the system reject the assumptions embodied in the framework within which that target was discussed 11/, such as perfect crowding-out of domestic absorption by public deficit and its nil impact on the final goal when the monetary intermediate target is held constant. Specification of the Supply Components of Goods and Services The specification of the model explicitly embodies the behaviour of the supply of goods domestically and externally produced. Imports are considered from the supply side as an alternative to domestic production. Change in inventories is defined as a residual in order to explicitly recognize their role of buffer-stock, but the specification of the model allows for feedback of unplanned stocks on output and import decisions.12/ Specification of the Price Sector The approach followed in the analysis of the inflationary process draws from the recent theoretical and empirical work on open economies the distinction between 9!This is the thesis brought about by J.G. Gurley (1960). 10/CTI is the so-called domestic total credit expansion and it represents the domestic component of financial assets. ll/F. Cotula, S. Micossi (1977), G. Vaciago (1975). l2/This is in the spirit of the work done by ~R. Bergstrom-C.R. Wymer (1976) and G.J. Anderson, I.F. Pearce, and P.K. Trivedi (1976).
Monetary and Fiscal Policy in a Small Open Economy
257
the price behaviour of traded and non-traded goods. ll/ The proposition that the price of output which is traded on the international market cannot differ from international market price is the underlying assumption of the price behaviour of the traded sector in the. equilibrium solution of the system. While the price of exportable goods is a.structura1 equation which embodies the above proposition, the implicit price def1ator is specified.as a reduced form of the price and wage sector under the hypothesis of different price behaviour in the traded and non-traded sectors.
All of the estimated parameters reported in Table 3 have the sign expected a priori. Of the 32 estimated parameters 29 are significantly different from zero at the 5 percent confidence level. Because the adjustment functions are based on the assumption that the agents behave in such a way as to bring the level of the variables under their control to their desired values, reacting to changes in the variable with an exponentially distributed lag, the inverse of each adjustment parameter can be interpreted as the mean of the exponentially distributed lag. l2/
The structural equations from which the reduced form is derived refer to the price of traded, non-traded goods and wages. The non-traded sector sets the price as a markup on long run average cost, workers pursue a target rate of growth of real wage. !if
These estimates give an immediate description of the speed of adjustment of the various markets and show what is the empirical relevance of the disequilibrium spi1lover among different markets. TABLE 3. Adjustment Parameters Estimate
Financial block Although the aggregation which has been chosen does not allow the separation of firms from households or the definition of separate budget constraints, the low propensity of firms to demand financial assets as such and of families to go into debt suggest the definition of bonds and loans as two separate assets, even when instantaneous adjustment of the structure of interest rates is assumed. The specification of the financial sector embodies the hypothesis of perfect substitutability between domestic and foreign assets and non-instantaneous adjustment of portfolio; only one interest rate enters the demand for domestic financial assets and the change in foreign assets responding to the interest rate differential works through pressure on reserves as the adjustment mechanism through which interest rates are equalized.
11. ESTIMATION RESULTS This section presents estimates of the parameters of the model for a sample period of quarterly observations extending from the fourth quarter of 1960 to the fourth quarter of 1975. The model has been estimated with the FIML procedure with linear and non-linear restrictions on the parameters within and across the equations, applied to the discrete approximation of the continuous model linearized about the sample means of the logarithms of the variables.
d1 a2
~5 ~6
~7 ~8
~9
a10 ~11
ll(12 ~13 ~14
C(15 ct16 ~17
«18 ~19
({20 ((21 ~22 ~23
t Value
0.373 0.203 0.376 0.443 0.605 0.407 1.663 0.0 0.112 0.161 1.209 0.289 0.140 0.005 0.022 0.116 0.107 0.068 0.268 3.235 0.052 0.250 3.353
2.21 2.60 3.07 1.87 4.18 2.92 4.46 5.87 3.56 4.61 2.51 7.38 5.50 1.16 4.28 3.51 4.18 3.05 4.41 1.72 4.31 4.76
Meantime lag 2.680 2.659 1.653 0.601 8.928 0.827 7.143 8.620 3.731
0.298
E1asticities, growth rate, average import Propensity
Bl 82 (l3
R4 {35 86 ~7 ~8
{39 ~l
A2 13/R. Dornbusch (1973), E. Helpman (1976), W.H. Branson and J. Myhrman (1976). l4/The underlying structural equation is in the spirit of the Sargan-Kuh model, see for reference J.D. Sargan (1971) and E. Kuh (1963) •
Estimate
~3
0.0 1.299 1.00 0.172 0.284 17.928 18.670 29.667 1.054 0.012 0.007 0.007
19.27 7.81 2.99 2.77 2.11 5.06 97.52 15.97 7.06 5.16
holds when for Py = ~(X - X), X and Y are not different variables.
12/This
258
G. Chiesa
Ill. 111.1
payments, level of domestic activity and domestic expenditure of different financing of the deficit.
DYNAMIC ANALYSIS
Contro~
and Actual Values
This section presents information about the performance of the model inside the sample period. Table 4 contains the two sets of mean square errors, the first one is the root-mean square error of the static simulation, the second set is that for dynamic simulation. 16/ Although the root mean square errors in sample dynamic simulation are somewhat larger than in one period case, the results are on the whole satisfactory. With the exception of government bonds and foreign assets h:ld by domestic residents, all the other var1ables have root mean square errors of less than 10 percent; and for 8 of them the errors are less than 5 percent. TABLE 4 Ex-Post Root-Mean-Square Errors Variable
Root-Mean-Square Error of Single Period Forecasts (1)
E X I y V P
Pt rd AD B F
Tax M
0.030 0.047 0.056 0.021 0.006 0.009 0.016 0.000 0.009 0.073 0.019 0.038 0.010
Root-Mean-Square Error of Dynamic Forecasts (2)
0.033 0.068 0.089 0.024 0.045 0.020 0.019 0.001 0.057 0.122 0.267 0.048 0.028
(1) Calculated from the restricted reduced
form for the sample period fourth quarter 1960 fourth quarter 1975. (2) Third quarter 1962 - fourth quarter 1975. 111.2 Dynamic Simulation of the Model
The simulation of the model is carried out with two objectives: 1. To evaluate the implication of the balance of payments constraint, embodied in the reaction function, on the system; this is done by comparing the effects on the main macroeconomic variables of comparable douestic and foreign impulses. 2. To evaluate the effects on the balance of l6/Since the variables are in logarithms, with the exception of the interest rate, square error gives the average error as a proportion of the actual level of the endogenous variables.
(a) Simulation of a Change in Government Spending in Goods and Services The simulation relating to real government spending assumes an increase of approximately 15% above the historical values . throughout the simulation period. Accord1ng to the structure of the model the deficit is initially financed by monetary expansion while later on tax receipts and interest rate response will dampen its effect on domestic credit expansion. The change in real government spending has two initial effects: a direct impact on aggregate demand and therefore output and imports, and an effect on prices which' respond to the increas: ~n . internal demand relative to the equ1l1br1um level. The output response is cyclical and reaches a maximum in the fourth quarter, it falls in the next two years and it reaches its long-run path in about 7 years, showing a lasting increase over the control solution which implies a multiplier effect lower than one: 0.6. The effect of government spending on domestic output is mainly crowded out by imports and exports which respond to the excess demand created by such stimulus. Interest rate responds to the increase of the current account deficit and thus dampens the effect produced by the increase in nominal sales and inventory accumulation on demand for advances; this effect together with the dampening effect on real financial assets brought about the increase in trade deficit, tax receipts and inflation largely affects the response of domestic private demand to the increase in disposable income, showing that the government spending partly crowdsout private sector demand, not directly but through the overall response of financial variables. The dimension of the effect on expenditure out of disposable income brought about the disequilibrium holdings of financial assets can easily be evaluated when the response of private absorption to the government expenditure stimulus is compared with that resulting from a world demand stimulus. (b) Simulation of an Increase in World Trade The increase in world trade is calculated so that the effect on aggregate demand, output and imports is equal to that in the previous case, once the adjustment of exports to the increased desired value is completed. The direct effect is to raise exports and therefore aggregate demand, output, imports and prices as well as a surplus on the balance of trade. Although domestic absorption increases in response to the sustained change of output and financial assets, its dampening effect on exports is largely compensated by the inc-
Monetary and Fiscal Policy in a Small Open Economy
crease of exports brought about by world trade, so their volume stabilizes at a higher level than in the control solution allowing for a sustained balance of trade surplus. This sets up a response of the interest rate which stabilizes at a lower level allowing for sustained increase of domestic credit expansion which together with the balance of trade surplus allows financial assets holdings to positively affect domestic absorption in addition to the income multiplier. These effects, combined with a sustained increase in exports, allow both domestic absorption and output to maintain a substantially higher level than the one obtained as a result of the simulated increase of government expenditure. (c) Simulation of a Change in Government Spending Holding Constant the Value of the Domestic Component of Financial Assets As in the previous case, real government spending increases approximately by 15% above the historical value throughout the simulation period, but the monetary authorities keep the level of bank credit such as to compensate the increase in the public deficit. The comparison between its effects on the level of output, private absorption and the balance of payments and those related with the policy mix allowing for higher levels of both money supply and domestic
component of financial assets, permits one to evaluate the effects of domestic policy with relation to the degree of aperture ~f the system. As in the previous case, the increase in government spending affects output and through demand pressure both the balance of trade and inflation. Disequilibrium holdings of financial assets, induced by the increase in output and decumulation of assets through the balance of trade, affects the adjustment of expenditure to the higher level of disposable income producing after the first quarters a reduction in domestic private absorption which, largely compensated by government expenditure, allows output to increase. As a consequence of lower increase in aggregate demand, both the trade deficit and the inflation rate are lower than in the previous case. This allows, after three years, through the effect produced on output and financial assets, a reduction in the gap between the simulated values of output and private absorption and those obtained under the hypothesis of a more expansionary monetary policy. These results, integrated with the comparatively higher rate of decumulation of foreign assets allows one to say that the larger implication of policy mix which imply different monetary rules is related to the change in reserves as a result of the openness of both real and financial markets.
'3.1%
:
1.5%
259
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~
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.
:
.. ... -----
. .. ....
,
...
,
,
"" "
\
, , ,
\
\ \
,,
,---------., ....
~-
~--
""
, "- .....
-1.3
, ,
-- - -- .....
~
--
..........
-----.--. --
0.'37
Real Product
10 years
Difference between the value of output
(a)
imports
(b)
exports
(c)
lbtained under simulation (a) and (c)
Deviation from control
10 years
G. Chiesa
260
3.5X
..
4.6l
·
't
.' . •
. .. ,
-0
....
•• 0
'
•
.
'
___ .!-'JfI'-~
\
\
0.00170
..
,
o. ,
Product Pricf:s
10 years
..... . '. - -
11.9:f.
C.25'
."",--
........................
--- ....
'--
Nominal Imports
10 years
o. ) 5
_..
'
,
0.
"
-2.H
,..."
........
..
- .- .0.27
Nominal Exports
Rond rate
.....
10 years
1.87
.'
.-
10 years ~
.... .. .. .,.
(a) (b) (c)
DeviatiGn from c,)ntrol
\
- .1.670
,,
,
--'"
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Outflows
10 years
Monetary and Fiscal Policy in a Small Open Economy
CONCLUSIONS conclusions one can draw from the estimation of the model and its simulation is that the sensitivity of trade and capital flows to the excess demand in domestic markets implies strong limits to domestic policy and a very different adjustment mechanism as compared to the closed economy. ~he
The balance of payments constraint on domestic monetary policy, embodied in the reaction function, strongly limits the possibility of sustaining the level of domestic activity, given the structure of the economy, and leaves the growth in output to be mainly sustained by foreign growth. Although the relevant interaction between real and financial markets would leave room for the crowding-out of domestic expenditure by debt-financing deficit, the role played by the balance of payments on assets accumulation implies that the financing of the deficit affects reserves more than the level of activity and domestic private absorption. BIBLIOGRAPHY Aghlevi, B.B., and C. Rodriguez (1979). Trade, Prices and Output in Japan: A Simple Monetary Model. Staff Pap., 26, 38-54. Anderson, G.J., I.F. Pearce and P.K. Trivedi (1976). Output, Expected Demand and Unplanned Stocks. In I.F. Pearce, P.K. Trivedi, C.T. Stromback and G.J. Anderson (Eds.), A Model of Output, Employment, Wages and Prices in the U.K., Cambridge Univ. Press, Cambridge,pp.2l-37. Bergstrom, A.R. and C.R. Wymer (1976). A Model of Disequilibrium Neoclassical Growth and Its Application to the United Kingdom. In A.R. Bergstrom (Ed.), Continuous Time Economic Models, North Holland, Amsterdam. pp. 267-327. Branson, W.H. and J. Myhrman (1976). Inflation in Open Economies; Supply-Determined Versus Demand-Determined Models. Europ. Econ. R., 7, 15-34. Cotu1a, F. and S. Micossi (1977). Riflessioni Sulla Sce1ta degli Obiettivi Intermedi della Politica Monetaria nella Esperienza Italiana. Contributi alle Ricerca Economica, 7-37. Courchene, T. and K. Singh (1975). The Monetary Approach to the Balance of Payments: An Empirical Analysis of 14 Industrial Countries. In J.M. Parkin and G. Zis (Eds.), Inflation as a World Phenomenon, Manchester Univ. Press, Manchester. pp. 189-215.
261
Dornbusch, R. (1976). Devaluation, Money, and Nontraded Goods. Amer. Econ. R., 63, 871880. Frenkel, J.A. and H.G~ Johnson (1976) (Eds.). The Monetary Approach to the Balance of Payments, AlIen and Unwin, London. Genberg, H.A. (1976). Aspects of the Monetary Approach to Balance of Payments Theory: An Empirical Study of Sweden. In J.A. Frenkel and H.G. Johnson (Eds.), (1976). pp. 298-325. Gurley, J.G. (1960). The Radcliffe Report and Evidence. A.E.R., 50, 672-700. Hahn, F.H. (1977). The Monetary Approach to the Balance of Payments. J. Int. Econ., 7, 232-249. Helpman, E. (1976). Macroeconomic Policy in a Model of International Trade with a Wage Restriction. Int. Econ. R., 17, 262-77. Jonson, P.D. (1976). Money and Economic Activity in the Open Economy: The United Kingdom, 1880-1970. J. Pol. Econ., 84, 979-1012 Kuh, E. (1963). A Productivity Theory of Wage Levels: An Alternative to the Phillips Curvey. R. Econ. Stud., XXXIV, 333-60. Marty. A. (1964). The Real Balance Effect: An Exercise in Capital Theory. Can. J. Econ. Polite Sci., 30, 360-67. Sargan, J.D. (1971). A Study of Wages and Prices in the U.K.: 1949-1968. In H.G. Johnson and A.R. Nobay (Eds.), The Current Inflation, Macmillan, London. pp. 52-71. Vaciago, G. (1975). Credito Totale Interno e Offerta di Moneta. Riv. Int. Sci. Soc., XLVI, 563-95. Wyme~C.R. (1972). Econometric Estimation of Stochastic Differential Equation Systems. Econometrica, 40, 565-77.
MONETARY AND FISCAL POLICY IN A SMALL OPEN ECONOMY G. Chiesa Conjederazione Generale dell'/ndustria Italiana and LU/SS University, Viale dell'Astronomia, 30 EUR 00144 Rome, Italy
AbstracL. This paper presents an aggregate model of the Italian economy, discusses its properties, simulation results and the implications on the main macroeconomic variables of different reaction functions of the monetary authority. The main features of the model are: (a) specification in continuous time; (b) specification of the dynamics of the model as a disequilibrium process; (c) estimation procedure: full information maximum - likelihood technique with restrictions on parameters within and across the equations. The model specifies the real and financial sectors, their interactions and those with the rest of the world. The specification is based on the more recent theoretical work on the behaviour of small open economies, and it recognizes the implications of the size and degree of openness of the economy on price behaviour and assets substitutability. The main empirical findings are the relevant impact of financial variables on the economic activity and the type of adjustment process which works mainly through quantity adjustment with strong and rapid impact on the balance of payments. Keywords. Disequilibrium; model; stochastic; differential equations; simulation; monetary; fiscal policy. of monetary policy within a framework which allows for the spillover of the disequiliINTRODUCTION brium of financial assets into real domestic and financial markets. This paper presents the results of a model of the Italian economy and discusses its The model is specified in continuous time as properties. Although the model is highly aga system of non-linear differential equations, gregated, it links together the real, finanthus giving explicit recognition to the poscial and foreign sectors. The specification sibility that at any point in time the econodraws on the recent theoretical work in monemy might be out of equilibrium. tary economics directed to the analysis of small open economies 1/; according to this This approach also provides a consistent approach the law of one price in the ·intertreatment of stock and flow variables and sanational markets is assumed to hold in long tisfies the objective of dealing with the run equilibrium. adjustment process of the economy without imposing any a priori constraint on the mean Particular attention has been given to the per- time lag. formance of the model under dynamic simulation and to its stability conditions in the analysis The specification treatment of the dynamic of the interaction between financial and real structure of the economy and the estimation markets. The hypothesis of instantaneous adprocedure 2/ of a model which includes market justment of markets to the equilibrium position identities~ a budget constraint and the reachas been relaxed, it has explicitly recognized tion function of the authorities also allow the possibility that the divergency between more accurate simulation exercises and therethe effective and the equilibrium value of fore the model is particularly useful for the demand for commodities and financial assets purpose of ana1yzing the effects of changes affects the level of prices and quantities in in economic policy variables. the other markets. The analysis is particularly relevant for the objective of evaluating Although the period of estimation includes the empirical relevance of the various approayears of exchange rate flexibility, the model ches to the balance of payments and it provides as it stands does not endogenize the exchange the information which one needs in order to rate. It is taken as an exogenous policy assess the intermediate quantitative targets variable under the assumption that the authority determine a target level of lira I am greatly indebted to A. Markandya, P. on the foreign exchange market and use their Savona, C. R. Wymer for helpful comments. instruments to achieve this target. l/See for instance the collection of essays on the approach to the balance of payments edited by J. Frenkel and H. Johnson (1976). 253
2/The model has been estimated simultaneously using a full information maximum likelihood method developed by C.R. Wymer (1972).
254
G. Chiesa
balance of payments and stocks of financial The paper is set out as follows: Section I assets is an integral part of the model. discusses the structure of the model, Section 11 presents the empirical results, and Section 111 In the present work the balance of trade can discusses its dynamic simulation. It analyses the relationship between the behaviour of be identified, in the long run, as the excess the monetary authority and the adjustment of supply o£ goods on the real market and the the system to changes in the exogenous variacapital movement as the excess supply of dobles and the effects of different monetary mestic financial assets. rules on the level of outpu~, private expenditure and balance of payments. On_the other hand, no prior assumption has been made on the speed of adjustment of the various markets so that the model does not prevent any effect of domestic policy on I. OVERVIEW OF THE MODEL prices and level of domestic activity other than their long. run final effect on the Macroeconomic modelling applied to open ecobalance of payments. nomies can be easily referred to two main approaches: one of structural form in line In.order to clarify the line followed in the with US modelling which tends to neglect specification, it is worth mentioning here the implication of the openness of the systhat output is in the short run defined by tem on the behaviour and adjustment of the aggregate demand relative prices (domestic markets. The other of reduced form type and foreign); on the other hand, the explicit which embodies the proposition brought about consideration of feedbacks from the gap betby the monetary theory related to open ecoween the actual and the equilibrium value of nomies, that the law of one price must domidemand onto prices and quantities (imports nate on the international real and financial and exports) traces the effect of the dismarkets. The growing integration of markets equilibrium of the real market onto the tends to support such propositions and to balance of trade and prices and therefore its deny that the specifications which exclude effects on the level of output at any point them can be of any use in analyzing the in time. relation between financial, and real domestic markets with the foreign one. The assumption of non-instantaneous adjustment of the system also allows for the effect The second approach which derives from the of the gap between the desired and actual line of thought known as the "monetary apholding of financial assets to affect the proach to the balance of payments" has equilibrium solution of other markets. It originated empirical work which implicitly affects the flow of expenditure over income assumes instantaneous adjustment of real and the capital flows with the foreign secand financial markets and identifies the tor; the latter acting as the adjustment balance of payments as the adjustment mechamechanism through which the monetary nism of the money market. i/ disequilibrium is eliminated. On the one hand, such assumptions are bound to give inconsistency to the empirical estimates, THE STRUCTURE OF THE MODEL whilst on the other they prevent the' analysis from giving any information on what is more The model specifies real and financial relevant to the approach to which they refer. sectors of the Italian economy and their What is needed is a greater knowledge of the in- interactions with the rest of the world. It teraction among markets out of equilibrium and incorporates market identities and a budget the implication on the balance of payments of constraint, and explicitly recognizes the the adjustment process which tends to fill the reaction of the monetary authority to the gap between actual and desired stock of wealth behaviour of the economy, emphasizing the and financial assets. 4/ The specification relevance of the balance of payments on the proposed here attempts-to deal with this probformulation of its interest rate target. lem. It borrows from the monetarist approach the identification of the external accounts as The specification of the model is related to the adjustment mechanism through which an open the behaviour of the following economic economy reaches the equilibrium of flow variaagents: bles on the real market and that of stocks on financial markets. The link between the (a) the private sector ~~~~~~~~~~~~~~~~~~~~~~~~(b)the rest of the world
3/T. Courchene, and K. Singh, (1975), H. A. Genberg (1976). 4/The relation stocKs-flows and the interpretation of real and monetary flows with the external market as consequences of wealth and portfolio adjustment is emphasized by H. Johnson in several works, see for example, H. Johnson (1976).
(c)
the monetary and fiscal authority.
The private sector produces a homogeneous stream of goods which are either traded in international markets or absorbed domes-
255
M)netary and Fiscal Policy in a Small Open Economy
tically. 5/ The private sector uses income from production and borrowing from domestic and foreign financial markets in order to purchase domestic and foreign goods and assets.
TABLE 2 Specification of the Model ~i10g
(E/E) + d210g Af / Af)
(1)
~rd - D log P})
A
log E = log (eo YD e -
The monetary and fiscal authority is defined as the aggregation of the government and the banking sector. Such aggregation has been chosen on the basis of the high degree of control that the Bank of Italy exercises on the banking system as far as domestic and foreign markets are concerned. The approach followed in the specification is consistent with the hypothesis that demand and supply for goods, financial assets, liabilities and prices react at any point in time to any divergence between actual and desired values; the latter being specified with respect to the behaviour of economic agents.
A
1\
D log E =
A
log Af
B log (ao YD 2)
log YD
log (Y - Tax/P + Tr/P)
log Af
10gCM/P + B/P + F/P) 1\
D log X =o(~log (X/X) - ~log (E + G) (E + Gr~eA,t ~
1\
log X
(Pw /P~
log (Xo Wd A
D log I =rl(; log (1/1) + /\
)
'" (V/V)
~,log
(3)
log (~ eA'Lt (P/Pm)"" S)
log I TABLE 1. Variables of the Model
(2)
1\
log (Vo S)
log V Endogenous
S = E + X+ G Output and expenditure variables D log y =~1log E X I Y V
P
Pt
Private domestic demand for goods Real exports of goods and services Real imports of goods and services Gross domestic product Inventories of goods and work in progress Gross domestic product implicit price deflator Price of goods traded internationally
Financial Variables Domestic banks advances to private sector B Government bonds held by the private sector F Net stock of foreign assets held by domestic residents rd Average market yield on government bonds Tax = Tax receipts valued in money terms M Domestic money stock (M2)
A
"
+ 0(& log V/v A A2.t f}5 log Y = log (S - /34 e (P /Pm) S)
DV
(Y /y)
Y + I - S
( 4)
(5)
D log P = o(~ log (p/P) '" + "fa log (E + G) t (6) (E + G)i1,A, A
log (Po Pw eA"t)
log P
AD
Exogenous
Pm Pw
Wd G rw AICS tr t
Unit value of imported goods Unit value of world manufactured exports Total exports of developed countries Government expenditure on current goods and services Foreign interest rate Special credit institutions loans to the private sector Transfer payments Time
l/A1though in the price sector different price behaviour for traded and non~traded goods is specified, the constant share of traded and non-traded output on the average_has suggested to neglect the effect of their relative prices on the system.
D log Pt =
'"
log (Pto Pw)
log Pt
D rd =~~(rd - rd) +~14log PmI PxX 1\
rd
(8)
rw +~~(D log P - D log Pw) 1\
A
D log AD = ~1' log ( (AD/P) / AD/P ) +,(nlog V/V +~1llog
log
(PmI) PS
ADh
(9)
= log (Ao S e-
Bfrd
)
A
D log B
=I(l~
log ( (B/P) /B/P ) 131
1\ )\
log ( B/P) = log (bo Y e D log F
=~(rw +«~(D
/3 1 (rd
(10)
- D log P)
log P - D log Pw) - rd)
A
+(1110g (M/P)/(M/P)
(11)
~'
256
G. Chiesa
A log (M/P) D log Tax
~~d
log (Mo Y e r ) =d~3log
A
(Tax/Tax)
log Tix = log {to (Y
(12)
P)~
DM = (PtX - PmI) + (PG + Tr - Tax) +
(13)
DAD - DB - DF + DAICS Aspects of Sectors This section highlights key aspects and sectors of the model in order to give the reader more insight into the model than may be gleaned from a simple listing of equations. Domestic Private Absorption The demand for goods and services of the domestic private sector is assumed to adjust towards a desired level determined by disposable income and interest rate. The adjustment is also assumed to be affected by disequilibrium holdings of financial assets, the last representing a generalization of the real money balance effect on expenditure within a model in which financial assets are not just money. 6/ It is worth pointing out here that the specification of the interaction between financial and real markets is not only consistent with a structure which including assets other than money allows them to absorb disequilibrium of money holdings 7/ but also it has been found relevant in defIning the dynamic properties of the model. When, consistently with the propos~t~on embodied in the theoretical and empirical analysis of monetarist type 8/ the strict monetary disequilibrium is Introduced although the estimates show that it has relevant and significant impact on expenditure, the dynamic simulation of such specification and the variable path in response to changes in policy variables have led to reject iL on the grounds of the lack of stability of the model. Such evidence integrated with the significant effect of disequilibrum money holdings into the demand for domestic and foreign financial assets allows one to say that the excess of money balances produces a readjustment of the financial portfolio and only because this 6/The effect of hoarding and dishoarding of money balances onto expenditure has been developed by A. Marty (1964) and taken up by R. Dornbusch (1973) in a model in which money is th~ only asset. 7//This is emphasized by F.H.Hahn (1977)in his criticism to the monetary approach to the balance of payments. a/See P.D. Jonson (1976); B. Aghle~i and C. Kodriguez (1979).
causes a non equilibrium holdings of the total financial assets it affects the real market. The empirical evidence seems therefore to confirm for Italy the thesis that in order to control domestic absorption the intermediate target of the monetary policy has to be defined in terms of liquid assets rather than its strictly monetary component 9/; given the relation between expenditure output and balance of trade one can also say that the intermediate target declared by the Italian authorities (CTI) 10/ is the appropriate one in controlling the balance of trade as compared with DCE, domestic component of the money supply. On the other hand it is worth emphasizing that although the channels through which the financial assets are domestically created have the same impact on the level of the intermediate target, this does not hold as far as the final goal is concerned, suggesting that the level of the monetary target cannot be defined independently of its composition: government deficit and bank credit. The direct and induced effects of the public deficit on the system reject the assumptions embodied in the framework within which that target was discussed 11/, such as perfect crowding-out of domestic absorption by public deficit and its nil impact on the final goal when the monetary intermediate target is held constant. Specification of the Supply Components of Goods and Services The specification of the model explicitly embodies the behaviour of the supply of goods domestically and externally produced. Imports are considered from the supply side as an alternative to domestic production. Change in inventories is defined as a residual in order to explicitly recognize their role of buffer-stock, but the specification of the model allows for feedback of unplanned stocks on output and import decisions.12/ Specification of the Price Sector The approach followed in the analysis of the inflationary process draws from the recent theoretical and empirical work on open economies the distinction between 9!This is the thesis brought about by J.G. Gurley (1960). 10/CTI is the so-called domestic total credit expansion and it represents the domestic component of financial assets. ll/F. Cotula, S. Micossi (1977), G. Vaciago (1975). l2/This is in the spirit of the work done by ~R. Bergstrom-C.R. Wymer (1976) and G.J. Anderson, I.F. Pearce, and P.K. Trivedi (1976).
Monetary and Fiscal Policy in a Small Open Economy
257
the price behaviour of traded and non-traded goods. ll/ The proposition that the price of output which is traded on the international market cannot differ from international market price is the underlying assumption of the price behaviour of the traded sector in the. equilibrium solution of the system. While the price of exportable goods is a.structura1 equation which embodies the above proposition, the implicit price def1ator is specified.as a reduced form of the price and wage sector under the hypothesis of different price behaviour in the traded and non-traded sectors.
All of the estimated parameters reported in Table 3 have the sign expected a priori. Of the 32 estimated parameters 29 are significantly different from zero at the 5 percent confidence level. Because the adjustment functions are based on the assumption that the agents behave in such a way as to bring the level of the variables under their control to their desired values, reacting to changes in the variable with an exponentially distributed lag, the inverse of each adjustment parameter can be interpreted as the mean of the exponentially distributed lag. l2/
The structural equations from which the reduced form is derived refer to the price of traded, non-traded goods and wages. The non-traded sector sets the price as a markup on long run average cost, workers pursue a target rate of growth of real wage. !if
These estimates give an immediate description of the speed of adjustment of the various markets and show what is the empirical relevance of the disequilibrium spi1lover among different markets. TABLE 3. Adjustment Parameters Estimate
Financial block Although the aggregation which has been chosen does not allow the separation of firms from households or the definition of separate budget constraints, the low propensity of firms to demand financial assets as such and of families to go into debt suggest the definition of bonds and loans as two separate assets, even when instantaneous adjustment of the structure of interest rates is assumed. The specification of the financial sector embodies the hypothesis of perfect substitutability between domestic and foreign assets and non-instantaneous adjustment of portfolio; only one interest rate enters the demand for domestic financial assets and the change in foreign assets responding to the interest rate differential works through pressure on reserves as the adjustment mechanism through which interest rates are equalized.
11. ESTIMATION RESULTS This section presents estimates of the parameters of the model for a sample period of quarterly observations extending from the fourth quarter of 1960 to the fourth quarter of 1975. The model has been estimated with the FIML procedure with linear and non-linear restrictions on the parameters within and across the equations, applied to the discrete approximation of the continuous model linearized about the sample means of the logarithms of the variables.
d1 a2
~5 ~6
~7 ~8
~9
a10 ~11
ll(12 ~13 ~14
C(15 ct16 ~17
«18 ~19
({20 ((21 ~22 ~23
t Value
0.373 0.203 0.376 0.443 0.605 0.407 1.663 0.0 0.112 0.161 1.209 0.289 0.140 0.005 0.022 0.116 0.107 0.068 0.268 3.235 0.052 0.250 3.353
2.21 2.60 3.07 1.87 4.18 2.92 4.46 5.87 3.56 4.61 2.51 7.38 5.50 1.16 4.28 3.51 4.18 3.05 4.41 1.72 4.31 4.76
Meantime lag 2.680 2.659 1.653 0.601 8.928 0.827 7.143 8.620 3.731
0.298
E1asticities, growth rate, average import Propensity
Bl 82 (l3
R4 {35 86 ~7 ~8
{39 ~l
A2 13/R. Dornbusch (1973), E. Helpman (1976), W.H. Branson and J. Myhrman (1976). l4/The underlying structural equation is in the spirit of the Sargan-Kuh model, see for reference J.D. Sargan (1971) and E. Kuh (1963) •
Estimate
~3
0.0 1.299 1.00 0.172 0.284 17.928 18.670 29.667 1.054 0.012 0.007 0.007
19.27 7.81 2.99 2.77 2.11 5.06 97.52 15.97 7.06 5.16
holds when for Py = ~(X - X), X and Y are not different variables.
12/This
258
G. Chiesa
Ill. 111.1
payments, level of domestic activity and domestic expenditure of different financing of the deficit.
DYNAMIC ANALYSIS
Contro~
and Actual Values
This section presents information about the performance of the model inside the sample period. Table 4 contains the two sets of mean square errors, the first one is the root-mean square error of the static simulation, the second set is that for dynamic simulation. 16/ Although the root mean square errors in sample dynamic simulation are somewhat larger than in one period case, the results are on the whole satisfactory. With the exception of government bonds and foreign assets h:ld by domestic residents, all the other var1ables have root mean square errors of less than 10 percent; and for 8 of them the errors are less than 5 percent. TABLE 4 Ex-Post Root-Mean-Square Errors Variable
Root-Mean-Square Error of Single Period Forecasts (1)
E X I y V P
Pt rd AD B F
Tax M
0.030 0.047 0.056 0.021 0.006 0.009 0.016 0.000 0.009 0.073 0.019 0.038 0.010
Root-Mean-Square Error of Dynamic Forecasts (2)
0.033 0.068 0.089 0.024 0.045 0.020 0.019 0.001 0.057 0.122 0.267 0.048 0.028
(1) Calculated from the restricted reduced
form for the sample period fourth quarter 1960 fourth quarter 1975. (2) Third quarter 1962 - fourth quarter 1975. 111.2 Dynamic Simulation of the Model
The simulation of the model is carried out with two objectives: 1. To evaluate the implication of the balance of payments constraint, embodied in the reaction function, on the system; this is done by comparing the effects on the main macroeconomic variables of comparable douestic and foreign impulses. 2. To evaluate the effects on the balance of l6/Since the variables are in logarithms, with the exception of the interest rate, square error gives the average error as a proportion of the actual level of the endogenous variables.
(a) Simulation of a Change in Government Spending in Goods and Services The simulation relating to real government spending assumes an increase of approximately 15% above the historical values . throughout the simulation period. Accord1ng to the structure of the model the deficit is initially financed by monetary expansion while later on tax receipts and interest rate response will dampen its effect on domestic credit expansion. The change in real government spending has two initial effects: a direct impact on aggregate demand and therefore output and imports, and an effect on prices which' respond to the increas: ~n . internal demand relative to the equ1l1br1um level. The output response is cyclical and reaches a maximum in the fourth quarter, it falls in the next two years and it reaches its long-run path in about 7 years, showing a lasting increase over the control solution which implies a multiplier effect lower than one: 0.6. The effect of government spending on domestic output is mainly crowded out by imports and exports which respond to the excess demand created by such stimulus. Interest rate responds to the increase of the current account deficit and thus dampens the effect produced by the increase in nominal sales and inventory accumulation on demand for advances; this effect together with the dampening effect on real financial assets brought about the increase in trade deficit, tax receipts and inflation largely affects the response of domestic private demand to the increase in disposable income, showing that the government spending partly crowdsout private sector demand, not directly but through the overall response of financial variables. The dimension of the effect on expenditure out of disposable income brought about the disequilibrium holdings of financial assets can easily be evaluated when the response of private absorption to the government expenditure stimulus is compared with that resulting from a world demand stimulus. (b) Simulation of an Increase in World Trade The increase in world trade is calculated so that the effect on aggregate demand, output and imports is equal to that in the previous case, once the adjustment of exports to the increased desired value is completed. The direct effect is to raise exports and therefore aggregate demand, output, imports and prices as well as a surplus on the balance of trade. Although domestic absorption increases in response to the sustained change of output and financial assets, its dampening effect on exports is largely compensated by the inc-
Monetary and Fiscal Policy in a Small Open Economy
crease of exports brought about by world trade, so their volume stabilizes at a higher level than in the control solution allowing for a sustained balance of trade surplus. This sets up a response of the interest rate which stabilizes at a lower level allowing for sustained increase of domestic credit expansion which together with the balance of trade surplus allows financial assets holdings to positively affect domestic absorption in addition to the income multiplier. These effects, combined with a sustained increase in exports, allow both domestic absorption and output to maintain a substantially higher level than the one obtained as a result of the simulated increase of government expenditure. (c) Simulation of a Change in Government Spending Holding Constant the Value of the Domestic Component of Financial Assets As in the previous case, real government spending increases approximately by 15% above the historical value throughout the simulation period, but the monetary authorities keep the level of bank credit such as to compensate the increase in the public deficit. The comparison between its effects on the level of output, private absorption and the balance of payments and those related with the policy mix allowing for higher levels of both money supply and domestic
component of financial assets, permits one to evaluate the effects of domestic policy with relation to the degree of aperture ~f the system. As in the previous case, the increase in government spending affects output and through demand pressure both the balance of trade and inflation. Disequilibrium holdings of financial assets, induced by the increase in output and decumulation of assets through the balance of trade, affects the adjustment of expenditure to the higher level of disposable income producing after the first quarters a reduction in domestic private absorption which, largely compensated by government expenditure, allows output to increase. As a consequence of lower increase in aggregate demand, both the trade deficit and the inflation rate are lower than in the previous case. This allows, after three years, through the effect produced on output and financial assets, a reduction in the gap between the simulated values of output and private absorption and those obtained under the hypothesis of a more expansionary monetary policy. These results, integrated with the comparatively higher rate of decumulation of foreign assets allows one to say that the larger implication of policy mix which imply different monetary rules is related to the change in reserves as a result of the openness of both real and financial markets.
'3.1%
:
1.5%
259
, • '
••• -
~
• • • • • • • • , . "'t
.
:
.. ... -----
. .. ....
,
...
,
,
"" "
\
, , ,
\
\ \
,,
,---------., ....
~-
~--
""
, "- .....
-1.3
, ,
-- - -- .....
~
--
..........
-----.--. --
0.'37
Real Product
10 years
Difference between the value of output
(a)
imports
(b)
exports
(c)
lbtained under simulation (a) and (c)
Deviation from control
10 years
G. Chiesa
260
3.5X
..
4.6l
·
't
.' . •
. .. ,
-0
....
•• 0
'
•
.
'
___ .!-'JfI'-~
\
\
0.00170
..
,
o. ,
Product Pricf:s
10 years
..... . '. - -
11.9:f.
C.25'
."",--
........................
--- ....
'--
Nominal Imports
10 years
o. ) 5
_..
'
,
0.
"
-2.H
,..."
........
..
- .- .0.27
Nominal Exports
Rond rate
.....
10 years
1.87
.'
.-
10 years ~
.... .. .. .,.
(a) (b) (c)
DeviatiGn from c,)ntrol
\
- .1.670
,,
,
--'"
Capit~l
Outflows
10 years
Monetary and Fiscal Policy in a Small Open Economy
CONCLUSIONS conclusions one can draw from the estimation of the model and its simulation is that the sensitivity of trade and capital flows to the excess demand in domestic markets implies strong limits to domestic policy and a very different adjustment mechanism as compared to the closed economy. ~he
The balance of payments constraint on domestic monetary policy, embodied in the reaction function, strongly limits the possibility of sustaining the level of domestic activity, given the structure of the economy, and leaves the growth in output to be mainly sustained by foreign growth. Although the relevant interaction between real and financial markets would leave room for the crowding-out of domestic expenditure by debt-financing deficit, the role played by the balance of payments on assets accumulation implies that the financing of the deficit affects reserves more than the level of activity and domestic private absorption. BIBLIOGRAPHY Aghlevi, B.B., and C. Rodriguez (1979). Trade, Prices and Output in Japan: A Simple Monetary Model. Staff Pap., 26, 38-54. Anderson, G.J., I.F. Pearce and P.K. Trivedi (1976). Output, Expected Demand and Unplanned Stocks. In I.F. Pearce, P.K. Trivedi, C.T. Stromback and G.J. Anderson (Eds.), A Model of Output, Employment, Wages and Prices in the U.K., Cambridge Univ. Press, Cambridge,pp.2l-37. Bergstrom, A.R. and C.R. Wymer (1976). A Model of Disequilibrium Neoclassical Growth and Its Application to the United Kingdom. In A.R. Bergstrom (Ed.), Continuous Time Economic Models, North Holland, Amsterdam. pp. 267-327. Branson, W.H. and J. Myhrman (1976). Inflation in Open Economies; Supply-Determined Versus Demand-Determined Models. Europ. Econ. R., 7, 15-34. Cotu1a, F. and S. Micossi (1977). Riflessioni Sulla Sce1ta degli Obiettivi Intermedi della Politica Monetaria nella Esperienza Italiana. Contributi alle Ricerca Economica, 7-37. Courchene, T. and K. Singh (1975). The Monetary Approach to the Balance of Payments: An Empirical Analysis of 14 Industrial Countries. In J.M. Parkin and G. Zis (Eds.), Inflation as a World Phenomenon, Manchester Univ. Press, Manchester. pp. 189-215.
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