Choosing an Exchange Rate Regime: The Challenge for Smaller by Victor Argy, Paul De Grauwe

By Victor Argy, Paul De Grauwe

This choice of papers, edited through Victor Argy and Paul De Grauwe, examines concerns surrounding the alternative of trade expense regime in smaller commercial international locations. It includes a finished precis via Jacques J. Polak.

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Fiscal expansion increases output, so that an appreciation is assumed to be needed to maintain the same level of output. The special case where wage indexation is perfect—and particularly where wages respond rapidly to prices, (the vicious circle devaluation cycle case)—is interesting in that it raises the possibility that, for a smaller economy, the exchange rate might be used to achieve price level objectives. This case is shown in ("hart 2. Imperfect Asset Substitution (Traditional Analysis) We assume here that capital controls are sufficiently effective to allow the authorities control over the money supply (or the interest rate) so sterilization policies are now feasible.

If the exchange rate is fixed we can use equation (61) to determine how this will affect output in the home economy. It is readily apparent that the combined effect of all three changes abroad on output (pf\yf\\rf\) is ambiguous. On the other hand it seems certain that under flexible rates output will rise on all three counts. In general, it is difficult to determine unambiguously which regime is more stabilizing. Consider now a money demand disturbance abroad. This lowers output and prices abroad but raises the foreign interest rate (Table 4).

The model comprises the following equations: P = pf + e (69) mo - p = axy - a2rd + u2 (70) r = rf + tEet+1 - e (71) y = Y(pt - t^Ept) + u3 (72) mo = n4e + n 5 r/ + l\6pf (73) Equation (69) assumes that purchasing power parity holds (that the real exchange rate is fixed). Equations (70—72) have been used previously and require no explanation. As in the model used earlier we have disturbance terms to money demand (u2) and aggregate supply (w3), with similar assumed characteristics. Equation (73) is the important novel feature of the model.

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