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Dynamic response to foreign transfers and terms-of-trade shocks in open economies

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  • Schmidt-Hebbel, Klaus
  • Serven, Luis

Abstract

The transmission of shocks and policy changes depends crucially on the structure of the economy. The authors analyze the impact of two classes of external shocks in open economies, using a rational-expectations framework that tests three prototype economies: (1) a neoclassical, full-employment benchmark economy, with intertemporally optimizing consumers and firms and instantaneous clearing of asset, goods, and factor markets; (2) a full employment economy, with partly liquidity-constrained consumers and investors; and (3) a Keynesian economy exhibiting both liquidity constraints and wage rigidity, which results in transitory unemployment. Their model is forward-looking in that the short-run equilibrium of the economy depends on current and expected future values of all exogenous variables, and displays hysteresis (that is, its long-run equilibrium is path dependent). Using parameters for a representative open economy, they simulate and compare the dynamic effects of foreign transfers and of terms-of-trade windfall in the form of a lower price for an imported production input. They contrast the role of Keynesian elements with the neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effectsof permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (i) both permanent and transitory disturbances cause changes in long-run capacity and output; (ii) transitory and permanent shocks may have opposite effects on the current account; in particular, a permanent favorable foreign shock produces a current account deficit, while a transitory favorable shock induces a current account surplus; and (iii) liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to external shocks.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1061.

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Date of creation: 31 Dec 1992
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Handle: RePEc:wbk:wbrwps:1061

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Keywords: Macroeconomic Management; Economic Stabilization; Banks&Banking Reform; Economic Theory&Research; Environmental Economics&Policies;

References

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  1. Krugman, Paul & Taylor, Lance, 1978. "Contractionary effects of devaluation," Journal of International Economics, Elsevier, Elsevier, vol. 8(3), pages 445-456, August.
  2. Easterly, William & Mauro, Paolo & Schmidt-Hebbel, Klaus, 1992. "Money demand and seignorage - maximizing inflation," Policy Research Working Paper Series 1049, The World Bank.
  3. Giavazzi, Francesco & Odekon, Mehmet & Wyplosz, Charles, 1982. "Simulating an oil shock with sticky prices," European Economic Review, Elsevier, Elsevier, vol. 18(2), pages 11-33.
  4. Warwick J. McKibbin & Jeffrey D. Sachs, 1989. "The McKibbin-Sachs Global Model: Theory and Specifications," NBER Working Papers 3100, National Bureau of Economic Research, Inc.
  5. Stephen J. Turnovsky & Partha Sen, 1990. "Fiscal Policy, Capital Accumulation, and Debt in an Open Economy," NBER Working Papers 3489, National Bureau of Economic Research, Inc.
  6. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 93(2), pages 223-47, April.
  7. Fair, Ray C & Taylor, John B, 1983. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 51(4), pages 1169-85, July.
  8. B. Douglas Bernheim, 1987. "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1987, Volume 2, pages 263-316 National Bureau of Economic Research, Inc.
  9. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  10. Nadeem U. Haque & Kajal Lahiri & Peter J. Montiel, 1990. "A Macroeconometric Model for Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 37(3), pages 537-559, September.
  11. Buiter, W, 1982. "Saddlepoint Problems in Continuous Time Rational Expectations Models : A General Method and Some Macroeconomic Examples," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 200, University of Warwick, Department of Economics.
  12. Francesco Giavazzi & Wyplosz, . "The Real Exchange Rate, the Current Account and the Speed of Adjustment," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 13-82, Wharton School Rodney L. White Center for Financial Research.
  13. Giavazzi, Francesco & Wyplosz, Charles, 1985. "The Zero Root Problem: A Note on the Dynamic Determination of the Stationary Equilibrium in Linear Models," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 52(2), pages 353-57, April.
  14. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, Econometric Society, vol. 50(1), pages 213-24, January.
  15. R. Glenn Hubbard & Kenneth L. Judd, 1986. "Liquidity Constraints, Fiscal Policy, and Consumption," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(1), pages 1-60.
  16. repec:fth:coluec:519a is not listed on IDEAS
  17. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
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Cited by:
  1. Warwick. J. McKibbin, . "Quantifying APEC Trade Liberalization: A Dynamic Analysis," Discussion Papers, Brookings Institution International Economics 122, Brookings Institution International Economics.
  2. AKITOBY, Bernardin, 1997. "Rigidité normale, dévaluation et équilibre général intertemporel," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 9708, Universite de Montreal, Departement de sciences economiques.

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