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Dynamic response to external shocks in classical and Keynesian economies

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  • Schmidt-Hebbel, Klaus
  • Serven, Luis
  • DEC

Abstract

The authors analyze the impact of three classes of external shocks in open economies, using a rational expectations framework that nests three prototype economies: a neoclassical full-employment benchmark, with intertemporally optimizing consumers and firms an instant clearing of asset, goods, and factor markets; a full-employment case with partly liquidity-constrained consumers and investors; and a Keynesian economy, with liquidity constraints and wage rigidity, which results in transitory deviations from full employment. Using parameters for a representative open economy, they simulate the model to compare the dynamic effects of foreign transfers, a terms-of-trade windfall in the form of a lower price for an imported production input, and a decline in the foreign real interest rate. They contrast the role of Keynesian and neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effects of permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (a) both permanent and transitory disturbances cause changes in long-run capacity and output; (b) transitory and permanent shocks may have opposite effects on the current account. In particular, a permanent increase in foreign transfers or a permanent terms-of-trade windfall result in a current account deficit; if temporary, they cause a surplus; and (c) 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 1300.

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Date of creation: 31 May 1994
Date of revision:
Handle: RePEc:wbk:wbrwps:1300

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Keywords: Economic Theory&Research; Environmental Economics&Policies; Banks&Banking Reform; Macroeconomic Management; International Terrorism&Counterterrorism;

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Cited by:
  1. Elbadawi, Ibrahim A & Soto, Raimundo, 1997. "Real Exchange Rates and Macroeconomic Adjustment in Sub-Saharan Africa and Other Developing Countries," Journal of African Economies, Centre for the Study of African Economies (CSAE), vol. 6(3), pages 74-120, Supplemen.
  2. Raimundo Soto, . "El Tipo de Cambio Real de Equilibrio: Un modelo no lineal de Series de Tiempo," ILADES-Georgetown University Working Papers inv094, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
  3. Francisco Gallego & Klaus Schmidt-Hebbel & Luis Servén, 2005. "General Equilibrium Dynamics of Foreign Shocks ans Policy Changes in Chile," Central Banking, Analysis, and Economic Policies Book Series, in: Rómulo A. Chumacero & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel ( (ed.), General Equilibrium Models for the Chilean Economy, edition 1, volume 9, chapter 4, pages 113-162 Central Bank of Chile.
  4. Schmidt-Hebbel, Klaus & Serven, Luis, 1995. "Fiscal and monetary contraction in Chile : a rational-expectations approach," Policy Research Working Paper Series 1472, The World Bank.
  5. Elbadawi, Ibrahim A. & Soto, Raimundo, 1994. "Capital flows and long-term equilibrium real exchange rates in Chile," Policy Research Working Paper Series 1306, The World Bank.

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