Monetarist Macroeconomic Policy Rules in a Small Open Economy Model

This chapter presents a small open economy model where it is assumed that the policymaker is following an orthodox monetarist rule. In the models considered so far, the exchange rate is determined by the following factors: price dynamics, wealth accumulation and the degree of capital mobility. It is also apparent that government intervention affects the exchange rate through fiscal and monetary policy. A great deal of research has focused on some specific aspects of the points outlined above, but attempts at integrating these three strands of the literature into a more general model of exchange rate determination are far less frequent1 and usually no attention is paid to the instability potentially arising when a textbook Dornbusch model is extended to account for the current account equation and a specification of aggregate demand that considers wealth effects. According to the models analysed in the previous chapter, stability obtains anyway, as in Dornbusch, and Dornbusch and Fischer, or depends on a restricted set of parameters about whose ‘normal’ values a widespread consensus in the economic profession seems to have emerged, as in Branson. This chapter will show that the risk of instability is potentially more serious.