The stock market and exchange rate dynamics
This paper articulates a model of the small, open economy in which the stock market, rather than the bond market, determines domestic aggregate demand. It resembles in many respects the widely adopted dynamic Mundell-Fleming approach, but can, in some circumstances, exhibit output and asset price dynamics that differ in economically illuminating ways from that more standard framework. In particular, if the stock market effects are important enough, then a monetary expansion can result in real exchange rate appreciation, rather than depreciation. Anticipated fiscal expansion can, if the favorable effects on future productivity lead to strong enough stock market effects, lead to an output expansion, rather than a contraction as in, for example, Burgstaller (1983), Blanchard (1984) and Branson, Fraga and Johnson (1985). Furthermore, if the delay between announcement and implementation of the fiscal expansion is long enough, an anticipated fiscal expansion can lead to exchange rate depreciation, rather than appreciation.
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