Inflation and Unemployment in a Disequilibrium of a Small Open Economy
The focus of this paper is on a disequilibrium model of a small open economy in which price and quantity adjustments are simultaneous. An important element of the analysis is the distinction between tradables and nontradables. The resulting two-sector model leads to the conclusion that relative price changes are at least of equal importance to absolute price changes when exogenous shocks are introduced to create a situation where there is a temporary divergence between the actual rate of unemployment and its natural rate and between the actually and equilibrium rates of inflation. It is shown that the effects of policy applications to stimulate total output and employment depend importantly on factor intensities of the two sectors. For instance, expansionary fiscal policy under fixed exchange rates, which increases absolute prices as well as shifting relative price in favour of nontradables will lead to increased output if the nontradable sector is labour intensive. It is noted that factor intensity assumptions have not been necessary in previous models of the Mundell type for determining the effectiveness of policy instruments for stabilization purposes.
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