Current account and exchange rate dynamics

In the theoretical part of the paper, we analyze the positive and normative effects of a surprise monetary expansion in a small open economy characterized by imperfect competition and short-run price rigidity in the domestic sector. The temporary output boom fostered by the monetary expansion is shown to come at the cost of a permanent squeeze of the domestic sector. In general this affects welfare ambigously, since the welfare gain from the monetary expansion reduces as net foreign assets become smaller and eventually turns negative if the economy accumulates too large a debt towards the rest of the world. The empirical part of the paper provides evidence in favour of a crucial role of monetary shocks in current account fluctuations. This holds especially for the more open economies in the G7, namely the European countries and Canada.