Dynamic response to foreign transfers and terms-of-trade shocks in open economies

The transmission of shocks and policy changes depends crucially on the structure of the economy. The authors analyze the impact of two classes of external shocks in open economies, using a rational-expectations framework that tests three prototype economies: (1) a neoclassical, full-employment benchmark economy, with intertemporally optimizing consumers and firms and instantaneous clearing of asset, goods, and factor markets; (2) a full employment economy, with partly liquidity-constrained consumers and investors; and (3) a Keynesian economy exhibiting both liquidity constraints and wage rigidity, which results in transitory unemployment. Their model is forward-looking in that the short-run equilibrium of the economy depends on current and expected future values of all exogenous variables, and displays hysteresis (that is, its long-run equilibrium is path dependent). Using parameters for a representative open economy, they simulate and compare the dynamic effects of foreign transfers and of terms-of-trade windfall in the form of a lower price for an imported production input. They contrast the role of Keynesian elements with the neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effectsof permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (i) both permanent and transitory disturbances cause changes in long-run capacity and output; (ii) transitory and permanent shocks may have opposite effects on the current account; in particular, a permanent favorable foreign shock produces a current account deficit, while a transitory favorable shock induces a current account surplus; and (iii) liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to external shocks.