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Dynamic response to external shocks in classical and Keynesian economies

Author

Listed:
  • Schmidt-Hebbel, Klaus
  • Serven, Luis
  • DEC

Abstract

The authors analyze the impact of three classes of external shocks in open economies, using a rational expectations framework that nests three prototype economies: a neoclassical full-employment benchmark, with intertemporally optimizing consumers and firms an instant clearing of asset, goods, and factor markets; a full-employment case with partly liquidity-constrained consumers and investors; and a Keynesian economy, with liquidity constraints and wage rigidity, which results in transitory deviations from full employment. Using parameters for a representative open economy, they simulate the model to compare the dynamic effects of foreign transfers, a terms-of-trade windfall in the form of a lower price for an imported production input, and a decline in the foreign real interest rate. They contrast the role of Keynesian and neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effects of permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (a) both permanent and transitory disturbances cause changes in long-run capacity and output; (b) transitory and permanent shocks may have opposite effects on the current account. In particular, a permanent increase in foreign transfers or a permanent terms-of-trade windfall result in a current account deficit; if temporary, they cause a surplus; and (c) liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to external shocks.

Suggested Citation

  • Schmidt-Hebbel, Klaus & Serven, Luis & DEC, 1994. "Dynamic response to external shocks in classical and Keynesian economies," Policy Research Working Paper Series 1300, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1300
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    References listed on IDEAS

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    1. Francesco Giavazzi & Charles Wyplosz, 1984. "The Real Exchange Rate, the Current Account, and the Speed of Adjustment," NBER Chapters,in: Exchange Rate Theory and Practice, pages 335-356 National Bureau of Economic Research, Inc.
    2. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
    3. B. Douglas Bernheim, 1987. "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Chapters,in: NBER Macroeconomics Annual 1987, Volume 2, pages 263-316 National Bureau of Economic Research, Inc.
    4. Turnovsky, Stephen J & Sen, Partha, 1991. "Fiscal Policy, Capital Accumulation, and Debt in an Open Economy," Oxford Economic Papers, Oxford University Press, pages 1-24.
    5. Easterly, William R & Mauro, Paolo & Schmidt-Hebbel, Klaus, 1995. "Money Demand and Seigniorage-Maximizing Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 583-603, May.
    6. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-1311, July.
    7. Fumio Hayashi, 1985. "Tests for Liquidity Constraints: A Critical Survey," NBER Working Papers 1720, National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Elbadawi, Ibrahim A. & Soto, Raimundo, 1994. "Capital flows and long-term equilibrium real exchange rates in Chile," Policy Research Working Paper Series 1306, The World Bank.
    2. Francisco Gallego & Klaus Schmidt-Hebbel & Luis Servén, 2005. "General Equilibrium Dynamics of Foreign Shocks ans Policy Changes in Chile," Central Banking, Analysis, and Economic Policies Book Series,in: Rómulo A. Chumacero & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (S (ed.), General Equilibrium Models for the Chilean Economy, edition 1, volume 9, chapter 4, pages 113-162 Central Bank of Chile.
    3. Elbadawi, Ibrahim A & Soto, Raimundo, 1997. "Real Exchange Rates and Macroeconomic Adjustment in Sub-Saharan Africa and Other Developing Countries," Journal of African Economies, Centre for the Study of African Economies (CSAE), vol. 6(3), pages 74-120, Supplemen.
    4. Raimundo Soto, "undated". "El Tipo de Cambio Real de Equilibrio: Un modelo no lineal de Series de Tiempo," ILADES-Georgetown University Working Papers inv094, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
    5. Schmidt-Hebbel, Klaus & Serven, Luis, 1995. "Fiscal and monetary contraction in Chile : a rational-expectations approach," Policy Research Working Paper Series 1472, The World Bank.

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