Applications of 'disequilibrium' macroeconomic theory to open economies have tended to focus on fixed exchange rate regimes. In Discussion Paper No. 152, Research Fellow Neil Rankin compares the impact of fiscal and monetary policy in an open economy, disequilibrium model to its effects in the standard open-economy, flexible exchange rate model (based on the work of Mundell, Fleming and Dornbusch). Rankin notes that it is necessary to include the capital account (i.e. holdings of bonds as well as money) in order to model flexible exchange rates properly. Decisions to purchase bonds are related to current and future consumption decisions and are inherently intertemporal: the model must therefore be dynamic if the capital account is to be analysed properly. Rankin uses a two-period framework, in which agents have perfect foresight, and he derives individuals' behaviour from microeconomic foundations. This, he argues, ensures wealth effects are not overlooked, a common criticism of the Mundell-Fleming-Dornbusch framework.

'Disequilibrium' arises in Rankin's model from the first-period rigidity of money wages, which causes an excess supply of labour. The goods market, on the other hand, is assumed to clear in each period. There is a single world output. As a result the real exchange rate, the ratio of the prices of home- and foreign- produced goods, cannot vary. A nominal exchange rate depreciation is thus fully passed on to the domestic price level. This in turn affects consumption through the real balance effect and the real interest rate and production through the real wage. Capital is perfectly mobile internationally, and its movements ensure that 'uncovered interest parity' holds.

Rankin analyses the effects of several policy changes, including permanent increases in the money supply and in government spending (balanced by adjustments in lump-sum taxes), and in foreign exchange reserves (balanced by new money issues). He finds that monetary policy has a similar impact in both the disequilibrium and the 'standard' models: an expansion of the money supply causes domestic output to expand and foreign output to contract. The exchange rate will depreciate, but whether it 'overshoots' its long-run equilibrium value depends on the values of the structural parameters of the model.

Fiscal policy, however, has quite different effects in the two models. In the disequilibrium model an increase in government spending causes domestic output to expand, even if the country is 'small' relative to the size of the world economy. Foreign output need not expand and might even contract. In addition, the real interest rate could fall rather than rise. Perhaps the most striking result is that a fiscal expansion always causes the exchange rate to depreciate in the disequilibrium model; in the standard model it appreciates. Rankin observes that fiscal policy appears to have such a different effect in the disequilibrium model because this model's microeconomic foundations incorporate the effects of private sector wealth on consumption and on the demand for money.


The Price, Output and Exchange Rate- Overshooting Effects of Monetary, Fiscal and Exchange Intervention Policy in a Two-Country Disequilibrium Model
Neil Rankin

Discussion Paper No. 152, January 1987 (IM)