Extended Mundell-Fleming two-country models, in which a monetary disinflation leads to an immediate appreciation of the exchange rate which overshoots its equilibrium value, are widely used in studies of international policy coordination. One typical result is that governments acting non-cooperatively disinflate too fast because they ignore the adverse consequences of excessive inflation and appreciation of the exchange rate on foreign real income.
Many of these models use ad hoc assumptions, however, about microeconomic behaviour. In Discussion Paper No. 366, Research Fellow Frederick van der Ploeg examines similar issues in a two-country model with microeconomic foundations. He takes into account the intertemporal budget constraints faced by the governments and private sectors, welfare functions based on the utility of a representative consumer, wealth effects and current account dynamics. The model assumes floating exchange rates, uncovered interest parity, imperfect substitution between home and foreign goods, perfect substitution between home and foreign bonds, no currency substitution or capital formation, international labour immobility and nominal wage rigidity. Taxes adjust to maintain a constant stock of government debt.
The foreign repercussions of monetary and fiscal policy do not affect the home economy in van der Ploeg's model, so the multipliers are the same as for a small open economy. A related property is that the real exchange rate adjusts to ensure continuous balance of trade equilibrium. Monetary disinflation no longer leads to overshooting of the nominal exchange rate, even though adjustment in labour markets is sluggish. It does lead to transient job losses, but purely due to nominal wage rigidities.
Since households are assumed to have infinite lifetimes, Ricardian debt neutrality holds and bond- and tax-finance are equivalent. It follows that there is only a trivial role for current account dynamics. In fact, the main channel of international transmission familiar from ad hoc Mundell-Fleming models disappears, as the nominal interest rate is independent of fiscal policy and of changes in foreign policies. Also, after a monetary disinflation, the nominal exchange rate does not overshoot but jumps straight to its new value. A monetary disinflation has no spillover effect on cumulative deviations of foreign output from its natural level, while a fiscal expansion has a beggar-thy-neighbour effect.
Van der Ploeg then alters the model to assume finite lifetimes. This gives a role for current account dynamics and monetary spillovers, because nominal interest and exchange rates are now affected by fiscal policies and by foreign policies. A monetary disinflation has an effect on foreign output and now leads to overshooting of the real exchange rate. Allowing for debt finance also gives a non-trivial role for fiscal policy, highlighting the importance of allowing for the intertemporal budget constraints of private sector agents and governments and the implied current account dynamics.

Monetary Disinflation, Fiscal Expansion and the Current Account in an Interdependent World
Frederick van der Ploeg

Discussion Paper No. 366, January 1990 (IM)