Open Economies
Shock Treatment?

The turbulence of the international economy during the last decade has focussed the attention of economists on the analysis of how an open economy adjusts to foreign and domestic shocks. In Discussion Paper No. 61 Programme Director Peter Neary presents a non-technical introduction to this research. He considers three alternative models of adjustment, each one appropriate to a different time horizon. Each model gives only a partial perspective on how economies actually adjust. In practice, Neary emphasises, the responses highlighted by each model are likely to occur simultaneously, so that an economist trying to understand any particular incident must keep the lessons of all three models in mind.

Neary's first model focusses on a time period sufficiently short that the stock of capital in each industry and the economy's overall endowments of productive inputs may be taken as fixed. With labour as the only factor mobile between sectors, Neary shows that adjustment is likely to be characterised by transitional differentials in wages between sectors as well as temporary, though possibly prolonged periods of unemployment. Neary uses this model to illustrate how a disturbance such as the adoption of new technology in the traded-goods sector can lead to temporary unemployment and cause the real exchange rate to 'overshoot' its new long-run equilibrium level.

The second model focusses on the medium run. The labour market is assumed to adjust rapidly and capital can now shift from declining to expanding sectors. Neary shows that if the declining sector is relatively labour-intensive, then the adjustment of the economy is likely to cause a steady fall in the equilibrium wage rate.

Neary also discusses a third model, drawing on work by Ronald Jones which permits an analysis of the interaction of long-run growth and changes in industrial structure in a small open economy. The pattern of production is determined by the interaction of available technology, given world prices, and the economy's endowments of labour and capital. The latter in turn are assumed to change over time. Labour force growth is assumed to be exogenous, but the rate of capital accumulation is determined by savings behaviour within the model. Neary illustrates how adjustment in this long-run framework may require the eventual elimination of whole sectors.

Neary briefly reviews the choice of policies designed to influence the dynamic adjustment process. From the perspective of welfare economics, the considerations which should guide the choice of policies are no different from those which apply in a static context. However, the dynamic nature of adjustment introduces some new issues. One example is the alleged 'irreversibility' problem, often used to justify the prohibition of 'dumping' by foreign producers. Market imperfections of various kinds may make it impossible for domestic producers to ride out a temporary disruption to their markets without assistance. From the very different perspective of political economy, there are many reasons why governments are likely in practice to interfere with the adjustment process. Neary argues that the list is so extensive that the degree of actual interference must be considered remarkably low. Only the existence of 'rules of the game' such as those agreed under the GATT (General Agreement on Tariffs and Trade) prevents more widespread use of measures to restrict the natural processes of adjustment which follow any exogenous shock.


Theory and Policy of Adjustment in an Open Economy
J Peter Neary

Discussion Paper No. 61, April 1985 (IT)