Pu is, Douglas D.
A icle
Wages, he Te ms o T ade, and he Exchange Ra e
Regime
Zei sch i ü Wi scha s- und Sozialwissenscha en (ZWS) - Vie eljah essch i de
Gesellscha ü Wi scha s- und Sozialwissenscha en, Ve ein ü Socialpoli ik
P o ided in Coope a ion wi h:
Duncke & Humblo , Be lin
Sugges ed Ci a ion: Pu is, Douglas D. (1979) : Wages, he Te ms o T ade, and he Exchange Ra e
Regime, Zei sch i ü Wi scha s- und Sozialwissenscha en (ZWS) - Vie eljah essch i de
Gesellscha ü Wi scha s- und Sozialwissenscha en, Ve ein ü Socialpoli ik, ISSN 0342-1783,
Duncke & Humblo , Be lin, Vol. 99, Iss. 1-2, pp. 9-39,
h ps://doi.o g/10.3790/schm.99.1-2.9
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Wages, he Te ms o T ade, and he Exchange Ra e Regime
By Douglas D. Pu is*
The issue o ela i e coun y size is ob iously one o much p ac ical
signi icance. Bu he choice o ela i e coun y size as he cen al heme
o his con e ence is also imely in e ms o he de elopmen o he cu -
en li e a u e on mac oeconomic heo y in an open economy. Ce ainly
he dominan heme in he cu en li e a u e is he mone a y app oach o
balance o paymen s and exchange a e analysis. One o he mos a -
ac i e ea u es o he mone a y app oach in i s ea ly s ages was i s
gene al equilib ium na u e, and one o i s ea lies and mos impo an
" ic o ies" was he laying- o- es o he pa ial equilib ium elas ici ies
app oach. Bu in emphasizing he mone a y na u e o balance o pay-
men s and exchange a e phenomena, ecen w i ings in he ield ha e
paid inc easingly less a en ion o gene al equilib ium in e ac ions, and
ha e wo ked wi h highly agg ega ed models which abs ac om he
ype o eal phenomena which he ea lie adi ions had emphasized.
The ques ion o ela i e coun y size is one which necessi a es ha a -
en ion be e ocussed on s uc u al aspec s o he economy. The pu pose
o his pape is o explo e he implica ions o imposing some " eal,
s uc u al cha ac e is ics" on a model which is o he wise e y mone a y
in spi i .
One o he key insigh s o he mone a y app oach is ha i made
explici he dis inc ion be ween he exchange a e, being he ela i e
p ice o na ional monies, and he e ms o ade, being he ela i e p ice
o aded goods. This dis inc ion was o en blu ed in olde Keynesian
models in which ou pu p ices we e ea ed as cons an in e ms o he
domes ic cu ency so ha a change in he exchange a e was also a
change in he ela i e p ice o na ional ou pu s. Mone a y models, in
con as , ha e ended o emphasize models wi h ull employmen and
ixed e ms o ade, al hough nei he assump ion is essen ial o he
* Yale Uni e si y.
This pape has e ol ed om my p esen a ion a Queen's Summe Wo k-
shop in Mone a y Economics, July 1976, and I am indeb ed o pa icipan s
he e o help ul discussion and o Robe Fo d o collabo a ion a ha ea ly
s age. (See Fo d [1976].) I would also like o hank Ronald Findlay and Ca los
Rod iguez o use ul commen s on an ea lie e sion o his pape . Remain-
ing opinions and e o s a e my own esponsibili y.
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10 Douglas D. Pu is
app oach. Such models sugges ha he p incipal e ec o a de alua ion
is o aise he domes ic p ice le el wi h he ensuing all in he alue o
domes ic asse s elici ing a educ ion in abso p ion and a ade accoun
su plus. This su plus appea s independen o elas ici y condi ions and is
inhe en ly empo a y, las ing only un il he loss in inancial weal h is
eco e ed. No ole need be gi en o ela i e p ice o ou pu e ec s.1
The app oach is consis en wi h he exis ence o a mul iplici y o asse s,
and he e m "mone a y app oach" is in many ways a misnome o
"po olio balance" app oach.
The app oach aken in his pape is one sugges ed by he ques ion o
ela i e coun y size iewed in a mone a y amewo k. We abandon
he "small, open economy" adi ion by explici ly disagg ega ing aded
goods in o impo s and expo s and ea ing hei ela i e p ice as
a iable, hus e-emphasizing he dis inc ion be ween he exchange
a e and he e ms o ade by displaying each explici ly and assigning
he app op ia e ole o each.2 In addi ion, u he s uc u e will be gi en
o he model by explici ly conside ing he beha io o agg ega e supply
and he nominal wage a e. This app oach is, I belie e, in he spi i o ,
and la gely complemen a y o, he mone a y app oach. Bu i is also a
eac ion o ecen ends in ha app oach which s ess small, " educed-
o m" models depic ing he exchange a e o he balance o paymen s
as being de e mined by mone a y o ces alone a he han as he con-
sequence o simul aneous in e ac ion be ween mone a y and eal phe-
nomena.
Th oughou , he amewo k o analysis is one o mone a y equi-
lib ium; gi en he alues o he exogenous a iables and he p ede e -
mined le el o inancial weal h, he model can be sol ed o he alues
o he endogenous a iables a a momen in ime. Tha solu ion also
yields he a e o change o some o he p ede e mined a iables so
ha a dynamic pa h o he model is also implied; s abili y equi es
ha he dynamic pa h con e ge o a s a iona y long- un solu ion.3
1 I is common o goods o be disagg ega ed in o aded and non- aded
goods, he ela i e p ice o which plays a cen al ole in sho - un adjus -
men o he sys em. Fo an analysis o such a model ha is e y complimen-
a y o he analysis o his pape , see Genbe g and Kie zkowski (1975).
2 The aded/non- aded goods disagg ega ion sugges s ha "openness" is
an impo an cha ac e is ic o an economy; he s iking cons ancy o he
sha e o se ices in a ious coun ies' economies sugges s ha his may no
be as dis inc i e a ea u e as is commonly hough . "Smallness" seems a mo e
ope a i e concep .
3 This app oach ollows he pionee ing wo k o Blinde and Solow (1973).
Tu no sky (1976) and Kou i (1976) ex end he analysis o he open economy
unde ixed and lexible exchange a es, espec i ely. On he o me , see
also Pu is (1976). In Kou i's model, inancial weal h is endogenous a a
momen o ime since i depends on he exchange a e. In e ms o he
momen a y equilib ium, I will ea expec a ions as p ede e mined.
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Wages, he Te ms o T ade, and he Exchange Ra e Regime 11
Howe e , o a a ie y o easons o be discussed below, we will be
p ima ily conce ned wi h he momen a y equilib ium.
In he nex sec ion he basic model is de eloped in he con ex o
ixed exchange a es; he analysis is ex ended o lexible exchange a es
in Sec ion II. Finally, in Sec ion III, some concluding commen s a e
o e ed on long- un equilib ium and o he aspec s o he issue o ela i e
size. I is use ul o no e a he ou se ha he model obeys he homo-
genei y pos ula e and is cha ac e ized by long- un neu ali y in he
sense ha a p opo iona e change in all nominal magni udes lea es he
eal equilib ium unal e ed. In pa icula , he exchange a e is neu al
in he sense ha i he model is s able, a change in he exchange a e
would, wi h lexible wages and p ices, lead o a p opo iona e change in
he equilib ium alues o all p ices and nominal asse s, and no change
in eal a iables. O cou se, such neu ali y does no necessa ily ob ain
in he sho un; an exchange a e change can a ec he e ms o ade
in he sho - un as a esul o ensuing weal h, wage-cum-ou pu , and
subs i u ion e ec s, a possibili y ha doesn' a ise, excep in he
absence o pe ec a bi age, in mone a y models which ely on he
small coun y assump ion a he han he homogenei y pos ula e o
dis inguish he e ms o ade om he exchange a e.
I. Rela i e Size and Momen a y Equilib ium:
Fixed Exchange Ra es
This sec ion de elops, and examines, he sho - un compa a i e s a ic
p ope ies o a simple wo-good model which cap u es he ea u es o
ela i e coun y size discussed abo e. The expo good is p oduced and
consumed domes ically and bea s he domes ic cu ency p ice P. The
impo good Ls p oduced ab oad and is a ailable o impo a he
exogenous o eign cu ency p ice Q*. The exchange a e, c, is de ined
o be he domes ic cu ency p ice o one uni o o eign exchange
(when he cu ency dep ecia es, he exchange a e goes up) so by he
assump ion o pe ec goods a bi age, he domes ic cu ency p ice o
impo s is Q = eQ*.
Domes ic p oduc ion,
Y,
is go e ned by a neoclassical p oduc ion unc-
ion Y (N K) which depends on employmen , N, and he capi al s ock, K.
Assuming he capi al s ock o be ixed and compe i i e i ms maximiz-
ing sho un p o i s, we can speci y an agg ega e supply unc ion
(1) YS = S(P,Q;oc) , $!><), S2< 0
whe e a is a shi pa ame e . The e a e ou special cases o equa ion
(1) ha a e o in e es :
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12 Douglas D. Pu is
(i) Keynesian I (Si = Y> 0, = 0). This ob ains when he nominal
wage a e, W, is igid and he e is excess supply o labo . Ac ual
employmen is de e mined by he demand o labo which is in-
e sely ela ed o he eal wage in e ms o he home good, W/P.
(ia) Keynesian II (Si = oo, S2 = 0). This is he ex eme Keynesian case
o pe ec ly elas ic ou pu , and is common in he ex books and he
li e a u e o he 1960's. As has been shown by Ba o and G oss-
man (1971) i can be mo i a ed by a quan i y-cons ained ixed-
p ice equilib ium.
(ii) Classical I (Y^1 > Si =
— S2
> 0). In his case he nominal wage
adjus s o clea he labo ma ke ; labo demand is as in (i) abo e
bu he supply o labo depends upon he eal wage de ined in
e ms o a p ice index in ol ing bo h impo and domes ic goods
p ices. An inc ease in P causes some inc ease in ou pu as he eal
wage alls; howe e he changes a e no as la ge as in case (i) since
in his model he nominal wage ises o pa ially o se he inc ease
in P. A equip opo iona e change in P and Q causes an equip opo -
iona e change in W and no ou pu change. By no malizing so ha
ini ial P and Q equal 1, we ge Si =
—
S2.4
(iia) Classical II (Si =
S2
= 0). This is a special case o (ii) abo e whe e
he eal wage demanded by wo ke s is independen o he p ice o
impo s and migh , in some ci cums ances, be hough o as cha -
ac e izing exchange a e illusion in he labo ma ke .5
In he ixed exchange a e case, Q is exogenous so he gene al cases
(1) and (ii) gi e ise o an upwa d ising agg ega e supply cu e; he
special cases (ia) and (iia) co espond o ho izon al and e ical supply
cu es, espec i ely. We shall concen a e in wha ollows on he gene al
cases (i) and (ii).
The o eign demand o expo s o he home good is gi en by
(2) Xd = X
(n;
§) , Xx < 0
whe e n is he ela i e p ice o expo s in e ms o impo s (P/Q), i. e.,
he e ms o ade, and
$
is a shi pa ame e . Again, he ex eme cases
4 Ou pu in his case depends on ela i e p ices, Y = G (P/Q), and
dY = (G'/Q) dP -
(G'
P/Q2) dQ .
Se ing P = Q = 1 yields S =
—
S2 = G'. Th oughou we se P = Q = n
= e = Q* = 1. This no maliza ion means ha de i a i es will ep esen pe -
cen age changes. Salop (1974) uses a simila model o agg ega e supply in he
analysis o de alua ion.
5 Exchange illusion could also sugges ha W esponds di e en ly o a
change in e han o a change in Q*, a sub le y I igno e in wha ollows. No e
ha ou cases (i) and (ii) a e ex emes, and one could imagine in e media e
cases whe e wages espond pa ially o changes in Q.
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Wages, he Te ms o T ade, and he Exchange Ra e Regime 13
common in he li e a u e can be ea ed as special cases whe e Xi = 0
(exogenous expo s) and Xi =
—
oo (small-open economy). An addi ional
sou ce o demand o domes ically p oduced goods a ise om go e n-
men which I assume no o pu chase any impo s. I ea go e nmen
expendi u e in eal e ms, g, as a pa ame e and assume ha he
nominal go e nmen de ici , G, is inanced by domes ic c edi c ea ion:
(3) G = Pg
—
T = C
whe e T is nominal axes, C is he domes ic c edi componen o he
money supply, and a " •" indica es a ime de i a e. (In he emainde
o his and he nex sec ion I assume nominal axes o be ze o.)
To al domes ic expendi u e in e ms o home goods is gi en by
(4) E = E (Y, A/P, 1 In) 0 < E1 < 1 , E2 > 0 , Es> 0
whe e A is nominal weal h in e ms o he domes ic cu ency, as de ined
below. The hi d e m ep esen s he Lau sen-Me zle a gumen ha
an imp o emen in he e ms o ade inc eases eal income and hence
educes he a io o expendi u es o income (1950, p. 286). Equa ion
T
(4) implici ly de ines a sa ings unc ion, A = Y ——
—
E, which e-
sponds posi i ely o income and he e ms o ade, and nega i ely o
eal weal h, wi h pa ial de i a i es e lec ing he income cons ain .
Expendi u e is alloca ed be ween home goods and impo s acco ding
o
(5) E = D
(E,
n) + — m (E, n) .
Now de ine M (E, i) o be he home goods equi alen o expendi u e on
impo s; i. e., M(E, i) = — m (E, n) so Mi = — mi and M2 = — ( i2
—
^ JZ J J
m), and u he , om (5), M2 =
—
D2. I he expendi u e-held-con-
n
s an demand o home goods is well beha ed wi h espec o n (i. e., i
D-2
< 0), hen he demand o impo s mus be elas ic and so he home
good equi alen o he demand o impo s mus be well-beha ed
(M2
> 0).6 Thus we can w i e
(5') E = D (E,
J )
- M (E, n) , 1 > Dx = 1 - Mx > 0 , D2 = - M2 < 0 .
« The impo elas ici y Em =
—
(3 ml3 (1 In)) (1 ln)lm = m^/M. F om he
de ini ion o M, his equals 1 + (P/M) M2 which is g ea e han one since M2
is posi i e. I m (.) we e no elas ic, D would no be mono onic in n.
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14 Douglas D. Pu is
Weal h is comp ised o domes ic money, L, plus he domes ic cu -
ency equi alen o o eign asse s, F = eF*. In o de o a oid he com-
plica ions associa ed wi h in e es ea nings on asse s and he com-
plexi ies o he in e es a e consequences o exchange a e expec a ions,
and in o de o emphasize he ole o he exchange a e as he ela i e
p ice o na ional monies, I assume ha
F*
is non-in e es bea ing o eign
cu ency.7 The e o e
(6) A = C + R + eF*
whe e R is he s ock o o eign exchange ese es held by he cen al
bank, e alua ed a cos : exchange a e changes gene a e di ec weal h
e ec s only o he ex en ha he public holds o eign cu ency; capi al
gains o losses incu ed by he cen al bank on i s o eign exchange
holdings a e no assumed o be mone ized.8
Equilib ium in he ma ke o domes ically p oduced goods is gi en
by (7)
(7) Y S = E + g + (Xd-M)
= D + g + Xd .
Equi alen ly we can de ine he amoun o home goods a ailable o
expo as
(8) Xs = Ys
—
(D + g)
and ew i e he equilib ium (7) in e ms o he equali y be ween expo
supply and demand
(7') XS = Xd .
Unde ixed exchange a es A is p ede e mined and Q is exogenous
(eQ*). We could sol e equa ions (1), (2), (4), (5'), (7') and (8) o P, Y, Xd,
Xs, E and M. Momen a y equilib ium in he model — gi en Q = eQ*,
9, * and A — is illus a ed in Figu e 1. The expo supply locus in he
igh hand quad an s a s a he alue o P a which domes ic demand
o domes ic ou pu , D + g, equals supply, Ys.9 (The expo supply
7 Do nbusch (1967 a, b) has de eloped models which make he in e es a e
endogenous in he sho un due o exchange a e expec a ions. Kou i has a
model simila o ou s, bu , by assuming Q* is always cons an , he ails o
make clea he di e en ole played by e and Q* ha I emphasize below.
8 Po e (1975) emphasizes ha po olio shi s in he an icipa ion o ex-
change a e changes shi he weal h e ec s o a dep ecia ion om he p i a e
sec o o he cen al bank, hus nulli ying much o he o ce o he de a-
lua ion.
9 D + g can be de i ed ei he by sol ing (7) o equilib ium income and
subs i u ing ha alue in o D, o by using Y = D + g +
X<*
o de ine Y as a
unc ion o P, and subs i u ing in D. The wo would in e sec a equilib ium
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Wages, he Te ms o T ade, and he Exchange Ra e Hegime 15
P P
D*g
0 home
goods 0 expo s
i
o
Fig.
1 :
Equilib ium wi h Fixed Exchange Ra es
cu e is la e han Ys since i combines he slope o Ys and D.) The
in e sec ion o Xs wi h he expo demand cu e de e mines P; acing
back o he le -hand quad an we can de e mine Y and D. A he
equilib ium p ice, he le el o expo s equals ho izon al dis ance VW
in he le -hand quad an , and he dashed line g + D + Xd in e sec s
Ys o yield an equi alen cha ac e iza ion o he equilib ium.
No e ha his goods ma ke equilib ium is ound wi hou e e ence
o asse equilib ium; only he p ede e mined s ock o inancial weal h
was used. This sugges s immedia ely ha mone a y policy can ha e no
e ec in he sho un; c edi expansion will, unde ixed exchange
a es gi e ise o ins an aneous o se ing po olio swi ches. Asse
equilib ium conside a ions a e, howe e , impo an in de e mining he
a ious ex e nal accoun s and hence in de e mining he mo ion o he
sys em. This is spelled ou in he appendix.
O pa icula in e es is he ade accoun su plus, gi en by
(9) Z = X-M = Y-QE + g)
In he assumed absence o deb se icing equi emen s, Z is equi alen
o he cu en accoun . Thus he ade accoun su plus also gi es he
ne a e o accumula ion o o eign asse s, eF + R, which in u n equals
he excess o domes ic sa ing o e domes ic c edi c ea ion.
P; he second would be less p ice elas ic since he educed o m o Y would
be nega i ely ela ed o P.
= (A
— G)
/ P .
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16 Douglas D. Pu is
P
g.D X
0 home goods
Fig. 2: The T ade Accoun Unde Fixed Exchange Ra es
The beha io o he ade accoun is illus a ed in Figu e 2, which
can be used o ela e ou analysis o he h ee adi ional app oaches.
Holding income cons an , we plo he o al demand o home goods,
D + g + Xd, and he o al home good equi alen o domes ic demand,
g + E, as unc ions o he p ice le el. The ho izon al dis ance^ de ines
he ade balance as a unc ion o he p ice le el, plo ed as Z (P; Yo).
The slope o D + g + Xd is gi en by Xi + D2 - Di (E2 A + E3) which
is unambiguously nega i e. The slope o g 4- E is gi en by
— (E2
A + E3),
also nega i e. In o de o he Zp o be nega i e, as d awn, we equi e
ha he Augmen ed Elas ici y Condi ion (AEC) gi en by (10) be me .
(10) AEC: X1 + D2 + (1-D1)E2A + E3)=X1-M2 + M1(E2A + Es)<0 .
This is simila o he Ma shall-Le ne condi ion wi h he domes ic im-
po elas ici y measu ed as he subs i u ion e ec plus he weal h and
Lau sen-Me zle e ec s on expendi u e.
An inc ease in income causes bo h cu es o shi igh , and he ade
accoun o gi en p ice le el unambiguously de e io a es (i. e., Zy < 0
as illus a ed by Z(P; Yi) whe e Yi > Y0) since g + D + Xd shi s by
only a ac ion D o he shi in g + E (gi en by
E%
dY). These wo
esul s illus a e he elas ici y and abso p ion app oaches espec i ely.
The hi d app oach, gi en by he mone a y heo y o he balance o
paymen s, con ends ha he o e all balance o paymen s will equal he
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Wages, he Te ms o T ade, and he Exchange Ra e Regime 23
As has been well- ecognized, he oppo uni y o engage in such s ock-
swi ches depends no only on "pe ec in e na ional inancial ma ke s,"
bu also on he commi men o he cen al bank o p o ide o abso b
domes ic cu ency in o de o main ain he exchange a e. No su -
p isingly hen, he ecu si e na u e o he momen a y equilib ium dis-
appea s unde a lexible exchange a e egime whe ein he cen al bank
no longe has such a commi men . Unde lexible exchange a es, he
money supply is exogenously de e mined by he mone a y au ho i y,
and momen a y equilib ium mus be consis en wi h i as well as wi h
equilib ium in he goods ma ke . Hence wi h c, and he e o e Q, now
endogenously de e mined, he single equa ion analysis o Sec ion I
canno be used he e.
To illus a e his, conside he analysis o de alua ion conduc ed in
he p eceding sec ion. Gi en an exogenous change in e we we e able
o deduce he equilib ium changes in P and Y om he goods ma ke
equilib ium and he alue o o al weal h A. We could ha e hen p o-
ceded o analyze he ensuing change in money as a esul o po olio
ea angemen . I is easily shown using he sys em de eloped below
ha i a change in money we e in oduced exogenously in o he lexible
exchange a e sys em, hen he same exchange a e change would all
ou endogenously. Bu in e e sing he expe imen , a simul aneous
sys em would ha e o be used o calcula e he exchange a e change.
Howe e , cu en mone a y w i ings (Do ibusch [1976 a, b], Kou i
[1976]) ha e sugges ed ha he exchange a e is essen ially de e mined
by po olio equilib ium alone, and ha low decisions de e mine he
capi al accoun (and p esumably he a e o change o he exchange
a e). The app oach aken in his sec ion is o emphasize ha he de e -
mina ion o c, P, Y, E, F* and e is a simul aneous one. Acco dingly, he
balance o paymen s equa ions o he appendix a e modi ied o no e
ha he only sou ce o change in he money supply a ises om he
go e nmen de ici and ha o eign asse s can only be accumula ed
by ne commodi y sales. Since he go e nmen is nei he buying no
selling o eign exchange he e is no o eign sou ce o addi ional money.
Tha is, he balance o paymen s mus be ze o, which is equi alen o
he equi emen ha he public be willing o hold he exis ing s ock o
money,14'15 and he capi al accoun de ici mus equal he cu en ac-
14 Equi alen ly, we could speci y ha he public be willing o hold he
exis ing s ock o o eign asse s! The o ce o he s a emen is simply ha
disc e e asse swaps a e uled ou so he mone a y equilib ium mus now be
consis en wi h he exis ing dis ibu ion o asse s. This, o cou se, p esumes
ha o eigne s hold no domes ic cu ency; his means in e ms o mo e com-
mon models, as Ron McKinnon poin ed ou o me, ha i is impossible o
change one's o wa d co e posi ion.
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24 Douglas D. Pu is
coun su plus. The goods ma ke equilib ium (7) mus be sol ed simul-
aneously wi h he po olio balance condi ion gi en by (14)
(14) L = l(Y; 6) A , Zy>0
whe e A is inancial weal h as de ined in (6) abo e, L is he domes ic
money supply (C + R)16 and S is a ec o o o he a iables which
may a ec po olio balance. (Fo example, Kou i s esses he ole o
exchange a e expec a ions.) No e ha om (14) and (6) we can deduce
he demand o o eign asse s,
F* = (Y ; G) A ; / (.) = 1 - I (.) ; Y=-lY
so ha only one asse equilib ium condi ion need be conside ed. Sub-
s i u ing o Y in (14) and di e en ia ing yields
(15) Aly S dP + (Aly S2 -1- IF*) de= - Aly S2 dQ* + (1 -
I)
dR
Combining (14) wi h goods ma ke equilib ium (11) yields a sys em
o wo equa ions in he unknowns P and e. Equilib ium is depic ed
in Figu es 5 and 6. Goods ma ke equilib ium unde lexible exchange
a es as gi en by (11) is depic ed by XX; as can be eadily seen i
has a slope X!2 which is posi i e bu less han one. In he same igu es
h ee possible loci o asse equilib ium as gi en by (14) a e depic ed
by MM, which has a slope - (Aly S2 + IF*)/Aly Si ^ 0. (Unless o he -
wise speci ied, we shall assume F* > 0.) Unde he easonable dynamic
pos ula e ha he exchange a e ises i he e is excess supply o domes ic
money and he p ice le el ises i he e is excess demand o goods,
he s abili y condi ion is ha MM cu XX om abo e; i. e., ha he
basic de e minan o he sys em, A =
X
Aly Si + 2 (Aly S2 + IF*) be
posi i e. Howe e , A is a p io i o inde e mina e sign which indica es
a po en ial ins abili y in he lexible exchange a e sys em; his ins a-
bili y u ns ou o be ela ed o ea lie analyses o he o eign exchange
ma ke which concen a ed solely on low equilib ium, and is wo h
explo ing in some de ail.
15 This is in con adis inc ion o Kou i's con en ion (pp. 285 - 287) ha s ock
and no low equilib ium mus be used o close he model. This di e ence
a ises in pa due o di e ences in he models as discussed abo e. Bu he e
is a b oade issue. I would con end ha s ock and low equilib ium a e bo h
in ol ed since in mone a y equilib ium one is con en wi h exis ing s ocks
only i hey a e changing a he desi ed a e. One could a gue ha in he
models unde discussion, as opposed o a model wi h ansac ions cos s as
alluded o by Kou i (p. 287) and analyzed in de ail an Pu is (1975, appendix)
he low demand o money is no de e mina e; bu his does no ende
he balance o paymen s inde e mina e unde ixed exchange a es no does
i make he ac ha unde lexible a es he low supply is ze o, o no con-
sequence.
16 C is s ic ly an accoun ing ela ion be ween he go e nmen and he
cen al bank; open ma ke ope a ions mus in ol e R and F* only.
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Wages, he Te ms o T ade, and he Exchange Ra e Regime 25
P
Fig. 5: Momen a y Equilib ium (MM nega i ely sloped)
Fig. 6: Momen a y Equilib ium (MM posi i ely sloped)
(a) uns able (b) s able
I is clea ha a su icien condi ion o s abili y is ha MM be
nega i ely sloped. A dep ecia ion in gene al has wo e ec s on he
excess demand o money: a posi i e weal h e ec and a nega i e in-
come e ec . I MM is posi i ely sloped he income e ec domina es and
hence a dep ecia ion in he ace o an excess supply o money is de-
s abilizing; only i he XX is s eepe han MM, i. e., only i he money
ma ke esponds ela i ely mo e s ongly o changes in P so ha
changes in P in esponse o goods ma ke condi ions will also equilib a e
he money ma ke , will he p ocess be damped.
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26 Douglas D. Pu is
I is in e es ing o examine he in luence o he a ious pa ame e s
o he model on he po en ial o ins abili y. Conside i s he in-
luence o exchange a e changes on wages as mani es ed in he alue
o S2. I is easily seen ha in he Keynesian s icky wage case wi h
S2 = 0, MM is nega i ely sloped, and he sys em is necessa ily s able.
In he o he ex eme case wi h S2 = 0 = Si (case (ii a) o exchange a e
illusion), income would be ixed so ha only one alue o he exchange
a e would be consis en wi h (14); MM would be e ical, he weal h
e ec would domina e, and he sys em would be s able. Fu he , i
can be shown ha as S2 inc eases in absolu e alue he slope o MM
inc eases as e han he slope o XX hus inc easing he changes o
ins abili y. [I MM is posi i ely sloped (S2 =
—
Si), F* > 0 ensu es ha
he slope is less han one.]
P oposi ion III. Inc eased wage esponsi eness o exchange a e
changes inc eases he chances ha he lexible a e sys em will be
uns able.
Gi en his las p oposi ion and obse ing ha he lexible-wage,
ull-employmen model is commonly used in mone a y models o he
exchange a e, i is cu ious ha ins abili y does no a ise in such models.
The answe lies in he ole played by a second pa ame e o ou model,
ela i e coun y size. In he small open economy case gene ally used
by mone a is s, XX akes on a slope o one which gua an ees ha i
will be s eepe han MM so long as F* is posi i e.
P oposi ion IV. The small open economy assump ion is su icien o
assu e ha an economy wi h ne o eign asse holdings will be
s able unde lexible exchange a es.
No e ha in his case, ela i e p ices can be hough o as de e mined
by XX and he p ice le el (exchange a e) by MM, and he simul-
aneous model (12) and (15) can be eplaced by a ecu si e solu ion
ela ing he exchange a e o he money supply. This is he in e p e a-
ion I gi e o Kou i's model. As he elas ici ies (Xi + D2) all in ab-
solu e alue, he slope o XX dec eases, inc easing he po en ial o
ins abili y. The s abili y condi ion A > 0 can be in e p e ed as an Aug-
men ed-Ma shall-Le ne -Condi ion which de ines, o he o he pa a-
me e s o he sys em, a c i ical alue o he sum — (Xi + D2) o exceed
in o de o ensu e s abili y.
A hi d pa ame e a ec ing s abili y is he ne o eign asse posi ion,
F*. Conside , o example, a Financially La ge Coun y which has
enough in luence in in e na ional inancial ansac ions ha i s in e -
na ional bo owings a e denomina ed in e ms o he home cu ency.
B i ain as he inancial cen e o he S e ling A ea was an example
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Wages, he Te ms o T ade, and he Exchange Ha e Regime 27
o such a coun y, jus as he Uni ed S a es and Swi ze land may be
cu en examples. In e ms o ou model, F* would be exchange-in-
dexed so ha an exchange a e change has no weal h e ec s. In case (i)
wi h S2 = 0, he inancially la ge coun y will ha e a la MM cu e.
Asse equilib ium is consis en wi h only one le el o income and hence
only one p ice le el; he sys em is s able. In case (ii) wi h S2 = — Su
ela i e p ices a e now ixed since again only one le el o ou pu is
consis en wi h asse equilib ium, and MM has a slope o one.
P oposi ion V. A inancially la ge coun y will be uns able unde
lexible exchange a es i wages espond o he exchange a e (F*
posi i e is su icien o s abili y in Case i; necessa y in Case ii.)
(I he coun y is a ne bo owe so ha F* is nega i e, ins abili y is
also ensu ed since MM akes on a slope g ea e han one.) E en he
SOE assump ion is o no a ail now since ha would ix ou pu a a
le el no necessa ily consis en wi h exis ing asse p opo ions, hus
us a ing po olio balance mo i es and possibly gene a ing a spe-
cula i e ush. The sys em is o e de e mined since we now ha e wo
independen condi ions on he ela i e p ice s uc u e.
Finally i is use ul o hink o combina ions o hese pa ame e s in
o de o emphasize he gene al equilib ium na u e o he exchange
a e. Fo example, he usual Keynesian p oblem o low elas ici y — (Xi
- D2) could be o se by low esponse o wages o he exchange a e
( hus inc easing he p ice elas ici y o ou pu ) o a high F* (c a ec ing
expendi u e in he la e case ia weal h a he han subs i u ion
e ec s.)
Using Figu es 5 and 6 we can now b ie ly examine he impac on
momen a y equilib ium o iscal policy, dg, o a pu chase o o eign
exchange asse s by he cen al bank, dR = — edF*. The compa a i e
s a ic esul s a e summa ized in Table 2, whe e h oughou we assume
F*> 0.
Conside i s an inc ease in go e nmen pu chase o home goods.
In he gene al case whe e ela i e size ma e s, his c ea es, a exis ing
p ices, an excess demand o goods and causes he XX cu e o shi
e ically. Assuming s abili y, he exchange a e alls (i. e., he cu -
ency app ecia es), domes ic p ices ise i MM is nega i ely sloped, and
all i MM is posi i ely sloped.
P oposi ion VI. Wi h lexible wages and a iable e ms o ade,
expansiona y iscal policy unde lexible exchange a es will cause
domes ic p ices o all i he income e ec on he demand o
money exceeds he weal h e ec .
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28 Douglas D. Pu is
Table 2
Compa a i e S a ics unde Flexible Exchange Ra es
Exog-
enous
Changes
Case
Induced Change
Exog-
enous
Changes
Case Domes ic P ices
dPa)
Domes ic Ou pu
dYa)
Exchange Ha e
dea)
Fiscal
Policyb)
dg = 1
i IF*
-j- > 0 (0) SidP>0 (0)
Aly Si ^
* 1 <0 (0)
Fiscal
Policyb)
dg = 1
ia 0 (NA) IF* ^
XAly + lF* j >0 (0)
Fiscal
Policyb)
dg = 1
di
IF*
- Aly /
^§0(0)
depends on slope
o MM
Sx (dP - de) > 0(0)
—
Aly Si ^
J—1 < dP (0)
Fiscal
Policyb)
dg = 1
iia i>0 (0) 0 (0) 0
Mone-
a y
Policyc)
= HP
-
= 1
i A>0[AIyS1 + IF*) SxdP> 0 (0) V > dP (dP)
A
Mone-
a y
Policyc)
= HP
-
= 1
ia 0 ¿M>0 (0>
(1 - E Di) ^
My I >0(0)
Mone-
a y
Policyc)
= HP
-
= 1
ii l>° S1 (dP - de) <0
(0)
y >dP (dP)
A
Mone-
a y
Policyc)
= HP
-
= 1
iia 2
IF*
> ° (
IF*
) 0 0
a) Second (b acke ed) en y gi es esul s o small coun y assump ion.
b) dZ/dg < 0 by AEC.
c) dZ/dR unce ain in case (i) — all bu weal h e ec o impo s lead o imp o e-
men . — dZ/dR > 0 in case (ii) by AEC.
(Al hough he ini ial impac is excess demand o goods and p ices
ising, he e is also excess supply o money in his case; e ises causing
excess supply o goods and gene a ing a cyclical adjus men whe eby
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Wages, he Te ms o T ade, and he Exchange Ra e Regime 29
p ices e en ually all.) Income unambiguously ises; P can all only
when
1S2
=
—
Si; and i P alls, i alls by less han he exchange a e
so dY > 0. Using AEC i can be shown ha he ade accoun de e i-
o a es. In he SOE case no ela i e p ice change is equi ed o o se
he induced excess demand so XX doesn' shi . Thus in his case he
go e nmen expendi u e has no e ec on he p ice le el, he exchange
a e o he le el o income; he adi ional esul abou he ine ec-
i eness o iscal policy unde lexible exchange a es is ees ablished.
P oposi ion la» In a small open economy, iscal policy is no e ec-
i e in in luencing income unde lexible exchange a es.
In his case, he impac e ec on he ade accoun is o cause a de e i-
o a ion in he exac amoun o he go e nmen expendi u e. These
esul s con o m o hose ob ained by Kou i; in addi ion, i we we e
o combine case (ii) wi h he SOE assump ion we can iew he model
ecu si ely whe eby he goods ma ke by de e mining ela i e p ices
also ixes income; asse equilib ium hen de e mines he p ice le el
and hence he exchange a e.
Mone a y policy c ea es an excess supply o money and causes MM
o shi e ically. In he gene al case, and again assuming s abili y,
his means ha bo h he p ice le el and he exchange a e ise, he
la e by mo e by i ue o he slope o XX being less han one. This
means ha in case (i) ou pu ises bu in case (ii) ou pu alls.
P oposi ion VII. Wi h lexible wages and a iable e ms o ade,
expansiona y mone a y policy unde lexible exchange a es will
be in la iona y on p ices bu con ac iona y o ou pu .
This is because he induced exchange dep ecia ion will cause a wage
explosion which esul s in highe eal wages, his inc ease in W/P being
in u n dependen upon he impac on he e ms o ade. In he Kou i
case o esponsi e wages and ixed ela i e p ices, he e will be no
ou pu esponse, and he exchange a e and p ices will ha e o ise
o elimina e he excess demand o money.
P oposi ion Vila. In a small open economy wi h lexible wages,
mone a y policy will no a ec ou pu bu will cause an equal
change in P and e, bo h ising mo e han p opo iona ely o he
mone a y dis u bance.
I wages a e esponsi e o he exchange a e, o i ela i e p ices a e
ixed, hen expansiona y mone a y policy will unambiguously cause a
de e io a ion o he ade accoun . (In he absence o one o he wo
s a ed condi ions, he impac o weal h on expendi u e is unce ain; see
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30 Douglas D. Pu is
he discussion o de alua ion in Sec ion I abo e.) Finally, i can easily
be shown ha o any de alua ion conside ed in Sec ion I, he e is an
equi alen mone a y policy unde lexible a es; he induced dep ecia-
ion in Sec ion II will equal he exogenous de alua ion o Sec ion I, and
he induced change in demand o money o Sec ion I will equal he
exogenous change in money supply o Sec ion II.
Conside now he e ec s o an exogenous inc ease in he o eign
p ice, dQ*. These esul s a e summa ized in Table 3. A exis ing alues
o P and e, assuming unchanged demand o expo s as a unc ion o
ela i e p ices, his c ea es an excess demand o he home good and
XX shi s e ically by a p opo ion
j/H
o dQ*. I S2 = 0, MM will
emain unal e ed, and since MM is nega i ely sloped, i is ob ious ha
P (and hence income) ises and e alls; bo h change less han p opo -
iona ely o dQ*; (dP
—
dc) can be shown o be less han dQ* so he
e ms o ade de e io a e. P oposi ion VIII is easily p o en:
P oposi ion VIII. In an economy wi h igid wages and a iable
e ms o ade, an inc ease in he o eign cu ency p ice o impo s
leads o a less han p opo iona e inc ease in he p ice o he ex-
po good. Fu he he p ice inc ease ha would ob ain unde ixed
exchange a es exceeds ha which occu s unde lexible a es; in
he la e case a less han p opo iona e app ecia ion o he cu -
ency occu s.
I wages espond o dQ*, ou pu would all a ini ial (P, e) causing an
excess supply o money and inc easing he excess demand o he home
good. The MM cu e shi s up exac ly p opo iona ely o dQ*. I is
easily shown ha , jus as unde ixed exchange a es, lexible wages
inc ease he esponsi eness o domes ic o o eign p ices.17 As can be
seen om Figu es 7 and 8, he compa a i e s a ic esul s depend
quali a i ely on he slope o MM. I he weal h e ec o a change in c
domina es he income e ec (in e ms o he money ma ke ) so MM is
nega i ely sloped, hen P ises less han p opo iona ely o
Q*;
i can be
shown ha he change in P is less han would ob ain unde ixed a es
so ha lexible exchange a es in his case do p o ide some insula ion
om o eign in la ion. Bu pe haps su p isingly, he adjus men in-
ol es a dep ecia ed cu ency (c ises) ensu ing ha he e ms o ade
and ou pu all, and he all in ou pu is g ea e han ha which would
ha e occu ed unde ixed exchange a es! I MM is posi i ely sloped,
lexible a es do no e en p o ide p ice insula ion since P ises mo e
han p opo iona ely o Q* and hence mo e han ixed- a e inc ease.
17 Flexible wages and lexible exchange a es a e no pe ec subs i u es
in he adjus men p ocess, as can be seen by compa ing he second and i h
ows o Table 3.
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Wages, he Te ms o T ade, and he Exchange Ha e Regime 31
Table 3
Compa a i e S a ic E ec o Fo eign In la ion
Changes Induced by dQ* = 1
Domes ic P ices
DPa) Exchange Ra e
dea) Domes ic Ou pu
dYa)
1. Rigid Wages (i) (S2 = 0)b); Va iable Te ms o T ade
a) Fixed Ex-
change Ra es
V
0< <1
(5 ;u) (2)
7Ì
SlY>0
(2)
b) Flexible Ex-
change Ra es0) .0<si«<1
(7,7)
^
—
yd
-1<w + s<0
(7)
SiV >0
2 + òk >
(3)
2. Rigid Wages (i) (S2 = 0); Cons an Te ms o T ade (Small Open Economy,
Xx = - oo)
a) Fixed Ex-
change Ra es 1
(2,1) (2)
S1>0
(1)
b) Flexible Ex-
change Ra esO 0<lÌi (6, U) -1<i + s<0
(6) (4)
3. Flexible Wages (ii) (S2 = - S^b); Va iable Te ms o T ade
a) Fixed Ex-
change Ra es
V
0<Y<1
(4,3)
0
(2)
MiH<o
(6)
b) Flexible Ex-
change Ra es«*)
V +
à' A
^
n ^ ^ 1 AlyS^Z- ) n ^ „
( j —
2) IF ^
b) Flexible Ex-
change Ra es«*) (1,U)
A 0<
(1)
Sl A <0
(7)
4. Flexible Wages (ii) (S2 = - S ); Cons an Te ms o T ade (SOE)
Independen o
Exchange Ra e
Regime
1
(2,1)
0
(2)
0
(5)
a) B acke ed numbe gi es anking by column, acco ding o algeb aic change. Col-
umn one has wo ankings, o 8 > 1 and 8 < 1, espec i ely. U means un anked as
be ween 4, 5, and 6.
b) Mo ing om Case (i) o (ii) 2 alls while y and X ise; hei anking, howe e ,
emains unchanged.
c) 8 = Aly S^IF* > 0. MM is posi i ely sloped i 8 > 1.
d)
8'
= 8/(1 -
8)
g
0
as
8
> 1. i
8'
> 0,
dP
> 1.
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32 Douglas D. Pu is
Fig. 7: Fo eign In la ion Pa ially Insula ed by Flexible Ra e
Fig. 8: Fo eign In la ion Exagge a ed by Flexible Ra e
P oposi ion IX. In an economy wi h lexible wages and a iable
e ms o ade, lexible exchange a es, a bes , p o ide pa ial
p ice insula ion om o eign in la ion, and hey exace ba e he
nega i e ou pu e ec s ha o eign in la ion po ends o such an
economy.
Ins ead o a emp ing an in ui i e explana ion o his esul a his s age,
i is wo h examining he small open economy case whe eby he e ms
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DOI h ps://doi.o g/10.3790/schm.99.1-2.9 | Gene a ed on 2023-04-04 11:56:53