International Transmission of Stabilization Policies

Abstract

<p>The interdependence of economic policies under flexible exchange rates has (finally) come to be accepted as a fact. As world markets have evolved from national markets into an internationally efficient system, the ability of governments to isolate their economies from international disturbances has decreased dramatically. That is, in today's highly integrated world economic system, economic authorities must come to terms with the economic interdependence of the system.</p> <p>This study consists of three essays on open economy macroeconomics. In each of these essays we focus our attention on different channels through which the effects of stabilization policies are transmitted internationally. In the first essay we construct an "extended" small open economy model (the rest of the world is explicitly modelled, but unlike the two country models the small country has no impact on the rest of the world), which recognizes the interdependence of rest of the world variables that are considered exogenous by the small country. We use this model in order to investigate the properties of five monetary policy rules (i.e., a fixed rate of monetary growth rule, a fixed nominal exchange rate rule, a nominal income rule, an inflation rate rule,and a fixed real exchange rate rule) in response to permanent monetary and fiscal disturbances in the rest of the world. Our major finding is that nominal income and inflation rate rules can be very effective in preventing any output and price deviations from their steady-state values, whereas pegging the real exchange rate is not a feasible policy when foreign disturbances affect the equilibrium real interest rate.</p> <p>The second essay examines stabilization policy options for some of the European Economic Community countries by considering a two-country currency area model involving floating exchange rates with the rest of the world and real wage rigidity within the currency area. Recognition of the supply-side effects of the exchange rate in this model yields conclusions which differ markedly from the existing results concerning beggar-my-neighbour effects between currency area countries. Moreover, both currency area countries are adversely affected by a foreign interest rate hike.</p> <p>The third essay preserves the three country (the two currency area countries and the rest of the world) setting of the second essay, but now the emphasis is on the short-run interdependence of monetary policies (i.e., open market operations) between the currency area's central banks. The portfolio balance model is used to show how the conventional results encountered in the one and two country models need to be qualified once the responses of the one of the currency area's central banks both to policy actions by the other currency area central bank and to exogenous disturbances are taken into account.</p>