Exchange Rate Economics: Theories and Evidence

258 The new open economy macroeconomics part 1
The effects of wealth transfers may now be seen by using the steady change
equivalents of (10.20) and (10.23) (i.e. rewriting these with over primes above
each of the variables) into (10.28) to obtain:
Ć − Ć ∗ =
( 1
1 − n
)( 1 + θ
2θ
)
δ ´F . (10.29)
Expression (10.29) indicates that steady-state domestic consumption can be greater
than foreign consumption by an amount determined as the product of the two
bracketed terms times δ ´F . If output was exogenous in the model the effect on
consumption would simply be determined by the first term in brackets (1 − n) −1 .
However,with endogenous income this effect is attenuated by the second term
in brackets (remember θ > 1). The intuition for this latter result is simply that
a positive wealth transfer to the domestic economy means that domestic agents
consume more leisure while in the foreign country agents consume less leisure
and work harder. By substituting (10.23) into (10.20),rearranging for relative
consumption and using (10.29) to substitute for relative consumption,the following
steady-state terms of trade relationship may be obtained:
ṕ(h) − Ś − ṕ ∗ (f ) =
( 1
1 − n
)( 1
2θ
)
δ ´F . (10.30)
Equation (10.30) shows that the home country’s terms of trade will improve as a
result of a positive transfer and this improvement is again driven by the labour–
leisure decision. We are now in a position to look more closely at the exchange
rate relationship implied by the model and the effects of monetary policy.
10.1.4 The exchange rate and unanticipated
monetary shocks
Subtracting equation (10.15) from (10.14) gives:
Ĉ − Ĉ ∗ = Ć − Ć ∗ . (10.31)
Equation (10.31) indicates that shocks to relative per capita consumption have a
permanent effect and this is nothing other than open economy analogue of the
random walk model of consumption (see Hall 1978). The t + 1 time subscripts
have been dropped here since we follow Obstfeld and Rogoff in assuming that
the economy gets back to steady state after a disturbance in one period. Hence
all t + 1 subscripted variables can be replaced with percentage changes in steady
state. With this assumption,hatted variables can be interpreted as short-run values,
while over prime variables are long-run. Similarly,assuming PPP – Ŝ t = ˆP t − ˆP t ∗ –
holds continuously (i.e. in the short- and long-run) the money demand equations
(10.16) and (10.17) can be manipulated to get:
Ŝ = ˆM − ˆM ∗ − 1 (Ĉ − Ĉ ∗) β
)
+
(Ś − Ŝ . 6 (10.32)
ɛ
(1 − β)ɛ