Exchange Rate Economics: Theories and Evidence

262 The new open economy macroeconomics part 1
%∆S
G
^
M9
^
M – M*
M
M9
G
M
^
^
%∆(C – C*)
Figure 10.2 Unexpected relative rise in home money in NOEM.
The effects of the monetary shock are as follows. In the short-run,with preset
prices,the home country terms of trade worsens and the world real interest
rate falls. Both of these effects stimulate consumption in the foreign country.
In the home country output and consumption rise,but the latter does not rise
by the same amount as the increase in income,due to consumption smoothing,and
therefore the domestic current account moves into surplus. Much as in the portfolio
balance model of Chapter 7,the latter effect implies a permanent improvement
in net foreign assets and in the new steady state this allows the trade account to
be in deficit: the positive net investment flow allows domestic consumption to be
permanently above domestic income. The wealth effect of the net foreign asset
position is such as to reduce domestic labour supply and output and this produces
a permanent improvement in the terms of trade. The latter may be seen formally
in the following way. By combining (10.37) and (10.41) we get:
(
Ĉ − Ĉ ∗ =
ɛδ(θ 2 − 1)
δ(θ 2 − 1) + ɛ[(1 + θ)+ 2θ]
)
( ˆM − ˆM ∗ ). (10.42)
The short-run current account (which by assumption also equals the long-run
change in net foreign assets) may be obtained by substituting the short-run output
gap relationship ŷ −ŷ ∗ = θŜ along with (10.37),(10.41) and (10.42) into (10.38)
to get:
(
´F =
2θɛ(1 − n)(θ − 1)
δ(θ 2 − 1) + ɛ[δ(1 + θ)+ 2θ]
)
( ˆM − ˆM ∗ ). (10.43)