Exchange Rate Economics: Theories and Evidence

The new open economy macroeconomics part 1 263
By combining equation (10.30) with (10.43) one may obtain the steady-state terms
of trade as:
(
)
ṕ(h) − Ś − ṕ ∗ ɛδ(θ − 1)
(f ) =
δ(θ 2 ( ˆM − ˆM ∗ ). (10.44)
− 1) + ɛ[δ(1 + θ)+ 2θ]
There are two aspects of (10.44) worth noting. First,comparing (10.41),which
with sticky prices gives the short-run fall in the terms of trade,with (10.44),which
gives the long-run improvement,we see that in absolute terms the short-run effect
dominates the long-run effect. Second,the impact of a monetary shock on the longrun
terms of trade is of an order of magnitude given by the real interest rate (=δ).
Note from (10.29) that the exchange rate depreciates less than proportionately to
the money supply change,even in the long-run (remember Ŝ = Ś for a permanent
money supply shock). The intuition for this is simple – since the home country’s
real income and consumption rise in the long-run,the nominal exchange rate does
not need to depreciate as much as it would under fully flexible prices. Obstfeld
and Rogoff (1996) are careful not to overstate this long-run non-neutrality result.
In particular,they argue that in an overlapping generation’s version of the model
the real effects of the monetary shock would eventually die out,although over a
relatively much longer time span than the price frictions.
10.2 Government spending and productivityeffects
In this section we introduce a role for government spending into the base-line
NOEM. Although the introduction of government spending affects most of the
equations introduced in the previous section,we focus only on a few of the key
relationships here (in general the introduction of government spending affects the
equations additively). Following Obstfeld and Rogoff (1995) we assume that the
government’s consumption index takes the same basic form as the private sectors:
[∫ 1
θ/(θ−1)
G = g j (z) dz] (θ−1)/θ , θ>1,(10.45)
0
where the government’s elasticity of substitution is assumed to be the same as
the private sectors. Both the government budget constraint and current account
relationship also have to be modified. The former is:
τ t + M t − M t−1
P t
= G t ,(10.46)
and the short-run current account relationship is:
F t+1 − F t = r t F t + p t(h)y t
P t
− C t − G t . (10.47)
The steady-state expression for the effects of a permanent (tax-financed) government
spending shocks on relative consumption is (this parallels the derivation of