Exchange Rate Economics: Theories and Evidence

272 The new open economy macroeconomics part 1
Since the elasticity of substitution between tradables and non-tradables is relatively
low,the increased consumption of non-tradables stimulates consumption of tradables
(10.81) and the current account goes into deficit. In the new long-run steady
state the current account must be balanced and so the long-run consumption of
tradables needs to fall (equation (10.82)) in order to generate the trade surplus
required to finance negative net foreign assets resulting from the monetary shock,
and these negative net foreign assets,in turn,require a long-run depreciation of
the real exchange rate – the relative price of non-tradables in terms of tradables
must fall (equation (10.84)).
With σθ,production and
consumption of the traded good falls in the new steady state. As in the portfolio
balance model of Chapter 7,this is due to the accumulation/decumulation of net
foreign assets which has a wealth effect on the desired level of consumption of the
non-traded good and the optimal supply of labour in the non-traded sector. In
particular,the former effect is inversely related to θ,the intra-temporal elasticity
of substitution,while the strength of the latter depends inversely on σ ,the intertemporal
elasticity of substitution. The former effect dominates when σ>θ. More
specifically,when σ>θnet foreign assets,as we have seen,become negative and
the implied wealth effect on the consumption of non-tradables (their desired level
falls) is greater than its effect on labour supply (the desired level rises). When σ