Dynamic Effects of Government Policies in an Open Economy 1

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Journal of Monetary

Economics 6 (1980) 213- 239. 0 North-Holland

Publishing Company


Robert J. HODRICK*

The effects of three government policies. an increase in the provision of government services. an open market operation, and an increase in the rate of growth of governmerit liabilities, are studied in a long-run model of a small open economy with flexible exchange rates. The government budget constraint. the degree to which government bonds are net wealth to the public, and the degree of substitutab:lity of government services for private market purchases are all considered. The determination of the exchange rate and the adjustment of the accounts of the balance of payments to changes in government policy are explored.

1. Introduction The government sector exerts a pervasive influence on the macroeconomic variables of an economy. The purpose of this paper is to consider a variety of ways in which these influences are manifest in a small open economy. The analysis is concerned with the perceptions of the public regarding government policies and with the long-run influence of the government sector. The analysis is conducted in a neo-classical growth model to contrast it to the neo-Keynesian analyses of Blinder and Solow (1973) and Tobin and Buiter (1976) who develop closed economy models which characterize the effects of monetary and fiscal policy in the long run when all variables including the capital stock are allowed to adjust to their steady-state values. Turnovsky (1976) has extended this analysis to consider a small open economy under the Keynesian assumptions that exports are exogenously determined and that the domestic bond is an imperfect substitute for the foreign bond. Since no consideration is given to growth, the long-run equilibrium requires that the government’s budget be balanced and that the balance of payments on current account be balanced, i.e.. the capital account must be zero. Within a neo-classical growth theory framework, Foley and Sidrauski (1971) analyze similar problems focusing on the effects of . *I wish to acknowledge helpful comments on an earlier draft from Robert Aicrq’. Walter Dolde. Dennis Epple. Jacob Frenkel. Peter Garber. Lars Hansen. Milton Harriv. Dale Henderson. and Allan Meltzer. Any remaining errors are those of the author. Financial support was provided by Carnegie-Mellon Institute of Research.


R.. ‘. Hodrick, Dq’namic ef,crs

of goue,vnme,lt policies

government policies on the value of capital per capita as the economy moves from one steady state to another. Brunner and Meltzer (1972, 1976) develop a series of models which address the influence of government policy on output and the price level in both the short run and the long run, first for a closed economy and then in a two country framework with fixed exchange rates. Paralleling this development of the theoretical influence of government policies on macroeconomic variables has been the resurgence of interest in the determination of flexible exchange rates between countries. Recent papers by Frenkel (1976), Dornbusch (1976a, b), Kouri (1976) and Mussa (1976) develop the monetary or portfolio balance approach to exchange rate determination. Stated simply, the theory is that since the exchange rate is the relative price of two monies, it will be in equilibrium when the outstanding stocks of the two monies are willinglg held. Bilson (1978) and Hodrick (1978) have examined the empirical conte:nr of the theory which appears to be a useful way to structure thougi;ts about the often volatile movements in flexible exchange rates. This model analyzes the movement of the exchange rate over time, the path of the accounts of the balance of payments, and the changes in wealth which occur in response to government policies and the perceptions of these policies by the public. A change in the provision of government services. an open market...
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