Dynamic response to foreign transfers and terms-of-trade shocks in open economies

Klaus Schmidt-Hebbel and Luis Servén

No 1061, Policy Research Working Paper Series from The World Bank

Abstract: The transmission of shocks and policy changes depends crucially on the structure of the economy. The authors analyze the impact of two classes of external shocks in open economies, using a rational-expectations framework that tests three prototype economies: (1) a neoclassical, full-employment benchmark economy, with intertemporally optimizing consumers and firms and instantaneous clearing of asset, goods, and factor markets; (2) a full employment economy, with partly liquidity-constrained consumers and investors; and (3) a Keynesian economy exhibiting both liquidity constraints and wage rigidity, which results in transitory unemployment. Their model is forward-looking in that the short-run equilibrium of the economy depends on current and expected future values of all exogenous variables, and displays hysteresis (that is, its long-run equilibrium is path dependent). Using parameters for a representative open economy, they simulate and compare the dynamic effects of foreign transfers and of terms-of-trade windfall in the form of a lower price for an imported production input. They contrast the role of Keynesian elements with the neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effectsof permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (i) both permanent and transitory disturbances cause changes in long-run capacity and output; (ii) transitory and permanent shocks may have opposite effects on the current account; in particular, a permanent favorable foreign shock produces a current account deficit, while a transitory favorable shock induces a current account surplus; and (iii) liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to external shocks.

Keywords: Macroeconomic Management; Economic Stabilization; Banks&Banking Reform; Economic Theory&Research; Environmental Economics&Policies (search for similar items in EconPapers)
Date: 1992-12-31
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Citations: View citations in EconPapers (2)

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