Output, Inflation and the Terms of Trade in a Small Open Economy

Lars Calmfors

Kyklos, 1983, vol. 36, issue 1, 40-65

Abstract: The possibilities of deviating from the natural rate of output in an open economy are analyzed. It is shown that output can be pegged for some time above the natural rate even under perfect foresight in such an economy. But this results in continuously improving terms‐of‐trade. In an open economy these terms‐of‐trade changes ‐ rather than rational expectations per se ‐ are the main constraint on employment policies. The natural‐rate hypothesis implies a trade‐off between the level of output and the rate of change of the trade balance. This trade‐off can be avoided temporarely only by letting government expenditure crowd out private expenditure.

Date: 1983
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