POLICY RESEARCH WORKING PAPER 1:3-00 Transitory and permanent Dynamic Response E shodks may have opposite to External Shocks effects on the curremt . b 1 Tz * ~~~~~~~~~~~~~~~accounL In particuar, an- in Classical and Keynesian accountn inrcTfase ini foreigni transfems or Econom ies a terms-oRfrade windfatl. if permanent, can resut in a current account deficit. But if Klaus Schmidt-Hebbel temporary. they cause a surpk.s. Uquicdty conscraints Zand wage- :igidities tend to amplify the cydical adjustment to extenal shocks. The World Bank Policy Research Departrnent Macroeconorics and Growth Division May 1994 POLICY REsEAACH WORKING PAPER 1300 Summary findings Schmidt-Hebbd and Serven analyze the impact of three They contrast the roles of Keynesian and neoclassical classes of external shocks in open economies, using a factors in determining the dynamic adjustment to shocks, rational expectations framework that nests three by analyzing the effects of permanent/transitory and prototype economies: a neoclassical full-employment anticipated/unanticipated disturbances in the three benchmark, with intertemporally optimizing consumers prototype economies. The results iflustrate three main and finns and instant clearing of asset, goods, and factor points: markets; a full-employment case with partly liquidity- * Both permanent and transitory disturbances cause constrained consumers and investors; and a Keynesian changes in long-run capacity and output. economy, with liquidity constaints and wage rigidity, * Transitorsy and permanent shocks may have opposite which results in transitory deviations from full effects on the current account In particular, a permanent employmcnt. incrcase in foreign transfers or a permanent terms-of- Using paramcters for a representative open economy, trade windfall rcsult in a cLrrent account deft; if they simulate the model to compare the dynamic effects temporary, they cause a surplus. of foreign transfers, a terms-of-trade windfall in the form * Uquidity constraints and wage rigidities tend to of a lower price for an imported production input, and a amplify the cyzlical adjustment to external shocks. decline in the foreign real interest rate. This pa;pcr- a producr of the Macroeconomics and Growth Division, Policy Rescarch Departnent- is part of a larger effort in the dqeacneto model macroeconomicadjustmenrin open economies. Copies of dhe paper-are available frec from the World Bank, 1818 HStreerNW, Washington, DC20433. Pleasc contacrEmily Khinc, room N1-061, ectension 37471(58 pages). May 1994. The Policy Raearh Workaig Paper Smes dissmnates the frndin of work in proeress to encoge the ehange of cs about devetopment nset An ojective ofte seris is toget the findis out quicMy, en if the presentations are Less than fugypshed The papers cany te names of the autoxs and should be msd and cted accodngly. he fIndings, inteiprnadons, and conluions are the authors Own and should not be attrbted to the World Bank is Executive Board ef Dretrs, or any of its member cauntries Produced by the Policy Research Dissemination Center EXTERNAL SHOCKS IN CLASSICAL AND KEYNESIAN ECONOMIES by Klaus Schmidt-Hebbel and Luis Serven The World Bank ' We are grateful to Giancarlo Corsetti, David Currie, Riccardo Faini. Warwick McKlbbin, Steven Symanski, and David Vines, and conference and seminar participants at the CEPR Conferenc on North-South Macroeconomic Intercons in Oxford. the Latin American meetngs of the Econometric Society in Tucumin. the Eastem Economic Association meetings in Boston, Centro Studi Luca d'Agliani in Turin, University of Rome DI, Tel Aviv University, and the World Bank. for valuable comments and discussions. Very efficient research assistance by Paul Bergin and Douglas Smith is gratefully acknowledged. CONTENS 1. INTRODUCnON ......................................... 1 2. THE MODEL ...........................................2 2.1 BUDGET CONSTRAINTS. 3 2.2 MARKET EQuILIBRIUM CoND1TIoNs . 7 2.3 FiRMs . : ........... 9 2.4 CONSUMERS .. .................................. ..I1 2.5 GOVERNMENT ............. 13 2.6 FOREIGNERS . .................................. 14 3. STEADY STATE AND STABILITY .............................. 14 3-1 TuE STEADY STATE. .S T A T 14 3.2 DYNAM1cs, STABILrrY AND MODEL SOLUTION ................. 17 4. SMULATION RESULTS ..................................... 19 4.1 MODEL PARAME ATION AND INlAL STEADY-STATE SOLUT[ON .... 19 4.2 A FOREIGN TRANSFER SHOCK ..3............... 4.3 A PERMANENT OIL PRICE WINDFALL .... 26 4.4 A FOREIGN REAL INTEREST RATE SHOCK . .29 5. CONCLUDING REmARKS .31 REFERENCES ........ .................................................... 32 FIGURE 1-25 ............................................ 34 I.INTRODUCTION A bewildering variety of macroeconomic tools is available today tO macroeconomic policy makers and analysts. The model developed here forms part of a small but growing sub-family of macroeconomic frameworks which, while firmly based on microanalytic foundations, introduce critical real-world features - such as short-run wage rigidities and liquidity constraints - which generate persistent deviations from the frictionless full-employment outcome of the unconstrained neoclassical paradigm. The dynamic general equilibrium model developed here nests as special cases the classical and Keynesian benchmarks, and assumes rational-expectation formation. Hence short-term equilibria depend on current and anticipated future trajectories of policy and external variables. Forward-looking behavior based on microanalytical foundations is a feature that this paper shares with an increasing number of recent models applied to open-economy issues such as oil shocks, interest rate changes or policy coordination in multi-country frameworks (Sachs, 1983; Giavazzi etal.. 1982; Lipton and Sachs, 1983; Bruno and Sachs, 1985; McKibbin and Sachs, 1989; McKibbin and Sundberg, 1990; McKibbin and Wilcoxen, 1992). Nesting of classical and Keynesian ben;hmarks characterizes also the model by McKibbin and Sachs (1989), although they do not discuss its implications for the response of the economy to shocks. This paper extends previous work in four dimensions. First it extends the analytical structure by incorporating simultaneously several realistic features that are relevant for most open economies: nominal wage rigidity, import content of capital goods, foreign holdings of domestic equity, public investment and monetary finance of budget deficits.' Second, it explores in some detail the short- and long-term consequences of liquidity constraints affecting private consumption and investment behavior. Third, the paper compares the differential effects of external shocks in neoclassical and Keynesian benchmark economies, for both permanent/transitory and anticip anticiped disturbances. Finally, the simulations are performed by solving the full non-linear model, in contrast with the conventional procedure that uses a linear approximation, whose accuracy can be highly unreliable when simulating large shocks. The paper is organized as follows. Section 2 spells out the model structure, which is based on the distinction of the domestic pnvate sector (households and firms), the consolidated public sector, and the external sector. The private secor comprises one group of intertemporally-opiimizing agents with another of liquidity-constrained (or myopic) agents. The domestic economy produces one single good, while the rest of the world produces both an intermediat input and a final good; the three goods are imperfect substitutes. The asset menu distinguishes between foreign and domestic bonds, domestic equity, and domestic money. Asset markets, as well as the domestic goods market, are assumed to clear instantly. In contrast, the labor market can display real and/or nominal wage inertia, giving rise to persistent deviations from fiull employment. Section 3 describes the steady state and the stability properties of the economy. The dynamics of the model are characterized by the combination of backward-looking dynamic equations describing the time paths of predetermined variables (asset stocks, as well as the real wage), and forward-looking equations describing the trajectory of asset prices. The model displays hysteresis and thus its steady state is path-dependent: it is affected by the initial conditions and the entire adjustment path followed by the economy in response to a shock. Transitory disturbances can therefore have permanent effec, whose Three of thse features (wage ngidity, import content of capital goods, and forign holdings of domestc equity) are considered in different forms by previous models, in partcular McK;bbin and Sachs (1989). Explicit inclusion of public invesment and monetary finance of budget deficits are novel featr of dhis framework. -2 - magnitude depends on key parameters determining the speed of adjustment of the system. The numerical solution of the model poses a two-point boundary-value problem. Section 4 presents simulation results for three external shocks: a unilateral foreign transfer, a rise in the external terms of trade brought about by a decline in the world price of an intermediate input (say an oil price windfall in the case of an oil-importing economy), and a decrease in the foreign real interest rate. The section discusses and compares the effects of the three shock classes on the dynamic pattern of the main endogenous variables, for different combinations of structural benchmarks (Neoclassical, liquidity constraints with full employment, and liquidity constraints with unemployment) and shock types (permanent, transitory unanticipated and transitory anticipated). Section 5 closes the paper with some concluding remarks. 2. THE MODEL The domestic economy produces one single final good, which can be used for consumption and investment at home, or sold abroad. This good is an imperfect substitute for the foreign final good, and its production requires the use of an imported intermediate input Domestic private agents hold four assets: money, domestic debt issued by the consolidated public sector (i.e., the govemment plus the central bank), foreign assets, and equity claims on the domestic capital stock. Money allows for inflationary finance of budget deficits. There are no restrictions to capital mobility and in the absence of risk and uncertainty, all non-monetary assets are assumed to be perfect substitutes. Hence anticipated asset returns satisfy the corresponding uncovered parity conditions. Foreigners hold domestic equity but not domestic public debt. Fmally, the public sector also holds foreign assets.2 Both goods and asset markets clear continuously. Equality between demand and supply of the domestic goods determines the real exchange rate. Under a flexible nominal exchange rate regime, money market equilibrium with an exogenously set money supply determines the nominal exchange rate. In contrast, the labor market may not clear instantaneously due to real and/or nominal wage rigidity. Wages are indexed to current and past consumer price inflation, and rea slowly to deviations from full employment. The dynamics of the model arise from two basic sources: the accumulation of assets/liabilities, dictated by stock-flow consistency of the sectoral budget constraints, and the forward-looking behavior of private agents. Expectations are formed rationally, which in this context of certainty amounts to perfect foresight. Thus, anticipated and realized values of the variables can only differ at the time of unexpected shocks or due to the arrival of new information about the future paths of exogenous variables. Behavioral rules combine explicitly two benchmark specifications: the neoclassical case of unconstrained, intertemporally-optimizing firms and consumers, along with labor market clearing, and the Keynesian case of liquidity-constained firms and households, along widt wage inflexibility? Following the standard theory of investment under convex adjustment costs (Lucas, 1967, Treadway, 2 Foreign assets held by dte domestic private and public sectors amr net assets (equal to gross foregn reserves plus odLer gross foreip assets less gross foreign liabilities) and dierefore can have eidLer sign 3 Export demand and wage setting are the only behavioral equalions in the mwde that do not follow (explicitly or implcidy) f first principles. -3 - 1969), unconstrained firms maximize their market value and link their investment decisions to Tobin's q (Tobin, 1969), i.e., the present value of the additional profits associated with the marginal unit of capital relative to its insallation cost (Hayashi, 1982). Unconstrained consumers gear consumption to their permanent income, as derived from intertemporal utility maximization along Ramsey-type behavior (Ramsey, 1928). In contrast, constrained firms (consumers) gear their investment (consumption) expenditure to their current profits (disposable income). Technology and preferences are kept as simple as possible - mostly by assuming unit elasticities of substitution. Two-stage budgeting in consumption and investment allows separation between the determination of expenditure and its allocation to domestic and foreign goods (thus avoiding the use of ad-hoc import fanctions). Harrod-neutral technical progress ensures the existence of steady-state growth, at a level given by the sum of the rates of technical progress and population growth. The model's detailed structure is introduced next, swting with sector flow budget constraints and market equilibrium conditions. Behavioral equations for firms, consumers, the public sector, and the external sector follow. Variable notation and definitions are summarized in table 1; all prices are defined relative to the price of the domestic good or to the foreign price level. All stock and flow variables other than prices and interest rates are scaled to the labor force in efficiency units.t The model is written in continuous time. Dots over variables denote right-hand time derivatives. 2.1 Budcet Constraints There are three basic agents in the model: the consolidated public sector, the domestic private sector, and the extenal sector. The first lumps the non-financial and financial (central bank) public sector together, the second aggregates private firms and consumers, and the third adds foreign investors, creditors, and trade partners. While some fiuther disaggregation between firms and consumers is implicit below, we do not need it at this stage. Walras' law makes one of the three sectoral budget constraints redundant when it is combined with goods and assets markets clearing. Hence we present the three budget constraints below only for expositional convenience. They are written equatng above-the-line current account surpluses with below- the-line increases in net real asset holdings per effective labor force unit. Therefore above-the-line interest flows are adjusted for the changes in real asset holdings per effective labor unit due to growth in effective labor (g) and inflation. 4 Labor tom in efficiency unks iLs equal to the actual labor face augmeted by Harrd-neutra technical progsa (see table 1). -4 - TABLE 1: NOTATION AND DEFINITION OF VARIABLES 1. Labor and Employment L Abslut employment LF - LFo cxp(pg t) Absolute labor force LFo Base-eriod absolute labor force N - L exp(Qg t) Absolute employment in efficiency units NF - LF exp(tg t) = eF0 exp(g t) Absolute labor force in efficiency units pg Population growth rate tg Harrod-neaml technical progress rat g = pg + tg Growth raze of absolute labor force in efficiency units I Time index 1 LLF = N/NF Employment (relative to labor force) Id Labor demand (relatvc to labor force) 2. General Not;aon All stock and flow variables other dn intrest razes are defined i real tems and in efficiency labor force umts. Cnrrentpice domestic (externl) income and ransfer flows and prices are deflated by tde price of the domestic good (external price deflaor). All stock and flow variables other than prices and inteest razes ar defined in terms of units of effective labor force. Domestc (exta)rave prices are m suredin ral domestic (extnl) curreny yunits. A dotovera variable denotes its right-and tim derivative. 3. hIcome, Transfer and Capital Flows Domcstic d Dividends paid op Opeational profits td Taxes yd Prvate disposable income prem Profit remittances abroad Exemnl: kg Foreign wansfers to toe public sectr flip Foreign tnasfers to the private sector yf Foreign income dfi Direct foreign investmnt 4. Stocks Domestic: a Non-human wealth of the private sector bg Domestic debt of the public sector fe Stock of donmstic equity (shares in domestic firms) held by foreigrs hb Domestic base money hu Human wealth of the private sector Ic Physical capital pvig Present value of government investment subsidy pvibb Present value of cost of holding money Exrnal: fbg Foreign assets held by the public s ctor fbp Foreign assets held by the private sector -5- TABLE 1 (Cont) 5. Goods Flows y Gross output of final goods cp Private aggregate consumption cmp Private inported-goods consumnption cup Private national-goods consumption cog Publc national-goods consumWion io Gross domestic investment n Private national-goods investmn.rr im Private imported-goods ;uvestu,it ig Public investme subsidy iac Investmnent adjustment costs x Export or Intermedite imnports 6. Various Rates Domestic (External) Rates: i (if) Nominal inerest rate on public debt (foreignae ies) r Crt) Rel interest rate on pubfic debt (forip ) ifr (lf-) Ansticipted domestic (Extrnal) infIaon rate mug Rate of growth of the nominal money stock 7. Goods Prices Domestic (4ll relative to se price of the domestc final good): PC Privat aggregate consumption deflor Pi Aggregate investment deflaor External (all rdative to the price of the foreign final good): pc*P Private imported-goods consumption deflator pim Imported-goods investment dflator pmr Intermediate inports deflator px Deflator of export-competing goods 8- Other Prices Domestic Prices: q Real quity price (Tobin's Q) in units of domestic output v Real wage per effective labor unt W Nominl wage per labor unit PC Noninal private consumption deflator Real Exchnge Rake: e = (E PP Real exchange rate E Nominal excbange rate P Nominal pric of the domestic good r NominaL external deflator (foreign pnce level) -6 - Public revenue includes conventional taxes, unrequited foreign transfers, growth-adjusted interest earnings from public assets held abroad, and the return on base money. The latter equals the sum of the inflation tax and the monetary revenue due to the growth of efficiency labor units. Public expenditure includes public consumption, which is assumed to fall entirely on domestic goods, an investment subsidy paid to domestic firns5, and interest paid on the outstanding stock of domestic public debt. Revenues include direct taxes, interest on net foreign assets of the public sector, and the inflation tax. The resulting adjusted operational surplus of the consolidated public sector finances acquisition of foreign assets and retirement of base money and domestic debt: [td + e ftrg - cug - pi ig] - (r-g) bg t (g +PIP) hb (1) + e(rf - g)fbg = efbg - bg - hb The external sector budget constraint - the balance of payments identity - reflects trade in goods and non-factor services, unrequited transfer payments to both the public and private sectors, loans from both domestic sectors, and foreign investment flows toward the private sector as well as profit remittances from the latter. Therefore, the external adjusted current account surplus and its financing, for convenience written in constant-price foreign currency units, is the following: |e pcmpc3p -pimIM-pMrMr + ftg + ] (2) + (rf-g) [fbp + fbg] - Xm = (fp + fbg) - dfi e The private sector budget constraint reflects the assumption that private firms do all production and investment decisions, own the economy's entire capital stock, and benefit from a public investment subsidy. Firm ownership is split between domestic consumers and foreigners. The consolidated domestic private sector (firms and consumers) budget constraint is given by: [y - pi inv - pi iac - e pmr mr + e ftrp - td + pi ig - pc cp] (3) - (g+P/P)hb + (r-g)bg - prem + (rf-g) e fbp - Ib + bg - e dfi + e fbp Publicscor ownership of the capital stock could be mimicked by inwoducing a tax on profits prportional to the cumulative volume of public investn. For simplicity, we do not pursue this option here. Also, we ar inplicidy naming ta public investment is a perfect substitute for private investment. -7 - 2.2 Market Equilibrium Conditions Equilibrium conditions are specified for goods, asset, and labor markets. Continuous market clearing at equilibrium prices and asset returns characterizes goods and asset markets, while sluggish wage adjustment is observed, under the general case, in the labor market. (ioods Markets The single good produced domestically can be used for consumption and investment at home, or sold abroad (thus there is no distinction between production for domestic and export markets). It is an imperfect substitute for the foreign final good. However, the economy is small in its import markets by assumption. Equilibrium in the market for domestic goods can be er-"ssed:6 (4) y = cnp + cg + in + pi iac + x Under continuous market clearing, this is an implicit equation for the real exchange rate. Asset Markets Asset market equilibrium conditions are specified for base money, domestic bonds, and equity claims on the fixed capital stock They reflect three features: perfect capital mobility, exteal interest rate determination in international markets (the small country assumption for financial markets), and absence of uncertainty (no risk premia). Imperfect substittability between base money and other assets is reflected by a conventional transactions-based demand for base money. In trn, domestic and foreign bonds, as well as equity, are assumed perfect substitutes; hence their anticipated rates of return must be equalized at each point in time. Base money market equilibrium assumes a conventional Cagan-type money demand (Cagan, 1956): (5) hb = k1 y+2 exp(403i) where *C, ½2 Ž 0, 4)3 s 0. 6 Notice dtat gross output y diffirs from conventional national-accounts value added or GDP for two reasons: y is defined as gross of tb_ value of intermediate imports (e pmr mr) and gross of the value of investment adjustment costs (pi ia). 7 Moncy demand could be explicitly derivcd from first priniples by bringig money into dte utly fnctiion Sidrausky, 1967) or the producion function (Fischer, 1974), or by imposing a cash-in-advance namactions technology (Cower, 1967). Eastey, Mauro amd Schmidt-HebbcL (1994) present a generlzed cash-in-advance anns technology (with iso-elastic substittion of money and bonds) givMg nse to a variable elasticity of money demand vnth respect to inflstion, generalizing the io-clastic Cagan forn In turn, equation (5) in the wa can be ngorously derived fomn a technology combining money and productive inputs to produce final goods; consta remurns to scale would imply qt1 = 1. -8 - Arbitrage between domestic and foreign bonds leads to the uncovered interest parity condition: e (6) r = rf + Similarly, arbitrage between equity and domestic public bonds is reflected by the following market equilibrium condition for equity prices (Tobin's q): m ~~~~d C7) q=r q-d Finally, the nominal interest rate is defined by the standard Fisher equation: (8) ii = r + p Labor Market In the general case, wage rigidity (nominal and/or real) prevents the labor market from clearing instantaneously. We follow the conventional assumption that employment is determined by labor demand: (9) 1=ld The labor market follows a wage-setting rule, which states that nominal wages are indexed to current and lagged consumer price inflation (with weights 0 and 1-0, respectively) and also respond to current labor market conditions (with an elasticity ca with regard to employment). Anticipating the simulations, the nominal wage equation is written in discrete-time form: W - exp(t PC tg I° PC 1)8W PC whereto 0,0 9 < 1. Using the relation between the nominal wage and the real (rroduct) wage per effective labor unit: W = exp(tgt) v we obtain, after some manipulations, the following real wage equation: -9 - (10) v ( PC H PC1 [ P-lP-l -1 This wage rule encompasses several interesting cases. First, when t tends to infinity, it collapses into the neoclassical full-employment condition ( = 1). Second, for finite w andO = 1, it represents the case of real wage resistance. In turn, with fnite co and 9 < 1, wages display nominal inertia. Finally, ex-post inflation can be defined from the relaton between real and nominal balances per effective labor unit:. p hb-1 (l+nmg1) hb (1+g) 2.3 Firms Technology is summarzed by a Cobb-Douglas production fimction for gross output with Harrod- neutral technical progress, and quadratic adjustment costs for investment. The investnent technology combines domestic and imported final goods according to a Cobb-Douglas specification, which allows for two-stage budgeting! There are two groups of fins. The first group is not subject to liquidity constraint and determines its investment according to the maximization of market value - i.e., the present value of fuue dividends - subject to conLvex adjustment costs. Investnent is financed by equity sold to domestic and foreign agents and through the public investment subsidy. However, because the latter is distributed to firms in lump-sum fashion, it has no efet whatsoever on investment levels by of unconstrained firms; for the unconstrained firms, the subsidy is simply a source of increased dividends- The second group of firms is restricted in its access to financial markets and gears its current investment to current profits inclusive of the public investment subsidy. Thus, for these constrained firms changes in the subsidy will affect fixed investment levels. The production technology for gross output is described by a Ccjb-Douglas production function, which allows for subsdtidon between value added (capital and labor) and intermediate imports: (11) y = % ldm' ks mrL-l) Notioe dst, fom (8), i-r is a mesure of anticpaed oneperiod ahead inflfion. Because of the ranal expecus a _uxndn, it vil equal acual (one-priod ahca) inflatko excct at tncs of 'nws'e abou the curet anor finue pahs of the exogenos variables. 9 Wildsin (1984) provides x contions under wich the invese technolo grres nrs to a two-sge ine daion. Soe also Ilyashi axd Inoue (1991) for a recent generazdon widh empiical aplpcatons. - 10- where mO , Os, ° S £2 a Investment adjustment casts are defined by: p[Qav (g+6)k)2] (12) iac = iv-gbk2 where it > 0. This specification has the useful property that adjustment costs vanish in steady-state equilibrium - i.e, when gross investment per unit of effective labor is just sufficient to maintain the capital/effective labor ratio. The evolution of the latter is described by: (13) k = miv - (g+S)k Market value maximization for unconstrained firms, as well as current profit maxxaion for constrained firms, yields the standard marginal productivity conditions for variable inputs (labor and imported materials):10 (14) Id = m1 v-1 y (15) mr = C1-al cc2) (e pmr)- y Investment demand is, as described above, a combination of the market-value maximing investment rule of unconstrained firms and the profit-constrained investment of restricted firms: (16) iv I [ [- k -1]+ (g +6) k] + (O-1) [p2 2 + ig] where BI is the share of non-onstained firms and 2 is th' marginal propensity of liquidity-constrined firms to invest out of operational profits; 0 5 PI' P2  . TJnconstrained irvestment (the conme of the first large right-hand side parenthesis) is derived from maimization of the value of the finn. This component of aggregate investment demand is geared to Tobin's marginal q - i.e., average q mimns the present value of the public investment subsidy per unit of capital"t. This reflects the fact that optimal investment is determined by the addition to future dividends of the marginal unit of capital, which excludes the subsidy due to its lump-sum nature. By I0Mm derivateon of dhese conditions, as wel as of he unconstained comonent of investment in equaion (16) beww, follows the standard nmiizaron of dte vliue of the firm, subject to equation (11) - (13), not presened here for brevity. " The general reasons dut cause mal and averp q to diverge are spelled out in Hayashi (1982). - 11 - contrast, the average value of existing capital (i.e., the present value of the dividends associated with an installed unit of capital) must include the subsidy. In turn, investment by constrained firms (the last term in the right-hand of (16)) rises one-for-one with the investment subsidy. The present value of the public investment subsidy is implicitly defined by the dynzmic equation: (17) ptig = (r-g) pvig - pig Aggregate operational profits - which determine capital formation by liquidity-constrained firms - are defined as: (18) op = y - v I - e pmr nr and dividends are the sum of operational profits, net of investment enditure, the invesmn subsidy and the proceeds of new issues of equity: (19) d = op - piiv- - pi iac + piig + q(k + gk) After determining aggregate investment according to equation (16), the second-stage investment decision involves allocating nvestment expenditure between domestic goods and imports, according to a Cobb-Douglas aggrngation which renders constant expenditure shores: (20) in = ypi iv (21) im = C-y) {[ IinV ]v where y is the share of national-goods investment in agg- ate investment expendiure, satisfjing 0 ) 2.5 Government The public sector could either determine policy exogenously or derivd it from optimization of some objective function; for realism and simplicity, we choose the first option. Thus public consumption and investment expenditures are exogenously given. To finance its activity, the public sector can choose among taxes, money, domestic debt or external borrowing (or any combination of them). The accumulation of per capita real balances can be characterized as: (31) Ib = [nmg - (PP) -g]b where it is worth noting that the rate of money growth nmg will be endogenous under money finance of the deficit and exogenous otherwise- - 14 - 2.6 Foreigners The demand by foreigners for the domestically produced good is given by a conventional export function, which embodies imperfect substitution between the national good and the foreign final good and a normal relation to foreign income: 32) xc = p1 (e pX)P2 yfP3 where P1 p2. P3 2 0. Finally, the path of foreigners' equity holdings remains to be described. At every instant, foreign investors use dfi units of foreign currency (in real per capita terms) to purchase domestic shares, whose price in terms of domestic output is q. Hence their per-capita holdings of equity evolve according to the equation: - e dfi (33) fe = g fe q In turn, profit repatriation equals the total volume of dividends earned by foreign investors, which is given by the product of the share of foreign-held equity and total dividends: (34) prem = f-e d k 3. STEADY STATE AND STABILITY 3.1 The Steady State The long run equilibrium of the model is characterized by constant asset stocks in real per capita terms. constant asset prices Ci.e., Tobin's q and the real exchange rate), and constant real wages with full em-ployment. Thus, the government's budget must be balanced, and the current account deficit must equal the exogenously given flow of foreign investment, which in turn is just sufficient to keep foreign equity holdings Cm real per capita terms) unchanged. Since the per capita real money stock is constant, long run inflation equals the rate of expansion of per capita nominal balances nmg-g. In turn, with a constant real exchange rate, domestic and foreign real interest rates are equalized by uncovered interest parity, -and nominal exchange depreciation is determined by the difference between domestic and (exogenously given) foreign inflation. Hence, across steady states changes in the rate of money growth are fully reflected in the inflation rate (and thus in the nominal interest rate) and in the rate of nominal depreciation. By combining the model's equations, the steady-state equilibrium can be reduced to two independent equations in the real exchange rate, real wealth, and the real interest rate: a goods market - 15 - equilibrium condition, and a zero private wealth accumulation condition (in real per capita terms)."' Together they imply a constant stock of per capita net foreign assets. Real wealth accumulation can cease only when per capita consumption equals the per capita return on wealth. But the laner is just (rf-g) times the wealth stock (because of the assumption of perfect asset substitutability), while in the steady-state the former equals (X2-g) times the wealth stock (from (25)-(2).17 Hence, this implies the well-known result that the rate of time preference k, must equal the exogenously given foreign real interest rat: (35) 12 = rf Since (35) provides no information on the steady state wealth stock, we would be left only with the goods market equilibrium condition tO detrmine both wealth and the real exchange rate-an obviously impossible task. This means that their steady-state values (and hence also those of aU variables that depend on them) depend not only on the long-run values of the exogenous variables, but also on the initial conditions and on the particular adjustment path followed by the economy - and therefore on parameters governing the speed of adjustment such as the degree of real wage rigidity or the magnitude of adjustment costs associated with investment In other words, the model exhibits hysteresis. As noted by Giavazzi and Wyplosz (1984), this follows from the assumption of forward-looking consumption behavior derived from intertemporal optimization by infinitely-lived households with a constant rate of dme preference and facing perfect capital markets. Nevertheless, certain imporant features of the steady state can easily be determined. On the production and investment side, long ran equilibrium is characterized by foil employment and a constant capital stock in per capita terms. From (13), gross investment is just mv = (g+6)k, and adjusument costs are idenically zero (from (12)). In turn, from (7), (17), 1,8) and (19), Tobin's q in steady state is given by: Fk-pi (g-a-) (36) q= F-i + pvig where Fk is the marginal productivity of capital. If no firms are liquidity constrained (that is, B= I in (16)), then (16) furter guarantees that marginal q equals the price of capital goods or, equivalently, that average q equals the price of capital plus the unit investmentsubsidy Ci.e. q = pi + pvig/k). Thus, from the above equation the marginal product of capial equals its user cost: (37) Fk = pi (rf+&) '6See Serven (1994) for an analysis of she stady-st and dynamic properties of a non-monetary neoclassical version of our model. 17This is stricdy correct only in the absence of liquidity constan (Q, = 1). However, when \, < 1, wealth accmuulaton woud still equal (r - , times the wealth stock of unconsained consmers (a + )t hu). ' Giavazzi and Wyplosz (1985) provide a method to solve analyticaly certain linear modds with hysteresis. They show tat the long-run cqulibrium depends on initial conditions and on the speed of adjustment of the 5system Since our model is nonlinear, however, a comparable solution technique is not available. - 16- Notice, however, that pi is an increasing fimction of the real exchange rate because of the import content of capital goods. In turn, for a given capital stock Fk is a decreasing function of the real exchange rate, due to the use of imported materials in production. Hence, (37) defines an inverse relationship between the steady-state capital stock and the real exchange rate: across steady states, a real depreciation must reduce the capital stock, and (from (11) and (14)) also output and the real wage. It also follows that the long-run values of these variables depend, like the real exchange rate, on initial conditions and on the adjustment path of the economy)" What if some firms are liquidity constrained Ci.e., fl < 1) ? The negative long-run relationship between the capital stock and the real exchange rate is unaltered; how-ver, in the steady state q does not equal the subsidy-inclusive price of capital goods, nor does Fk equal the user cost of capital. Provided the marginal propensity to invest of constrained firms (f2 in (16)) is not too large,' the marginal product of capital must exceed the user cost, and Tobin's q must exceed the price of capital goods plus the investment subsidy. Formally: (38) Fk= pi [(ff+) + f] where f > 0 is a term that depends positively on the adjustment cost coefficient , and the rate of depreciation of capital, and negatively on B1, &6 and the investment subsidy-' Tobin's q under liquidity constraints becomes: (39) q = pi [(ffe+8) tL + pvii The intuition behind dtese results is simple: with binding liquidity constaints, firms cannot invest as much as they would want and therefore cannot close the gap between the shadow value of one additional unit of capital and its cosL This implies that, for a given long-run real exchange rate, liquidity constaints wil cause the economy to achieve a !ower capital stock and output, and a lower real wage as well, than in the fully unconstained case. Using (37) or (38), the steady-state goods market equilibrium condition (4) can be rewrien as: "See Scrven (1994) fir firther elaboration. This is in coust to similar dynamic modds (eg., Sachs (1983), Giavazri et al (1982)), where capital goods have no import content and thus the steady-stave marginal product of capitl (as well as the capil stock and =al outpt depends only on dte relative price of mateils in terms of domestic goods (e pam in our nottn). Here the import content of capial goods creates a negatve relationship between the real exchange rat and FP, even for a give rcal cost of imported inputs. Gavin (1991) and Srvsn (1991) have shown that this has im t consequences for the deks of macroeconomic policies on investment -v The exact condition is £i < (g+W(rf+6) - ig/(mf:). Ni (rf+b) + (1-Bil) 21L (rf-g)(g+b ; 21 Thc act expsion for fif =s _ ( -(rf+), where Z - _ is the OIL + (I-#,8) 21 (rf-g) P,* j Y publc invetmeatlgros output ratio. - 17 - (40) y(e,-..)= ql (rf-g)(a+hu) + cg + y pi (g+8) k(e....) +- which defines an inverse relationship between the long-rmn real exchange rate and real wealth: an increasL in the real exchange rate (a real depreciation) generates excess demand for domestic goods and requires a fall in private wealth and consumption to restore market equilibriumY2 As noted before, the particular levels of real wealth and the real exchange rate that will obtain in the long run depend on the initial conditions and on the dynamic path followed by the economy. Aside from real wealth, the other key element in the determination of the long-mn real exchange rate is the distribution of demand between the public and private sectors. Since public consumption is assumed to have no import content, an increase in cng creates excess demand for domestic goods and leads to a real appreciation. As argued before, this would cause the capital stock and output to rise as well. An important implication of the model's hysteresis property is that transitory distuLrbances have long-run effects. For the case of fiscal policy, this has been recently highlighted by Turnovsky and Sen (1991).? In our framework this also means that even transitory monetary disturbances can have permanent real effects: if some consumers are liquidity constrained (or myopic), a transitory increase in inflationary taxation matched by a reduction in direct taxes will raise disposable income and consumption, leading to reduced wealth accumulation and eventually causing a fall in long-ran wealth and a permanent real depreciation.' 3.2 Dynamics. Stabilitv and Model Solution The precise dynamics of the model depend on the way the public deficit is financedk Under tax or money finance, the model is driven by ten dynamic equations. Four of them describe the time paths of predetermined variables: the capital stock, private foreign assets, foreign holdings of equity, and the real wage. At each moment in time, these variables are given by current and past values of endogenous and exogenous variables. Further, the four prede ed variabies have to satisfy well-defined initial conditions. Under debt (domestic or foreign) finance, a fifth dynamic quation describes the time path of the relevant debt stock. l This is guaranted by our assumWon of constant expenditr shares of domeic goods and imports in private consumption and investmn With more general specifications allowing lower substituility between domestic and foreign goods, a positive associatton between real wealth and the real exchange rae in steady sre (i.e., a 'conarctionary devaluaton" of the type analyzed by Krugman and Taylor (1978)) could not in principle be mled ouL 3 Tumnovsky and Sen (1991) use a non-moneary model with interemporally optimizing consumers to show that tnsitry fiscal disuaces have long-rna effects. Their remsuk depends critically on the endogeneity of blbor supply in their fiamework. which makes long-rmn employment endogenous. In our case, the dependence of the long-un capital stock on dLe real exchange nate ensures that tansitry fiscal shocks have permanent efcts despite the consancy of full employment across sdy states. 24 Wlithout liquidity constaints, a monetry accderation (an incrase in mx) holding constant public consumption wold just amount to a change in the composition of taxaton between die inflation tax and (jprest or future) dict taxs (or transfers). without any effect on wealh. consumpnion. or any other real variable. - 18- The remaining six dynamic equations describe the time paths of 'jumping' variables: Tobin's q, the real exchange rate, real money balances, human wealth, the present value of the investment subsidy, and the present value of the cost of holding money. They are not predetenmined by the past and can react freely to 'news' about current and future values of exogenous variables; their equilibrium values at any point in time depend on the entire future anticipated path of the forcing variables. For the complete dynamic system not to explode, these jumping variables have to satisfy certain terminal (transversality) conditions. Solving the model basically amounts to finding initial values for the non-predetermined variables such that, following a shock, the model will converge to a new stationary equilibrium. The necessary and sufficient conditions for the existence and uniqueness of such initial values in linear models of this type have been investigated in the literature and will not be discussed here.5 However, this is not the case for large nonlinear models such as this one.6 While a formal proof of stability cannot be provided, numerically the model was always found to converge to the new long-run equilibrium under reasonable parameter values. The requirement that the predetermined variables satisfy initial conditions, while the jumping variables must satisfy terminal conditions, poses a two-point boundary-value problem, for whose numerical solution several differem techniques exisL One leading example is the "multiple shooting" method proposed by Lipton et al. (1982), which solves the model over a flied time horizon starting from arbitrary guesses for te initial and future values of the juumping variables. The second is the "extended path" algorithm of Fair and Taylor (1983), which first solves the model also over a fixed time horizon, but starting from arbitrary guesses for the expected values of the jumpers, which are updated until they become sufficiently close to the actual values obtained from the model's equations, and then gradually extends the horizon untfl the solution path is unaffected by the addition of more time periods. For the simulations below, we combine both techniques. First, we solve the model over an arbitrarily chosen time horizon using multiple shooung. To prevent the solution from being distorted by the choice of too short a time horizon (which would force the model to reach the terminal conditions too early), we then extend the horizon and recompute the solution path until the resulting changes in the solution trajectory of the endogenous variables fall below a certain tolerance,= at which time the process stops. h practice, the length of the simulation horizon required for this procedure to converge is strongly affected by two parameters governing the speed of adjustment of the system: the elasticity of real wages to employment (i.e., the slope of the augmented Phillips curve), and the magnitude of adjustment costs associated with investment. Finally, the model is made discrete for the numerical simulations, so for any variable x, i = X1 - L 3See Blanchard and Kahn (1980) and Buiwr (1984). 'In principle, we could linearize the system around a steady state to detertnmine analytically the conditions under which the transion mmtrix possesses the saddle-point property. For a ten-ord system, however, tbis would be an intActable tasL. 2J We used a very stnct convregence criterion, requiring dta the maximum relative change between solutions in any vriable at any time period not exceed one-thousandth of one percenL This tpically requied a horizon between sixy and aghty penods for convergence. -19- 4. SIMULATION RESULTS This section discusses the dynamic response to exteral shocks, by presenting simulation results for the model introduced above. In a companion paper (Schmidt-Hebbel and Serven, 1993) we have explored the model's response to permanent/temporary, anicipated/unanticipated fiscal shocks under current taxation (a halanced-budget fiscal expansion), debt-financing, and money financing Here we simulate the dynamic adjustment to a favorable foreign transfer shock (an external grant), a favorable terms-of-trade shock (a decline in the price of the intermediate import used in production, say oil), and a favorable interest rate shock (a decline in the exogenously given foreign real exchange rate). The first- round magnitude of the first two shocks is common, equivalentto a 4% gain of initial steady-state output. 'For the foreign real interest rate shock, we simulate a reduction by 4 percentage points. We start by introducing the values of model parameters and exogenous variables and presenting the values of the endogenous variables at the initial steady-state equilibrium Then we discuss the simulation results. 4.1 Model Parameterization and Initial Steady-State Solution W-ithin the general structure spelled out above, three economies will be considered: U) a neoclassical (NC) benchmark, Cii) an economy with liquidity constaints bUL with full-employment (LCFE), and (iii) a Keynesian benchmark combining liquidity constraints and unemployment (LCUN). Table 2 summarizes the common and distinct parameter values for these three economies. Under the neoclassical benchmark, liquidity constraints on consumption and investment are ruled out %L =XL 1.0). For the LC cases, the latter coefficients are reduced to 0.5. For the full-employment cases, the elasticity of real wage changes with respect to current employment is set at a very high level (co = 1,000) and indexation to lagged oonsumer-price inflation is ruled out () = 1.0). By contast, wage-seing behavior in the Keynesian benchmark gives rise to unemployment, as a result of a low employment elasticity (wa = 0.25) and an important role of lagged inflation (6 = 0.5). The latter feature reflects nominal stickiness of wages. Numerical values for other coefficients in the structural equations were borrowed from empirical estimates (Serven and Solimano, 1991, Elbadawi and Schmidt-Hebbel, 1991) and preceding simulation models (McKibbin and Sachs, 1989, Giavazzi and Wyplosz, 1984) for various countries, complemented by estimates deemed to be representative for open economies. Table 2 also reports these parameter values shared by the three economies. Base money demand exhi-bits unit income elasticity. The interest semi-elasticity is 0.5, implying a seignorage-maximizing inflation rate of 200%- The share of labor, capital and intermediate imports in production (grss of imported materials) is 0.6, 0.3, and 0.1, respectively. The quadratic adjustment coefficient of investment is 2.5 and the rate of capital depreciation is 0.04. The import component of aggregate investment is relatively large (0.4), exceeding that of private consumption (0.1). The rate of discount of consumers is set at 0.06, which, according to equation (35), is also equal to the foreign real inerest rate. Export demand exhibits a unitary foreign-income elasticity. The price elasticity of foreign demand for exports is 1.5. Before discussing the values of exogenous variables, a remaining question on model closure has to be addressed: one residual endogenous variable for each of the two independent budget constraints remains to be chosen. For the simulations discussed below, the adjusting variable for the public sector -20 - is total taxes (td) and for the private sector the residual budgetary variable is foreign asset holdings (fbp).'29 The numerical values for exogenous variables are also based on both representative country magnitudes (as ratios to output) and previous models. Table 3 summarizes the exogenous variables for the initial steady state, common to the three economies. While the simulations show the response to changes in one exogenous variable, all other exogenous variables are maintained at the levels summarized in table 3. Because in the initial steady-state domestic output per efficiency labor force unit is 1.0, all exogenous variables can be interpreted as ratios to initial steady-state output. Both the public and private sector benefit from foreign transfers, at 0.015 each. Foreign income is normalized at 1.0. Foreign direct investment flows amount to 0.005. Public indebtedness in foreign and domestic capital markets is 0.30 and 0.20, respectively. The sum of public consumption and investment is 0.19, with a relatively large share of consumption. All absolute foreign price indices are normalized at 1.0, with zero foreign inflation. The rate of growth of the labor force in efficiencv units is equal to the sum of population growth (2%) and the rate of Harrod-neutral technical progress (1%). The foreign real (and nominal) interest rate is 6%. Finally, nominal base money grows at 5%. The initial steady-state values of endogenous variables for the NC economy (and of most endogenous variables for the liquidity-constrained economies)' are reported in table 4. Initial (and final) steady-state output growth is detenined by the rate of growth of the labor force in efficiency units (3 %). Hence output per efficiency labor is constant; parameter values were chosen so that its numerical value is 1.0. At the initial steady-state equilibrium, total private sector (or consumer) wealth is almost 20 times output, corresponding to the sum of non-human wealth (4.990) and human wealth (14.417). The four components of non-human wealth (other than the exogenous public debt) are domestic base money (0.15), the domestic-currency value of foreign assets (0.874), the net value of equity given by the product of q (0.6) and the difference between the total capital stock (30) and the equity owned by foreigners (0.115), and minus the present value of costs derived from holding base money (0.4). Steady-state inflation at 2% is given by the difference between money growth and output growth. Seigniorage is defined as the product of base money holdings and its rate of growth. At initial and final steady-state equilibria, seigniorage is 0.75% of output - the amount required to finance an operational public sector deficit of the same magnitude. Note that only at steady-state positions seigniorage is equal to the sum of the inflation tax (0.3% of output) and the growth effect on money demand (0.45% of 2AcaW modd simuaons assume that te private sector intratemporal budget cons_aint (equation (3)) is the redundant budget consamint by WiIran' Law, hence it is excluded from the set of modd equations. (Obviously the intertniporal budget constaint is still used in deriving optimal pnvate consumption levels). Hence id and ftp are the endogenous variables associae to tde public sector budget consmtaint (1) and the external setr budget constaint (2), respectively. I As dscussed in section 3.1, Tobin's q is higher and investment is lower under binding liquidity constints than in die neocassical economy. In ft initial steady-staue values in the LC economies arm 1.479 for q and 0.208 for gross domestic investment, which can be compared to the staionary values in the NC economy, reported in table 4. The stationary capital stock is slightly lower in the LC economies (2.973), but the total equity value (q times k) is larger. Higher equity mor than offsets lower fomign assets held by the pnrvate sector (equal to 0.853 in the LC economies). Hence steady-sta total consumer wdlth and consumption are slightly larger in the LC economies. Te stationary trade deficit is slightly lower in die LC economies, as dte return on foign asset holdings has sligbtly deteriorated due to the lower stock of private foreign asset holdings. All other variables remain unchanged in the LC econonies as conpared to die NC case. - 21 - output). At non-stationary equilibria, accumulation of money holdings drives a wedge between seigniorage and the latter sum. Initial steady-state private consumption is 0.58, mostly comprised by national-goods consumer spending. Stationary gross domestic investment is 0.21, all of which goes to replace depreciated capital per efficiency labor force unit. 60% of investment falls on domestically-produced goods. Investment adjustment costs are zero at the steady state, because they are only incurred on net investment. Exports are 0.20, intermediate imports are 0. 10, and total imports reach a level of 0.242. The corresponding trade deficit of 0.042 and profit remittances (0.0 1) are financed by foreign transfers (0.03), the net retrn (net of growth) on foreign-held assets, which yields 0.017, and direct foreign investment flows (0.005). The latter flow finances an initial current account deficit (net of accumulation of foreign assets to maintain constant assetloutput ratios) of 0.005. TABLE 2: PARAMETER VALUES FOR SIMULATIONS Basemoney denmand 01 = 0.16.2 i,.0 = -0.5 Wage-seing rule u = 1,000 (Neoclassical and Liquidity Constains) or 025 (Liquidity Constrints with Unemployment), 0 = 1.0 (Neoclassical and Liquidity Constraints) or 0.5 (Liquidity Constaints with Unemployment) Production fiuwtioa , = 0.91, a1 = 0.6, az = 0.3 hzves5mcnt adjustent cost I = 2.5 Physic capital depreciation rae a = 0.04 Privza investment denund B, = 1.0 (Neoclassical) or 035 (Liquidity Constaints), B1 = 0.5 Domestic content of investment y = 0.6 Private consumption demand = 1.0 (Neoclassical) or 0.5 (Liquidity Cosuints), 2 = 0.06 Domestic content of consumption i= 0.9 Export demand pi 0.2, p, = 1.5, p3 = I TABLE 3: INITIAL VALUES OF EXOGENOUS VARIABLES Income, Transfer and Capital Flows All Foreizn Price Levels 1.0 Foreign transfer to public sector (ftrg) 0.015 Rates Foreign transfer to private sector (ftrp) 0.015 Foreign income (y) 1.0 Population growtL (pg) 0.02 Foreign direct investment (dfi) 0.005 Harrod-euta technical progress (tg) 0.01 Foreign real interest (rf) 0.06 Stocks Nominal base money growth (smng) 0.05 Domestic debt of public sector (bg) 0.2 Foreign assets held by public sectar (e fg) -03 Goods Flows Public national-goods consumption (cnp) 0.15 Public investment subsidy (ig) 0.04 - 22 - TABLE 4: INITIAL STEADY-STATE VALUES OF ENDOGENOUS VARIABLES Income, Capital and Transfer Flows Ernmlovment (1) 1.0 Operational profits (op) 0.300 Outout () 1.0 Dividends paid (d) 0.260 Taxes (td) 0.183 Rates Private disposable .;ncome (yd) 0.433 Profit Renittances (prem) 0.01 Nominal interest rate on public debt (i) 0.08 Real interest rate on public debt (r) 0.06 Stocks Inflion rate 0.02 Totl private sector wealth (a+hu) 19.407 All Relative Goods Prices 1.0 Non-hunman wealth of private sector (a) 4.990 Stock of domestic equity held by foreigners (fe) 0.115 Other Prices Domestic base money (hb) 0.15 Human wealth of private sector (ht:) 14.417 Real equity price (Tobin's q) 1.444 Physical capital (k) 3.0 Real. wage per effective labor unit 0.6 Present value of government investment subsidy (pvig) 1.333 Real exchange rate (e) 1.0 Present value of cost of holding money (pvihb) 0.40 Foreign assets held by private sector (e fbp) 0.874 Goods Flows Privae aggregate consumption (cp) 0.582 Private importd-goods consumption (cmp) 0.058 Private national-goods consumpion (cup) 0.524 Gross domestic investment (mv) 0.210 Private national-goods investment (in) 0.126 Private imported-goods investmenat (im) 0.084 Investment adjustnent costs (iac) 0 Exports (x) 0.20 Intermediate imports (mr) 0.10 Total imports (mr) 0.242 Trade balance -0.042 Current account balance -0.005 - 23 - The steady-state nominal interest rate of 8% equals the sum of long-mn domestic inflation and the real interest rate. At a real exchange rate of L 0, all relative goods prices are also equal to I 0. The price of equity in units of national goods (a) is 1.444. Having normalized employment at 1.0. and with a labor share in production of 0.6, the real product wage is also equal to 0.6. The simulations for the shocks below explore three altematives: a permanent unanticipated (P) disturbance (hitting the economy from period I to terminal period T), a transitory unanticipated (IC) shock (hitting during periods 1-4), and a transitory anticipated (IA) shock (bitting during periods 2-5). Full information on the current and future nature of the shocks is made available in period 1. The discussion of the simulation results below focuses on the deviations from an initial steady- stare equilibrium (represented by period 0), distinguishing between the impact effects (m period 1) and the transition toward the new steady-state equilibrium (from period 2 to terminal period T). The discussion of the simulations will be based on the figures depicting the dynamic paths of the main endogenous variables. For the foreign-transfer simulations, each figure page is divided into an upper panel, which reports the dynamic trajectories under the dmree types of shocks (P, TIU, and TA) for the NC case, and a lower panel which combines the tiree shock types with the two remaining model categories: LCFE and LCUN. For the oil price windfall simulations, each panel represents a different variable, depicting three dynamic trajectories to a permanent shock, one for each benchunark economy. The figures report trajectories of endogenous variables for period 0 (the initial steady-state), 1 to 11, and T-1 and T. Tne terminal period T varies between 70, 80, and 90 periods. 4.2 A Forei2n Transfer Shock The dynamic trajectories of the main endogenous variables in response to a 4%-of-outputtransfer of cash from the rest of the world to the public sector (ftrg rises from .015 to .055) are shown in Figures 1-10, for different model categories and types of shocks. Talxes are the adjusting variable for the public sector budget. Therefore the foreign transfer to the public sector is completely passed on to the private sector by a tax reduction. Private sector disposable iacome and wealtb rise accordingly, leading to increased consumption. Higher private consumption leads to both a real exchange rate appreciation and higher output during period 1 when either the shock materializes (under P or TU shock types) or is first known to materialize in subsequent period 2 (under a TA shock type). Additional output increases in the following periods are a result of capital accumulation (which responds only gradually to higher investment profitability), and cause a depreciation of the real exchange rate. First consider the neoclassical economy (NC), positively affected by a permanent shock. Ricardian consumers internalize the government's intertemporal budget constraint, anticipating current and future fbreign transfers and corresponding tax cuts. Consumer wealth rise in period I (Fig. 1, upper panel) and continues to rise thereafter (due to the ongoing capital and output rise), approaching asymptotically its new long-run level. Private consumption increases accordingly, exhibiting an impact effect of plus 4 percentage points (pp.) of output (Fig. 2). In the long run, consumption increases by 9.7%, slightly exceeding the 8.9% rise in stationary consumer wealth.tm D1 The 0.8 % difference is due to dhe decline by this magnitade in thc private coamnption deflator, promptod by the real exchange rz appreciaion. - 24 - The consumption-led increase in aggregate demand causes a contemporaneous real appreciation (Fig. 4)9 and an output expansion (Fig. 3). Higher production in period 1 is nade possible by importing more intermediate goods in response to the appreciated real exchange rate, and hence by shifting the input mix away from value added. In subsequent periods the real exchange rate depreciates as a result of aggregate supply shifts due to a higher capital stock. Therefore the real exchange rate initially overshoots its new long-nn level - a result of the gradual supply response that partly offsets the initial appreciation. In the new steady-state, the real exchange rate exlhibits a 7.4% appreciation as relative to the initial long-run equilibrium, while output has risen by 2.8%.- With the transition path characerizer' by a gradual real exchange rate depreciation, the domestic real interest rate slightly exceeds its foreign counterpart throughout the transition (Fig. 5). Aggregate private investment is determined by the ratio of Tobin's q nm units of output) to the aggregate investment price deflator. The decline in the latter - due to cheaper capital goods imports - dominates the reduction in Tobin's q, and hence the impact effe is an increase in aggregate investment by some 1.5 pp. of output (Fig. 6). Subsequent additions to the capital stock drive down the profitability of new projects and hence investment levels off toward its new long-rum value. The latter exceeds the initial value due to the higher capital stock (per unit of output), which requires higher replacement investment The impact effect on inflation (defined in Fig. 7 as the backward-looking price change between periods t-I and t) is a reduction by 1.1 pp. from the initial (and final) steady-state value of 2%. The reason for lower short-run inflation is the need to accommodate a higher money demand (which expands with higher real income) under a fixed monetary growth rule. Subsequently inflation converges monotonically - from below due to transitorily high income growth - toward its unchanged long-run equitibrium leveL An tering result refers to the current account adjustnent berween the initial and (unchanged) final long-run equilibrium deficits of 0.5% of output Since Ricardian consumers raise consumption in anticipation of future output gains, the current account deficit increases by 0.5 pp. of output in period I (Fig. 8). The initial higher deficit is gradually reversed in subsequent periods as the anticipated output gains materialize Finally, the initial increase in aggregate demand and subsequent rise in the capital stock stimulate labor demand. Since labor is fully employed, higher labor demand is entirely reflected in a real wage increase (Figs. 9 and 10). The new long-rn real wage exceeds the initial level by 2.8%. It is worth underscoring that all these dynamic effects arise because of the import content of productive inputs. If capital goods had no import content, and if no imported materials were required for production, adjustment to the transfer shock would simply entail an instantaneous rise in private wealth and consumption, along with a real appreciation, without any change in real output, the capital stock, or the current account Next consider the case of a temporary unanticipated (MU) foreign transfer in this neoclassical economy, lasting from periods I to 4. The qualitative effects on most variables are very similar to the case of a permanent shock. However, a temporary decrease in taxes raises permanent income by a small amount, hence consumption increases only by little. Consequenly, all the effects described above occur with diminshed force. The only qualitative difference is that now the current account shows a significant 1 [ii figurEc 4, an appreciaion is represented by a decline in the value oft, wbhich accords to the mode's deinition of the real exchac ratnt -25 - surplus while the shock lasts - a surplus of approximately 4% of output as compared to the permanent shock - as consumers accumulate wealth to smooth out their consumption over the entire future horizon (see the dashed line in the top panel of Fig. 8). Consider now the case of a temporary anticipated (TA) shock taking place during periods 2 to 5. The effects are nearly identical to the unanticipated temporary shocE Consumption rises already in period I in anticipation of fuure lower taxes* The current account goes initially into deficit, followed by four periods of surplus while the transfer lasts. Next we focus on a full-employmen economy with liquidity-constrained consumers and firms (LCFE). Aggregate investment and consumption respond only in part to forward-looking variables (wealth and Tobin's q), while now dtey are also sensitive to contemporaneous flow variables (consumer disposable income and operational profits). For the permanent shock the dynamic paths of the endogenous variables in the LCFE economy are similar to the neoclassical case. By contrast, richer dynamics are observed under temporary shocks. Because temporary tax cuts relax liquidity constraints of some consumers, aggregate consumption is boosted far beyond the smooth consumption levels of the NC economy during the 4 periods of shocks (cf. upper and botom panels, Fig. 2). While consumer wealth declines duing the 4 periods of shocks (Fig. 1, bottom panel), private consumption levels increase during the periods of tax cuts (Fig. 2, bottom panel). Thus the LCFE economy exhibits a more pronounced cycle. Output expansion and real exchange rate appreciation are stonger than under the comparable temporary shocks in the NC economy, followig U or inverted-U paterns during the 4 periods (botom panels, Figs. 3 and 4.). The dynamics of the real interest rate, detmined by the real exchange rate fluctuations, meri a closer look. Under a TU shock, the real exchange rate depreciates at a low rate during the next 3 periods (2 to 4), then depeciates sharply in period 5 (due to the decline of consumption by liquidity- consutained agents), and subsequenty depreciates again at a low rat until converging to the new long-mn value. This implies that the real interest rate exhibits a one-period spike in period 4 (reaching 8%), in anticipation of the strong real exchange rate depreciation. Compare this result to what happens under a TA shock which srs in period 2. Then the initial real exchange rate appreciation continues through period 2, only to be reverted in perod 3 and thereafter, with a strong depreciation occurrig in period 6. Hence the real interest ratexehibits a trough in period I and a spike in period 5, before slowly converging to the (unchanged) long-run value of 6% Aggregate investment reflects now the influence of both the shadow price of capital and operational profit flows. As Tobin's q declines more than operatonal profits increase, aggregate investment flls during the four periods of shocks. Inflation falls in the first period, as in all previous cases, due to the adjustmen of real balances to higher money demand. However, in the TU and TA cases inflation exhibits a cycle that mimics the developments in goods markets. Finally, note that the transitory current account surplus is lower tan in the NC economy since consumption is higher due to the 4-period relaxation of liquidity constraints. n Thc rise is slightly sml ler than hmder TU because dh tempoay x reducon mu be dicountd one addfional pFio -26 - The third and last economy to consider is the Keynesian benchmark, which combines liquidity constraints with wage rigidity and unemployment (LCUN). The new long-run values of all endogenous variables are similar to those attained in the previous fill-employment economy (LCFE)l The difference lies in the adjustment path: now real wages do not rise as much in response to higher labor demand, and hence employment initially rises above the full-employment level Lagged wage indention introduces a strongly cyclical pattern of real wages and employment, which is absent in the fill-employment economies. In the case of a P shock, total wealth exceeds that of the LCFE case, a result of higher employment and production during the adjustment periodc Consumption rises accordingly, although as a ratio to (higher) output it remains prtctically unaltered from the previous economy- Output follows an oscillatory path, first rising to a temporary peak in period 3, then declining to reach a trough in period 8, and finally coaverging toward its long-run value (which exceeds the levels achieved by the full- employment economies). The output dynamics are a result of slowly inreasing capital and the cyclical pattem of employment The latter exhibits a peak of 2.3 % over-employment in period 2 (as real wages decline in that period due to lagged indexation), after which it starts an asymptotic convergence back to full employment The real exchange rate mimics the dynamics of output after period 1; the real interest rate evolves accordingly. Positive output growth reduces inflation below its 2% long-run value during the first three periods Tobin's q, as opposed to all preceding runs, increases through period 2, when it reaches its peak This is a result of significandy higher dividends from higher output Afterwards it starts to decline toward its lower steady-state value. Investnent is accordingly higher than before - although as a ratio to output it remains at the level of the LCFE economy. Real wages also exhibit inresting dynamics. Their initial rise in period 1 is more moderate than in the full-employment economies, as the labor demand expansion is pardy met by higher employment In period 2 they fall - a result of backward indexation as inflation falls in period 1. After period 2, real wage increases in response to higher employment push wage levels asymptotically toward higher steady- state values. Concerning the sinmlation results for temporary shocks in a Keynesian (LCUN) economy, the main point to be emphasized is related to the cyclical behavior of output Aggregate demand, and hence output, rise much more during the four periods of foreign transfers, and then decline to lower levels than in the preceding fill-employment economies. We conclude that, like liquidity constraints under temporary transfer shocks, wage rigidity intensifies the amplitude of the adjustment cycle to both temporary and permanent transfer shocks. 4.3 A Permanent Oil Price Windfall We analyze now the dynamic response to a permanent decline in the price of intermediate imports. This can be interpreted as an oi price fall in an oil-imporing economy. The shock has been normalized again to a first-round gain (or direct effect) of 4% of output, reflecting a 40% drop in the international price of intermediate imports (pmr declines from 1 0 to 0.6)- Figures 11-15 report the dynamic trajectories of the main macroeconomic variables in response to a permanent oil price windfall, for each of the thre economies. While the first-round magnitude is similar to that of the foreign tansfer analyzed above, a lower pmr entails a production substtution effect in addition to the transfer's income effect. That is, even - 27 - before considering second-round income and substitution effects stemming from induced real exchange rate changes, a lower pir encourages the substitution of capital and labor by cheaper oil. Again consider first the NC economy (represented by continuous lines in Figs. 11-15). Consumer wealth and consumption levels (fig. 11) exhibit a dynamic patten which is qualitatively similar to that in response to a transfer shock: a strong first-period increase and subsequently a gradual and asymptotic convergence to higher long-mn levels. Wealth rises by a similar amount than under the transfer shock. But private consumption increases by much less (ong-nm consumption as a share of output is now 5817% instead of 62.1 % before), due to a strong increase in the private consumption deflator, caused in tur by the real exchange rate depreciation. Output grows much more than under the foreign transfer shock. The impact effect on output is now 5.4% (as compared to 1 1% before), and long-run output is 6.8 % higher (as compared to 2.8% under the transfer shock). This significantly higher output level reflects the massive incentive to change the input mix away from value added and toward intemdfiat imports, in respon.e to the lower international price of the latter. The strong supply expansion causes a 3.5% initial real exchange rate depreiation, which stnds in contrast to the initial pQreciation under a foreign transfer shock In the long run the real exchange rate depreciates by 5.4%, while it had appreciated by 7-4% under the transfer shock. Long-run intermediate imports grow now by a massive 69%, a result of a positive substitution effect (a significantly lower international oil price slightly dampened by the moderate real exchange rate depreciation) and a positive scale effect; by comparison, they rose only 11% under the transfer shock, resulting from a more modest scale effect and a substittion effect stemming only from the real exchange rate appreciation. The signficant substitution effects - in both cases - reflect the high (unitary) elatcity of substitution between imports and value added, embodied by the Cobb-Douglas production technology. The real interest rate behaves in a similar way as under the tansfer shock because of gradual real exchange depreciation along the transition path. Tobin's q Cm units of output) gets a boost in the first period, stemming from the rise in dividends (due to the lower price of intermediate imports), which more than offsets the negative influence of a slightly higher real interest rate. However, investment goods are now dearer due to the real exchange rate depreciation. Hence aggregate investment (which depends on the ratio of q anti the price of investment goods) rises in period 1 by only a moderate amount. The long- run capital/output ratio is now 2.94, lower than in the initial steady state, as a result of the real exchange rate depreciation; by contrast, under the foreign transfer shock it had risen to 3.09, helped by the real exchange rate appreciation. Therefore the new long-mn invesment ratio to output must be lower under the oil windfall; in fact, it declines to 20.6%. Inflation presents a similar pattern as before. The diffierence lies in the magnitude ofthe period-l inflation decline. The high output expansion under the oil windfall boosts money demand and therefore requires a one-perod deflation of 3A4%, which contrasts to the slight but still positive inflation caused by the transfer shock. The current account behavior replicates the interesting result that a favorable externaL shock causes a transitory deficir due to the combinadon of investment adjustment costs (which cause a gradual capacity expansion) and forward-looking consumers (who anticipate higher fuatre income levels and therefore raise their current spending). - A8 - Finally, short and long-term real wages are boosted by higher output levels. The long-run real wage increases in the same proportion as output (6.8%), exceeding significantly the 2.8% rise observed under the foreign transfer shock. The full-employment economy with liquidity constraints (the LCFE case, depicted by dashed lines in Figs. 11-15) displays a pattern very similar to that of the fully neoclassical case. The chief difference is that liquidity-constrained consumers do not initially adjust their consumption in anticipation of future output gains. As a result, the current account deficit is now smaller, allowing for additional asset accumulation, which in the long-run leads tO higher wealth and sustains an increased consumption/output ratio. The Keynesian benchmark LCUN (represented by the dotted lines in Figs. 11-15) yields richer dynamics. Private wealth shows a much more pronounced transitory hump, which reflects the underlying humps in employment (which boosts human wealth), the real exchange rate (which raises the domestic- currency value of privately-held foreign assets), and the price of equity (q). Consumption as a share of (higher) output follows a path which is similar to the LCFE economy. The short-term real exchange rate depreciation exceeds significantly the levels reached under the full-employment economies. The reason is a significant transitory output expansion made possibte by over-employment in response to sluggish real wage adjusmentm Real output reaches a peak in period 2, with a level which is 9.0% higher than in the initial steady state and also exceeds signifianty the 5.6% increase in the full-employment economies. Subsequent catch-up of real wages reduces output (which reaches a local minimum of 1L066 in period 10) until convergence to its new long-run eqilibrium of 1.069. The real echange rate mimics the cyclical pattern of outpuL The swings in the real interest rate - in conast with its relative flatness in the full-employment ecnomies - reflect the period-2 real exchange rate depreciation and subsequent appreciations (untl period 10) and deprutitions (thereafter). This causes quite significant short-term fluctnuaions of the nterest rate, from a peak of 7.6% at period 1 to a trough of 5.5% at period 3. Investment as a share of output, affected by countervailing influences of the price of eqiwty, the real exchange rate, and operational profits, shows a similar behavior as in the LCFE economy. Inflation, which mimics the cycle of output growth, reaches the most negative value across shock categones and economy types in period 1, when the massive income growth requires a 5% deflation to balance the money market Note that from period 3 to 10 inflation slightly exceeds its long-term equilibrium value of 2%, a result of declining output. Finally, the dynamic pattern of the real wage and employment under a permanent shock is similar to that of the Keynesian benchmark benefitted by a permanent external transfer. The real wage, determined by backward nominal indexation, reaches a trough in period 2, reflecting the preceding period l's price deflation. Afterwards it catches up fast to converge toward its higher long-run value. Employment reflects the pattern of real wages, reaching an all-time high of 5.4% over-employment in period 2, subsequendy returning asymptotically to full employment Average over-employment is 3.8% during periods I to 5, exceeding significantly the corresponding average of 1.7% in the Keynesian economy affected by a permanent transfer shock. As in the case of the transfer shock, wage rigidity intensifies the amplitude of the cyclical response to an oil price shock. In concluding, the main difference between the oil price windfall and the permanent transfer is that the former involves both a favorable supply shock which boosts production directly and depreciates - 29 - the real exchange rate, while a foreign transfer implies an income effect wbich boosts aggregate demand and appreciates the real exchange rate, with an indirect induced effect on supply. Most other variables behave in a qualitatively similar fashion under both shocks, although the quantitative response is significantly more intense under the oil price windfalL 4.4 A Foreign Real Interest Rate Shock We analyze now the dynamic response to a 4-period temporary decline in the exogenously given foreign real interest rate by 4 percentage points. The analysis is restricted to temporary shocks (TU in periods 1-4, TA in periods 2-5). The reason for not considering a permanent foreign interest rate change is that it drives a wedge between the domestic interest rate and the subjective discount rate, precluding the economy from reaching a new stationary equilibrium. The param ion considered here is for a net creditor economy, with a private sector holding initial foreign assets 87.4% of output and a governmentwho has issued foreign debtequalto 30% of initialoutpuL Figures 16-25 reportthe dynamic trajectories of the main macroeconomic variables in response to the temporary interest shocks. Consider first the neoclassical economy (NC). The decline in the foreign real interest rate translates ino a lower domestic real interest rare. The latter entails for the NC consumer the well-known substion, income, and wealth effects. The first two effects offset each other as a result of a uny inreremporal elasticity of consumption substitution. However consumer wealth rises with a lower real inerest rate because future net income streams - labor income streams net of money holding costs - are less discounted. As labor income wealth is the largest component of total consumer wealth, the wealth increase m period 1 (3.6% in both T[J and TA cases) is quite substatial (Fig. 16). En the TA case, wealth continues to mcrease in penod 2 (when the itrs rate dline actally taes place), reaching a peak which exceeds initial steady-ste wealth by 4.1% NC consumption replicates the pattern of wealth. T.he consumption to output ratio in both caS increases by 2 pp. and peaks in period 1 (Figure 17). Consumption declines subsequendy for two reasons. First, after the initial jump, wealth diminishes gradually untl foreign real interest rates jump back to 6 % in period 5 M) or 6 (TA). Second, the temporary consumption spree leads to dissavmg in periods 1-4 (or 2-5), lower private foreign asset holdings, and hence reduced new stationary levels of wealth and consumption. The new steady-state consumption to output ratio falls by 0.6 pp. relative to the initial stationary level in the TU case, and by a bit more in the TA case where dissaving of foreign assets is larger, because it starts in period 1, anticipating the decline in the foreign interest rate that will take place one period later. As in the preceding cases of temporary foreign transfer and oil-price shocks, the impact effrct of the aggregate demand expansion - stemming from both higher consumption and investmen - is an output expansion (Fig. 18) and a real exchmge rate appreciation (Figure 19) in period 1. But under the intert rate shock the made of the impact effec on both output and the ral exchange rate is very large. The subsequent paths of output and the real exchange rate are now, however, quite different from the ones observed under the temporary foreign trnsfer and oil-price shocks. Output follows initially a hump-shaped trajectory, pealdng in periods 2 (CU) or 3 (rA) in response to a strong supply expansion stemming from temporary high investment and material import levels. In the long term, however, output converges to a stationary level that is roughly 0.4% below the initial level in response to lower long-term consumption demand due, in turn, to lower wealth. -30 - The real exchange rate follows a surprising appreciation - depreciation - appreciation path. The impact effect of the foreign interest shock is a 9 % appreciation, rapidly offset by a 4 or 5-period string of depreciations, leading in period 5 (TI) or 6 (TA) to a real exchange rate level which is not only 25- - .1 % more depreciated than the initial steady-state level but also more depreciated than the new stationary level. The small but systematic real appreciations after period 5 or 6 are a result of a contactng output supply which raises the relative price of natonal goods Behind the supply reduction is net disinvestment after the capital stock reached a peak in period 5. Disinvestment responds to the low marginal value of capital in period 5 (reflected by the through reached by Tobin's q). Note, however, that the overshooting of the real exchange rate in period 5 or 6 is not a general result If investment adjusment costS were more stringent than assumed under this model's parametrization, the temporary investment boom would have been weaker (or, under extremely high adjustment costs, it would not have taken place at all), so that the real exchange rate would have followed a path of steady depreciation after the initial appreciation, reflecting only the effecs of aggregate demand shifts. The domesuc real intert rate (Fig. 20) reflects the temporary foreign interest rate decline and the real exchange rate depreciation Under the TU shock, for instance, the domestic rate exceeds the 2% foreign rate by the significant rate of real exchange rate depreciation during periods 14 Subsequendy the domestic rare falls slightly short of the foreign 6% by the (small) rates of real appreciation. As aleady satd above, a massive and short-ived ivestment boom tkes place, driven by low interest rates reflected in a large Tobin's q. The investment rate jumps from 21% to 25% of output in period 1, but starts declmiing strongly thereafter (Fig. 21). Net disinvestment from period 5 or 6 onward implies that the investment rate approaches its long-erm level from below. Inflation (Fig. 22) shows a trough of 0-6% in period I when higher income raises the demand for money and a spike of 2.6 % in period 5 or 6 when the large increase in real interest rates reduces money demand. The current account (Fig. 23) shows a massive temporary deficit on impact, equal to 4.75 pp. of output, which is gradually corrected thereafter. Under conditions of fll employment, the real wage mimics exactly the patt of output it petks in period 2 or 3 and then converges toward the new stationary equilibrium level, somewhat below the initial stationary level (Fig. 24). Now consider the LCFE economy, when aggregate investment and consumption respond to both forward-looking and contemporaneous flow variables. Interestingly, tis feature has opposite effets on consumption and investment Constrained consumers - as opposed to unconsUtrained agens - raise consumption in response to the government's tax rebate in periods 14 or 2-5, and hence aggregat consumption is larger than in the NC economy. Constained firms, however, do not respond to the large increase in Tobin's q but respond to the much more modest rise in operational profits. As a result, the aggrega invesnt boom is much less pronounced than in the NC case. In fa, the weaker investment response more than offsets higher consumption, so that the temporary aggregate demand expansion is slightly weakr now than in the NC economy. Therefore output expands and the real exchange rate appreciates slightly less on impacL The qualittive dynamic pattern of all variables remains the same. But as a result of the slighdy less intense spending spree during the first 4 or 5 periods - reflected by a smaller current account deficit - dissaving of private foreign assets is smaller and hence the new stationary levels of consumption and output are marginally higher while the real exchange rate is marginally less deprecated. -31 - Finally consider the Keynesian (LCUN) economy, where unemployment is added to liquidity constraints. As a result of employment changes caused by short-term wage rigidity, output shows strong cyclical variations around the hump-shaped trajectory of the LCFE economy. The output peak in period 2 or 3 - at 2.2-2.5% above initial stationary levels - roughly doubles the temporary output expansion reached in the LCFE economy. And subsequently - from period 5 or 6 onward - output falls below the LCFE tajectory. The slightly dampened trajectory of the real exhage rae reflects the changes in goods supply resulting from non-flexible wages. Inflation falls almost to zero in periods 1 and 2 as a result of strong money demand. In the Keynesian economy, the real wage is determined by backward nominal indexanon to inflation and current employment conditions. Lower inflation conutes to moderate wage growth today and tomorrow, implying that the level of real wages responds only wealdy to the higher demand for labor during the first 4-5 periods. The reverse is observed when inflation peaks in period 5 or 6 at 3.1% . Then real wages peak in period 6 or 7 before starting asymptotic convergence toward lower new stationary levels. Employment mimics the output cycle the Keynesian economy. Sluggish wage adjustment causes large overemployment which peaks in period 2 or 3 at 1.9% above fuUl employment levels. The reverse is observed when wages reach thei peak; employment falls to a trough of mugbly 1% below fall-employment levels. After period 6 or 7 employment converges asymptotically back to full employment 5. CONCLDING REMARKS This paper has developed a dynamic macroeconomic general equbrium model for three economies: a neoclassical case wit frictionless, instantaeous clearing in goods, asses and labor markets, a fill-employment economy with grups of liquidity-constrAined consumers and investors, and a Keynesian benchmark with liquidity-constrained agents and wage rigidity gin rse to temporary deviations from full employment The model has been applied to simulate the impact, transitional, and steady-state effects of permanent, tmporary unaicipated, and temporary anticipated extenal shocks. These types of shocks can be meaningfilly differentiated due to the assumpton of rational expectations embodied in the model. Three shocks have been considered a higher foreign tmnsfer, a lower inteional price of inmdiate imports, and a lower exogenously given foreign real interest rate. The simulations demonstrate the usefulness of a consistent framework based on first principles for tracing out and undestandingthe macroeconomic response to disturbances. The numerical exercise illustae th main points. First, due to the import content of production in the model, both permne and transitory exteral shocks lead to long-nm changes in productive capacity and real output, as well as in the other endogenous variables. Second, whea favorable permanent shocks lead to higher steady- state capital and output (as is the case in two of the simulations above), their short-rn effect is to case a current account deterioration. The reason is that consumption by unconstrined consumers immediatey rises in response not only to crrent, but also to anticipated future real income gains, and the latter accrue only gradually due to the existence of investment adjustment costs. This is in sharp contrast with the effect of favorable transitory shocks, which unambiguously improve the current account while they last. Third, market imperfections have important consequences for the dynmi response of the economy to exogenous disturbane. In contrast with the relatively smooth, often monotonic adjustment paern displayed by the neoclassical benchmark economy in the simulations above, liquidity constraim or wage iT If H,rr a it p 'liii 4ii I I'I' iii; r1 j[;' 'Ii un fls [ j J [I [ NW zI [ 111K Ii 1 iii LA I Ii e I I I i u rh fi I I I 31 H ii if f1111 I li I I Ta a' - 33 - Hubbard, G. and L. Judd (198): 'Liquidity Constrinss, Fiscal PoEcy and ConmOpioe", Broolin. Pacrs on Ecoucc Activity 1. Krugmau, P. and L. Taylor (1978): woaoy Effects of Dealuation", Journal of Tnteional Economrics 3. Leideman, L. and M_ Blejer (1988): "Modeling and Testing Ricardian Equivalece" IMF Saff- 35. Liptn, D. and 1. Sachs (1983): "ACCUUI6auiO and Growth in a Two-Country Model", Journal of Initeraonal Economics 15. Lucas, RE. (1967): "Adjustmmt Costs and the Theory of Supply', Journl of Political Economy 75 (4). McKibbin. WJ andJ. Schs (1989): Te McKbin-Sachs Glbdl Mod Theoy and Spcification, N3ERR Wo*an Paw 3100, Cambridge, Mass. and M.W. Sunderg (1990): tLo_ inkages Between the OECD and the ca-Pacc Reion", B n Discussion P*er in Internaxional Econm No. 80 May. and PJ. W ;coxn (1992): "G-CUBED: A Dynamic Multi-Sector Equilirium Moded of die Glbal Econmy (Qualfying the Costs of Curing CO, Emissions), Brootins Discussion Pers in 1natonal cN o. 98, November. Ramsey, F. (1928): "A Mathematica Theoy of Saving", Economic Journl 33 (152), 123. Sachs, JL (1983) "Energy and Growth un lexibl Exchange Rts: A Simuaton Study", in J1S. Ehadari and BE. Paetnn Economin and Flexible Exchane. Rates M1T Press. Schnidt-Hebbcl, K. ad L. Serves (1994): "Dynamic Response t Externul Shoct. in Clamsica and Keynesian EcBoonee, in D. Cuiric and D. Vies (ads.): Nordw 5outh Libses and Intadona c Policy. Cambdgp Univ y Press farcoming. Sclzmidw -Hebbl, K andL. Serve(1499: "FscalPolcyiClscalandKeyn OpenEconomies", j, Wod Bank, Marh. Seater, L (1993): "Ricardian Eu et,J of Fonouic Lierat 1, p. 142-190. Serves, L. (1991): wAtricd Ral Exchange Rate Changes and die Dynamics of lvet", m aDer urEseg4 at the 1991 Latin American Metine of the Econontic Society Uruguay, Angus. (1994): "Capta Goods Impomts, de Rea Exchange Rate and the Currnt Account, Journal of ltmnatoal Eec.sis!o foithconung. and A. Solimao (1991): "An Empiical M o Model for Poicy Desigu: The Case of Che" PRP, WorkiuggP 709, The Wodd Bank, June. Sidrausky, M. (1967): "Rational Choice and Panerr of Grwth in L Moneay Econmy", American Ecmonoic Review 57, p. 534-544 Tobin, J. (1969): 'A Geneal Equilbrum Approach to Monetary Theory", Joural of Money. Creit and Banking 1, p. 15-29. Treadway, A. (1969): "On Rationl Enepreneurial Bdevior and die Demand for Inveftacrn, Review of Economic Soufies 36 (106). Turnovsky, S. and P. Sen (1991): "Fiscal Policy, Capital Acmulaion, and Debt in an Open Economy," OxfrdEcononi P=s Report 43, p. 1-24. Wildasin, D. (1984): The q Theory of Ivestment with Many Cpil Goods", American Economic Review 74, p. 203-210. Wodrd Bank (1991): World Develment Renort, Oxford UP. 34 Figure 1 Foreign Transfer Shock- Total Wealth Neoclassical Economy 21.4. . . . . . . . . 21.0 20.6 20.2 19.8 19.4 0 1 2 3 4 5 6 7 8 9 10 1 1 -T.1 T -Pwtmanent temporary Unantixtpd Temporry Antpted Non-Neoclassical Economies 21.0 20.5 20.2 19.8 19.4 .. . _........... 19.0 . . . . . . . . . . . 0 1 2 3 4. 5 6 7 8 9 10 11 -T1, T - c4- .~~~ ~ ~ ~~~~ T.e..e. _ r_ e --Lie. Can. A Unownsi.nyww P- P..m.i _ - -TIRI.WGI u _uet.d l ~ ~~~~~~~~ _a--, se.4 35 Figure 2 Foreign Trcnsfer Shock - Private Consumption J Output Neoclassical Economy 0.63 . . . . . . 0.62 0.61 0.60 0.59 0.58 0.57 B _ t| o 1 2 3 4 5 6 7 8 9 Io' 11 -.T_ T ....... To-Pon _0C* Non-Neoclassical Economies 0.63 0.62 0.61 0-60 -.. 0.59/ 0.58 0.57 , . . 0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T. .... _ - Z; ,~e.pu.uuaa Li. Cm.& UeEI1. - _ 0- Lk _...pwm" UminAt id._ * ... ~~~~~-MWPrUY &b 36 Figure 3 Foreign Trcnsfer Shock - Output Neoclassical Economy 1.035 1.030 1.025 1.020 1.010 1.005 1.000 0.995- 0 1 2 3 4 5 6 7 8 9 lo t1 -T.. T Non-Neoclassical Economies 1.035 . , ., , . . . . . . 1.030 . 1.025 - 1-020 - 1.015 - 1.0100i 0.995 0.990 . X _ o 1 2 3 4 5 6 7 8 9 10 11 -T_. T _ ~~~~~~~- r_tgu. A..Ie . Liw. C.. a".. -..P. s . - r..n,.p, ftruhd.id - ?.mpu.-v Aadotides. 37 Figure 4 Foreign Transfer Shock - Real Exchange Rate Neoclassiccl Economy 1.02 1.00 0.98 0.96 0.94 0.92 - 0.90 o 1 2 3 4 5 6 7 8 9 1 11. -T_1T -Permanent Timparary Unanticipated Temporary Anticipated Non-NeoclOssical Economies 1.02 . . . . . 1.00 o.ss \ _ *,-:= ... ...... 0.96 - 0.94 - 0.92 \ < a --a_ 0.90 0 1 2 3 4 5 6 7 8 9 10 11 -T_t T u.sv cw 4 - _ - - - reu- Un,hI.ed _- US. Ce. & UnM.Ierue" -P P _ - remee.w U_ _d T wu v~~~~~~~~~ _1.m.wu _ Teie 38 Figure 5 Foreign Transfer Shock - Real Interest Rate Neoclassical Economy 0.080 , , , . - I - * 0.076 0.072 0.068 0.064 0.060 0.056 0.052 0.048 0.044 0.040 0 1 2 3 4 5 6 7 a 9 10 11 -T-1 T Non-Neoclassical Economies 0.0B0 0.076 0.072 0.068 0.064 0.056 0.044 0 1 2 3 4 5 6 7 8 9 10 11 -T_ T Um...... b..u - rum... U01;A, co1...w au.sgg U- U. Co& a UI,aqbei.n* pwmm I... _ r_mwmy 5.S....(.i 39 Figure 6 Foreign Transfer Shock - Privote Investment / Output Neoclassical Economy 0-232 . . . . . . . . 0.228 0.224 . 0.220 0.216 0.212 0.204 0.204. 0a.200 * . . . , , , . , . t. 03 1 2 3 4 5 6 7 8 9 10 11a -T-1 T I- - r.mmfvmMmi ........ r4WWAmdO Non-Neoclassical Economies 0.232 . . . . . . . 0.228 0.224 0.220 0.216 0.212 0.208 011 - - -_ 0.204 0.200 . . . . . , . . . . 0 1 2 3 4 5 6 7 8 9 10 11 -T.1 T _ _ - r_inpmF U_*eIel.d~ - Lin. CM. & U r - Pmm _ - - r..iuuu.et a. _.umi... , . . . . _~~~ r..uw hi.as 40 Figur 7 Foreign Transfer Shock - Inflation Neoclassical Economy 0-02a . . . -. . . . . . 0.024 0.016 \ 0.012 0.005 0.004 00 0.000 ' * 0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T Permnent - - Tempoaray Unanticioted --** -- Tmporary Anticipated Non-Neoclassical Economies 03028 a a , . , . . 0.024 - 0.008 0.004 . 0 000 o 1 2 3 4 5 6 7 8 9 10 11 -T-1 T - c~~4 T.uu.refnwt UNm4wihwd *- tie. CeM. aU"PWite n p_ Nfu_t _ _ _ r_,~~TO-~M unet_" Z. ~ ~ ~ ~ Vii i '.~ uk 0~~~~~~~~~~~~~~~~ I-~~~~~~~~~~~~~~~~~~~~~~~~c 0 u . ..... 0 0 11) r-0 111V 4v ~~~~~~~~~~~~~~~0 ........................i...................... 0 -~~~~~~ - 00 IL 0~~~~~~~~~~~0C 0 42 Figure 9 Foreign Transfer Shock- Real Wage Neoclassical Economy 0.621 0.618 C0-614 0.610 0.606 0.602 0.598 0 1 2 3 4 5 6 7 8 9 10 111 -T-1 T I - Purwmanent - - Tomporwy Unantieipatud ... rmpDorary Anticipated Non-Neoclassical Economies 0.622 . . . . . . 0.618 0.610 0.606 0.602 . 0.598 0.594 . 0 1 2 3 4 5 6 7 a 9 10 11 -T_1 T , . s.;o Cm,aImtu --wwua ....~~~~ _ r _ hibI..s v X. C.. & Ugwqq., - Pgn..g.. _- _ r_ugqm U.eie -- - -u.u. r_ uiSe4 43 Figure 10 Foreign Transfer Shock - Employment All Economies 1.04 1.03 1.01 1-00~~~~~~- 0.99 0 1 2 3 4 5 5 7 8 9 10 1 1 -T.. T 0 -. Us e.PU,.uu.i,-9,GrWA I a- - - 1~~~r.&O.u. U..gmqdp.* i 9-. - lrWWV A_ .,s. . 44 Figure 11. Permanent Oil Price Windfall - Totol Wealth All Three Economies 21.8 *- * . . . . . . . . . . 21-4 - 21.0 20.6 _ 20.2 - 19.8 19.0 0 l 2 3 4 5 6 7 8 9 10 11 -T_, T - - Uiquidity Constrained - Lqidity Constrained I UnrnWormant Permanent Oil Price Windfall - Private Consumption / Output All Three Economies 0.590 0.589 0.588 - ------- ---- 0.587 ' -. - 0.586 1: 0.585 0.584 0.582 0-581 0.580 0 1 2 3 4 5 6 7 8 9 10 11 -T1T - NeQciasutcal -- Uquidity Constrained Liquidity Constroined & Unemployment 45 Figure 12 Permanent Oil Price Price Windfall -Output All Three Economies 1.10 0.98~~ 0 1 2.......78... l -T.1 D8 *. -...-.-.- .... . ... r 06 - W l R xa 1.'5 1.04 - 1_02 1.01 0 1 2 3 4 5 6 7 8 9 I Ol -T-1 T Liquidity Conimed f UMpb ym -... Liquedfty Consu,dined &UuPW- Permanent Oil Price Windfall - Real Exchange Rate All Three Economies 1.07 ~~~~. 1.06 - .'0 1.04 . i 1.03_v i.02v o .2 3 4 6 7 8 9 I0. ll -T-1r Neotck"110 -Liauidibt constined ...... Lkiditr Coztrwo & un\emP° 46 Figure 13 Permanent Oil Price Windfall - Real Interest Rate All Three Economies 0.082 . . a . - . . 0.078 0.074 - 0.070 - 0.066 0.062 0.058 0_054 _ 0.050 U U 0 1 2 3 4 5 5 7 8 9 10 11 -T_, T - Neoclasical - - Liquidity Constrained Liquidity Constrained & Unemployment Permanent Oil Price Windfall - Privote Investment / Output All Three Economies 0.214 . 0.212 0.210 0.208 0.206 ............. 0.204 - 0-202 0.200 , J. . _ . . , 0 1 2 3 4 5 6 7 8 9 lo 11 -T1 T - N.cla.scal - - Liquidity Construain --.- Liquidity Constrained & Unemployment 47 FLgiLe 14 Permonent Oil Price Windflll - Inflation All Three Economies 0.04 . . . . . . . . 0.02 .. 0.00 -0.02 -0.04 -0.06 . . . I . . 0 1 2 3 45 6 7 8 9 10 11 -T_. T M.NaciaauicIl - - Liquidity Conbtr ined --.. iquidity Consintraid & Uneemploywent Permanent Oil Price Windfal - Current Account / Output All Three Economies 0.000 . . . . .. . -0.001 -0.002 -0.003 -0.004 -0.005 -0.006 - -0.007 ... ....... - -0.008 Q _ -0.009 -0.010 I X X e I r S I * 0 1 2 3 4 5 6 7 a 9 10 ll -T-1 T - Neoclassial - - Liquidity Constrained - ---.iUquidity Constroined & Unemployment 48 Figure 15 Permanent Oil Price Windfall- Real Wage All Three Economies 0.65 .. . . . . . . . - 0.64 0.63 0.62 / 0.61 0.60 0.59, . . . . . . . . . . . . . 0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T Liquiditr Constrained ------- Limidity Contrained Unmmt Permonent Oil Price Windfall - Employment All Three Econormies 1.06 . . . . . . . . . . , -. 1.04 1.02 . ''-. 1.00 t==_ 0.96 0 1 2 3 4 5 6 7 8 9 10 1I -T_1 T - - Liquidity Constrained Liquidity Constrained & Unrnplayr;2nt 49 Figure 16 Foreign Interest Rate Shock - Total Wealth Neoclassical Economy 20.8 20.6 20.4 20.2 .- - 20.0 I N - 19.8 i 19.6! ¾ - 1 9.4__-=--._ t A .- 19.2 N 19.0 o 0 1 2 3 4 5 6 7 8 9 10 11 -T_. r Non-Neoclassical Economies 2.0.8 - 20.6 . - WOA N 20.2 h20.0 19.8 19.6 19.4 19.2 19.0 a 1 2 3 4 5 6 7 8 9 10 1 1 -.T_, r - Tmnstdey Uuntinm - iditY Cawhinhd M Usmct .-TM_ An-idoad - Uiquid CoMIUUiUd k Umd@m _ Tmnstcy Umntcatd -Liquidity Cnund Trcandt Anticted - Liquidit Contmtio.d 50 FigLure 17 Foreign Interest Rate Shock - Consumption/Output Neoclassical Economy 0.610 . 0.606 0.602 .;,-X 0.598 / 0.594 0.590 i . . 0.586 4 0.582 0.578 _ _ _ . ................ ....... 0.574 0 1 2 3 4 5 6 7 8 9 10 11 -T_, T | _ - Ty UnqntiXs#U I T -- mnitery hWcited Non-Neoclassical Economies 0.610 - 0.606 - 0.602 0.598 0.594 0.590 0.586 0.578 . 0.574 0 1 2 3 4 5 6 7 8 9 10 11 -T-. T -- Tr-nikoey Unanticinm-I LiquiditFr Cano nw d & Un-fnvlyment .... Tmrw ntkiwSnd - Uquiditv Censtmipd & Una-wmnt _Tseae.ee tbaetieWtd - Uquidity Cnsrned -Traatcqv AnticiDqted - Uquidi* Censtmtuwd 51 Figure 18 Foreign Interest Rate Shock - Output Neoclassical Economy 1.030 1.026 1.022 1.018 1.014 - 1.010 . - 1.006 - 1.002 0.998 \ 0.994 0.990 . . . 0 1 2 3 4 5 6 7 8 9 10 11 -rT1 T 7- - T" U ntGp;d .....- Traml6by I"ikDCI| Non-Neoclassical Economies 1.030 1.026 - i.o22 -/- 1.018 1.014 1.002 0.998 0.994 0.990 -- O. 0O 1 2 3 4 5 6 7 a 9 l 10 I I-T1 T- - try Unenticipaed-Lmwityr Can&tsind * Umemnpwya"t ----Trennibwy Antiwipaetd - Laiqcii Constard JcUnn7¢yment _Trargsdtr lnaes.ted -iUquidity Consbawd rramnrkw beAnticctd - Liamidity Constliw 52 Figure 19 Foreign Interest Rate Shock - Reel Exchange Rcte Neoclassicol Economy 1.-04- _ 1-02 /-s .94 t. 1092 / - ~ . 0 1 2 3 4 5 6 7 B 9 lO I11 -T_1 T -TrilnetZ | Non-Neoclassical Economies 1.02 1.00/ 0.98. 0.961 .0.94 1 0.929 0.9o0 0 1 2 3 4 5 6 7 8 9 10 11 -T_1 Non T-site clasateld -Eiud Conamieds a _Tra_sd Unadcrkod - LkpuidRy Canolnod -Tfan=t Aniptute - L,iquidW Canxtmn el 53 Figiire 20 Foreign Interest Rate Shock - Real Interest Rate Neoclassical Economy 0.064 ' . 0.060 0-056 - .~~~~~, 0.052 - N00 0.048 0.044 0.040 - 0 1 2 3 4 5 6 7 8 9 10 II -.T, T - |- ~~~~~~~~Trenutly I _ ....-- Tntawy mwa| Non-Neoclassical Economies 0.064 0.060 .- . i . 0.056 0.052 0.044 -0404 0.04'0 0 1 2 3 4 5 6 7 8 9 10 11 -TL1 T - - Ttne.toey Unnbemootod - Liaotft CanastrVama Unemoyuiant -. .Tranmit Anticiated -Liauig&y Constumid k Ua no T onmiY Unanticpatud -ULqit7 Constrnwu Trmntom An.iooted - Li,uid4V Conitbmed 54 Figure 21 Foreign Interest Rate Shock - Investment/Output Neoclassical Economy 0.250 0.245 - 0.240 - 0.235 t -. 0.230 0.225: 0.220 .\ 0-no~~~~~~~ 0.215 0.210 - 0.205 x.- _----- =- - 0.200 0 1 2 3 4 5 6 7 8 9 10 11 -r., T - Tryat unantl"dt" 710--4- T Antilillt| Non-Neoclassical Economies 0.250 - 0.245 0.240 0235 0.230 0.225 0.2-20 0.215 0.210 0.205 0.2001 0 1 2 3 4 5 6 7 8 9 1 1 1 -T_, T 'c *Troneunri Ubicae.d - lUidIr Constrained a UnemvO#lIUt .rrans"b AntiCbaid - iJWGidiLy Caeatrined & U n eM Trang Unonticoated - LiUidity ConmWain:d Tarps" Anticiaat - ijuiditv Constrain d 55 Figure 22 Foreign Interest Rate Shock - Inflation Rate Neoclassical Economy 0.035 . . 0.030 0.025 N . .. . 0.020 0.015 -7 0.010 ; Z 0.005 - 0.000 -0.005 - 0 1 2 3 4 5 6 7 8 9 10 11 -T_, T Tr* Tmry Unofiptd| Non-Neoclassical Economies 0.03S 0.030 0.025 0.020 0.015 0.005- 0.000 -0.005 0 1 2 3 4 5 6 7 8 9 10 t 1 -T_, . _ . Toanat Unamticiatcd - uquIid;t Constrained a Unemlaoyment . . . Trom*Td Aticipated - Liquidity Constgin d & U.wtwnltymmt _- Tatmy ulntiepatad - Liquidily CoASto,ad - nituy Antciadste - Liquidit Con.ttmn.a 56 FigUre 23 Foreign Interest Rate Shock - Cur Acc Bal/Output Neoclassical Economy 0.00 -0.0/ ,-- -0.01 / .03 1 2 . 1 *- t ~/: Non-Neoclassical Economies --0.01 -0.02 -0.03 -0.04 -0.05- 3 1 2 3 4 5 6 7 8 9 10 1 l -+T_l T TrMMAn- DN - LTseq U n_ o u|a -r,,gt U| u X - - - Liquindiy Co |b Te'onuitorlayAtiiDoNd - UEaidt Contouisd 57 Figure 24 Foreign Interest Rate Shock - Real Wage Neoclassical Economy 0.614 0.610 :~~ _ - 0.606 f - 0.602 , 0.598 N- 0.594 0 1 2 3 4 5 6 7 8 9 10 II -_,l T Non-Neoclcssiccl Economies 0.614 _ , 0.610 0.506 0.598 0.9 1 2 3 4 5 6 7 8 9 10 I11 -T_, T -- Ttmn Unenticuu. - LiUavd*r COutrb & UnebnIGuWa .T---- itmy DAtiip,t. - luiddit Ca.tmu. d U _mpl.nt Ttreunt Unanhicitd - liSUidi Comutrs..6 Tra sitaqy Antrucited - LiWuidity Coant1Ma" - ~~~~~~~~~~58 Figure 25 Foreign Interest Rate Shock -Employment Neoclassicaf Economy 1.025 1020 1.015 1.010 1.005- 1.000 0.995 0. 990 0.985 A0 1 2 3 4 5 . 7 8 9 10 II-4T.1 T Non-Neoclassicci Economies 1.025 0.995 0.990 0.98. 03 1 2 3 4 5 6 7 8 9 10 I11 -T_, T |-Truumy -non6ckwted - Li_idity Cunutmd a Unal"may .Trwitmo Afiticitu t Uwidity Co.strmi.d & UnwuituIoni - 01-n7 UN-Mas LiquiEc Comied -Trguatm Mt,ciuqtg t imuiditv Conutmuifld Policy Research Working Paper Series Contact Title Author Data for paper WPS1278 Regulation and Commitment in the Ahmned Gala! March 1994 B. Moore Development of Telecommunications 38526 in Chile WPS1279 Optimal Hedging Strategy Revisited: Ying Oian March 1994 S. Lipscomb Acknowledging the Existence of Ronald Duncan 33718 Nonstationary Economic Time Series WPS1280 The Economic Impact of Export Wendy E Takacs March 1994 M- Patefna Controls: An Application to Mongolian 37947 Cashmere and Romanian Wood Products WPS1281 Human and Physical Infrastructure: Emmanuel Jimenez April 1994 L Longo Public Investment and Pricing Policies 37786 in Developing Countries WPS1282 Copper and the Negative Price of DonaldFrederick Larson April1994 A. Kim Storage 33715 WPS1283 Interest Rates in Open Economies: Dipak Das Gupta April 1994 B. Kirn Real Interest Rate Parity, Exchange Bejoy Das Gupta 82467 Rates, and Country Risk in Industrial and Developing Countries WPS1 284 The Soviet Economic Decline: William Easterly April1994 RF Martin Historical and Republican Data Stanley Fischer 31320 WPS1285 Capital Fundamentalism, Economic RobertG. KCing April 1994 P. Sintim-Aboagys Development, and Economic Growth Ross Levine 38526 WPS1286 Economic Transformation and the Luca Barbone April 1994 S. Harbi Fiscal Crisis: A Critical Look at the Domrenico jr. Marchetti 37143 Central European Experience of the 1990s WPS1287 Unstable Inflation and Seignorage Jacques Morisset Apr 1994 D. Jenkins Revenues in Latin America How Many 37890 limes Can the Govemment Fool People? WPS1288 The PublicFinanceof Infrastructure: VinayaSwaroop April1994 C. Jones Issues and Options 37699 WPS1289 A Fiscal Needs Approach to Equali- AnwarShah April 1994 C. Jones zation Transfers in a Decentralized Federation 37754 WPS1290 Oil Price Instability, Hedging, and an Stijn Claessens April 1994 D. Gustafson Oil Stabilization Fund: The Case of Panos Varangis 33714 Venezuela WPS1291 A Survey of Viet Nam's Legal Natalie G. Lichtenstein April1994 M. Rangarajan Framework in Transition 81710 Policy Research Working Paper Series Contact Title Author Date for papar WPS1292 Services as a Major Source of Growth William Easterly April 1994 C. Rollison in Russia and Other Former Soviet Martha de Mob 84768 States Gur Ofer WPS1293 Product Standards, Imperfect Glenn Harrison April 1994 N. Artis Competition. and Completion of the Thomas Rutherford 38010 Market in the European Union David Tarr WPS1294 Regulations. Institutions, and Hadi Salehi Esfahani April 1994 B. Moore Economic Performance: The Political 35261 Economy of the Philippines' Telecommunications Sector WPS1295 Why Higher Fiscal Spending Persists Bruno Boccara April1994 M. Pfeif!enberger When a Boom in Primary Commodities Ends 34963 WPS1296 Earnings-Related Mandatory Salvador Vald6s-Prieto Apnl 1994 H. Rizkalla Pensions: Concepts for Design 84766 VNPS1297 How Relative Prices Affect Fuel Charles C Guo May 1994 C. Jones Use Patterns in Manufacturing: Jaames R. Tybout 37699 Plant-Level Evidence from Chile WPS1298 Capital Goods Imports, the Real Luis Serven May 1994 E- Khine E Exchange Rate, and the Current Account 37471 VWPS1299 Fiscal Policy in Classical and Klaus Schmidt-Hebbel May 1994 E- Khine Keynesian Open Economies Luis Serven 37471 WPS1300 Dynamic Response to Extemal Klaus Schmidt-Hebbel May 1994 E. Khine Shocks in Classical and Keynesian Luis Serven 37471 Economies WPS1301 Estimating the Health Effects of Bart Ostro May 1994 C. Jones Air Pollutants: A Method with an 37699 Application to Jakarta WPS1302 Sustainability: Ethical Foundations Geir B. Asheim May 1994 C. Jones and Economic Properties 37699