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WORKING PAPERS
TranslUon and Maror-Adjutment
Country Economics Department
The World Ban
December 1992
WPS 1061
Dynamic Response to Foreign
Transfers and Terms-of-Trade
Shocks in Open Economies
Klaus Schmidt-Hebbel
and
Luis Serven
Both permanent and transitory disturbances can change long-
run capacity and output - although they may have opposite
effects on the current account. Liquidity constraints and wage
rigidities tend to amplify the cyclical adjustment to external
shocks.
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Transition and Mfiacro-Adjustment|
WPS 1061
This paper - a product of the Transition and Macro-Adjustment Division, Country Economics Depart-
ment -is part of a larger effort in the department to understand macroeconomic adjustment in developing
countries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington,
DC 20433. Please contact Anna Maranon, rom Ni 1-039, extension 39074 (December 1992, 46 pages).
The transmission of shocks and po!icy changes namic effects of foreign transfers and of a tenms-
depends crucially on the structure of the of-trade windfall in the form of a lower price for
economy. Schmidt-Hebbel and Serven analyze an imported production input. They contrast the
the impact of two classes of external shocks in role of Keynesian elements with the neoclassical
open economies, using a rational-expectations factors in determining the dynamic adjustment to
framework that nests three prototype economies: shocks, by analyzing the effects of permanent/
transitory and anticipated/uanticipated distur-
A neoclassical, full-employment benchmark bances in the three prototype economies. The
em inomy, with intertemporally optimizing results illustrate three main points:
consumers and firms and Insantaneous clearing
of asset, goods. and factor markets. * Both permanent and transitory disturbances
cause changes in long-run capacity and output.
*A full-employment economy, with partly
liquidity-constrained consumers and investors. * Transitory and permanent shocks may have
opposite effects on the current account; in
* A Keynesian economy exhibiting both particular, a permanent favorable foreign shock
liquidity constraints and wage rigidity, which produces a current account deficit, while a
results in transitory unemployment, transitory favorable shock induces a current
account suiplus.
Their model is forward-looking in that the
short-run equilibrium of the economy dependg on * Liquidity constraints and wage rigidities
current and expected future values of all exog- tend to amplify the cyclical adjustnent to
enous variables, and displays hysteresis (that is, extenal shocks.
its long-run equilibrium is path-dependent).
Using parameters for a representative open
economy, they simulate and compare the dy-
The Policy ReseachWorking Papr SePres disseminate the fedmgs of woseiway m theBank Anobjectveof the series
is to get these findings out quickldy, even if presentation are less tha fully polished. 'Me fmdings, hiterpretations, and
conclusions in these papers do not necessarily repesent official Banlc polic y.
Produced by the Policy Resarh Dissmtion Center
DYNAMIC RESPONSE TO FOREIGN TRANSFERS
AND TERMS-OF-TRADE SHOCKS IN OPEN ECONOMIES
by
Klaus Schmidt-Hebbel and Luis Serven
The World Bank
We are indebted to Wanwick McKibbin and Steven Symanski for stimulating discussions of
model solution and simulation techniques. We thank Leonardo Auernheimer, Michael Ellis and
participants at the XIth Latin American Meetings of the Econometric Society (Mexico, September
1-4, 1992) and at the World Bank Macroeconomics Seminar for useful comments. Very efficient
research assistance by Paul Bergin and Gylfi Zoega is gratefully acknowledged.
ThE CONTEM
1. INTRODUCTION ....................................... I
2. THE MODEL. 2
2.1 Budget Constraints .................................. 3
2.2 Market Equilibrium Conditions. 7
2.3 Firms. 9
2.4 Consumers .11
2.5 Government .13
2.6 Foreigners .14
3. STEADY STATE AND STABILITY .14
3.1 The Steady State .14
3.2 Dynamics, Stability and Model Solution .17
4. SIMULATION RESULTS ..19
4.1 Model Parameterization and Initial Steady-State Solution .19
4.2 A Foreign Transfer Shock .23
4.3 A Permanent Oil Price Windfal .26
5. CONCLUDING REMARKS .29
REFERENCES
FIGURES
1. INTRODUCTION
"Despite the increased attention that macroeconomic management in developing countries
has received during the past decade, no consensus has emerged on the appropriate
framework for the study of developing country macroeconomic issuds ... This lack of
consensus ... is even more pronounced et the empirical level" (Haque, Lahiri, and
Montiel, 1990).
The current outlook of the developing world is rather mixed. High growth and stable
macroeconomic balances characterize the economies of old and new East Asian tigers. A return to
fore:gn financing flows, significant real exchange rate appreciations, and booming stock markets are
observed in many highly-indebted countries, with some of them leaving this category as they overcome
the debt problem that haunted them for the last decade. Other developing and former socialist economies
are barely initiating ambitious stabilization and structural reform programs, whose short-term costs excpiZ
most forecasts. Finally, a number -)f developing economies -- many in Sub-Saharan Africa -- face
stagnation as a result of depleted resource bases, external shocks, and/or massive domestic
mismanagement.
While this paper is far from offering a comprehensive assessment of the various "challenges of
development" faced by these country groups', its more limited objective is to analyze some of the macro
management issues faced by most of them. For this purpose the paper develops a small open economy
model and applies it to assess the orders of magnitude of the effects of two frequently analyzed external
shocks.
As the opening quotation states, a bewildering variety of macroeconomic tools is available 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 - snch 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 Neo-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 el., 1982,
Lipton and Sachs 1983, Bruno and Sachs 1985, McKibbin and Sachs 1989). Nesting of classical and
Keynesian benchmarks 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 two dimensions. First it extends the analytical structure by incorporating simultaneously several
realistic features that are particularly relevant for developing countries: nominal rigidities, monetary
finance of budget deficits, import content of capital goods, foreign holdings of domestic equity, and
public investment. Second, it explores in some detail the short- and long-term consequences of liquidity
constraints affecting private consumption and investment behavior. The analysis is based on the
comparison of the differential effects of external shocks under Keynesian and neoclassical benchmarks,
both for permanent/transitory and anticipated/unanticipated disturbances.
I See the 1991 World Development Report under this title (world Bank, 1991) for a comprehensive treatment of current
development issues.
-2-
The paper is organized as follows. Section 2 spells out the model stvc. cure, which is based on
the distinction of the domestic private sector (households and firms), the consolidated public sector, and
the external sector. The private sector comprises one group of intertemporally-optimizing agents with
another of liquidity-constrained (or myopic) agents. The domestic economy produces one single good,
while the reit of the world produces both an intermediate input and a final good; the three goods are
imperfect substitutes. The asset meni 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 full 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 effects, whose
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 two favorable external shocks: a unilateral foreign
transfer and 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-impoting economy). The section
discusses and compares the effects of the two shock classes on the dynamic pattern of the main
endogenous variables, for different combinations of structural benchmarks (neo-classical, 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 basic features of the model represent a compromise between theoretical rigor, real-world
relevance, and model implementation costs. The domestic economy produces one single final good, which
can be used for consumption and investment at home, or sold abroad. The domestic 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 government plus the central bank), foreign assets and equity claims on the domestic
capital stock. Money allows for inflationary finance of budget deficits. In the absence of risk and
uncertainty, all non-monetary assets are assumed to be perfect substitutes, and there are no restrictions
to capital mobility. Hence their respective anticipated returns satisfy the corresponding uncovered parity
conditions. Foreigners hold domestic equity but not domestic public debt. Finally, 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
2 Foreign assets held by the domestic private and public sectors are net assets (equal to gross foreign reserves plus other
gross foreign assets less gross foreign liabilities) and therefore can have either sign.
-3 -
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 react 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-constrained firms and households, along with wage inflexibility3.
Following the standard theory of investment under convex adjustment costs (Lucas, 1967, Treadway,
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 installation 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 functions). 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, starting 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.4 The model is written in
continuous time. Dots over variables denote instantaneous time derivatives.
2.1 Budget Constraints
There are three basic agents in the model: the consolidated public sector, the domestic private
sector, and the external 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. Wnile some further disaggregation between firms and consumers is implicit
below, we do not need it at this stage.
3 Money demand, exports, and wage setting are the only behavioral equations in the model not derived from first
principles.
'Labor force in efficiency units is equal to the actual labor force augmented by Harrod-neutral technical progress (see
table 1).
- 4 -
TABLE 1: NOTATION AND DEFINITION OF VARIABLES
I. Labor and Emglovment
L Absolute employment
LF = LFo exp(pg t) Absolute labor force
LFo Base-period absolute labor force
N = L exp(tg t) Absolute employment in efficiency units
NF = LF exp(tg t) LFo exp(g t) Absolute labor force in efficiency units
pg Population growth rate
tg Harrod-neutral technical progress rate
g = pg + tg Growth rate of absolute labor force in efficiency units
t Time index
I= L/LF = N/NP Employment (relative to labor force)
Id Labor demand (relative to labor force)
2. General Notation
All stock and flow vacables other than interest rates are defined in real terms and in efficiency labor force units.
Current-price domestic (external) income and transfer flows and prices are deflated by the price of.the domestic good (external
price deflator), All stock and flow variables other than prices and interest rates are defined in terms of units of effective labor
force. Domestic (external) relative prices are measured in real domestic (external) currency units. A dot over a variable denotes
its time derivative.
3. Income. Transfer and Capital Flows
Domestic:
d Dividends paid
op Operational profits
td Taxes
yd Private disposable income
prem Profit remittances abroad
External:
ftrg Foreign transfers to the public sector
ftrp Foreign transfers to the private sector
yf Foreign income
dfi Direct foreign investment
4. Stocks
Domestic:
a Non-human wealth of the private sector
bg Domestic debt of the public sector
fe Stock of domestic equity (shares in domestic firms) held by foreigners
hb Domestic base money
hu Human vwealth of the private sector
k Physical capital
pvig Present value of government investment subsidy
pvihb Present value of cost of holding money
External:
fbg Foreign assets held by the public sector
fbp Foreign assets held by the private sector
TABLE I (Cont )
iS. GoodS PSows
y Gross output of fmal goods
cp Private aggregato consumption
cmp Private imported -iods consumption
cnp Private national-goods consumption
ong Public national-goods consumption
inv Gross domestic invostment
in Private national-goods investment
im Private imported-goods investment
is Public investment subsidy
iao Investment adjustment costs
x Exports
mr Intermediate imports
6. YAdos RaX
Domestic (External) Rates:
i (if) Nominal interest rate on public debt (foreign assets/liabilities)
r (rf) Real interest rate on public debt (foreign assets/Uabilities)
i-r (if-rf) Anticipated domestic (Extemal) inflation rate
nmg Rate of growth bf the nominal money stock
7. Goods Prices
Domestic (all relative to the price of the domestic final good):
pc Private aggregate consumption deflator
pi Aggregate investment deflator
External (all relative to the price of the foreign final good):
pcmp Private imported-goods consumption deflator
pim Imported-goods investment deflator
pmr Intermediate imports deflator
px Deflator of export-competing goods
8. Other Prices
Domestic Prices:
q Real equity price (Tobin's Q) in units of domestic output
v Real wage per effective labor unit
W * Nominal wage per labor unit
PC Nominal private consumption deflator
Real Exchange Rate:
e = (E P)/P Real exchange rate
E Nominal exchange rate
P Nominal price of the domestic good
PI Nominal external deflator (foreign price level)
-6-
Walras' law makes one of the three sectoral budget constraints, when combined with goods and
assets markets clearing, redundant. Hence we present the three budget constraints below only for
expositional convenience. They are written equating 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
!abor (g) and inflation.
Public expenditure inciudes public consumption, which is assumed to fall entirely on domestic
goods, an investment subsidy paid to domestic firms', 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 - cng - piig] - (r-g)bg + (g+P/P!hb
(1)
+ e(rf - g)fbg = efbg - bg -ib
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 w,ll 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:
[% - pcmp mp - pim im - pmr mr + ftrg + ftp]
(2)
+ (rf-g) [fbp + fbg] - Prem = (fp + fbg) - dfl
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 - pff fe + (rf-g) e fbp
= fib + bg - e dfi + e f6p
Public sector ownership of the capital stock could be mimicked by introducing a tax on profits proportional to the
cumulative volume of public investment. For simplicity, we do not pursue this option here. Also, we are implicitly
assuming that public investment is a perfect substitute for private investment.
2.2 M kt Euilibriurn, 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.
Goods 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.
Equilibrium in the market for domestic goods can be expre3sed:6
(4) y = cap + cng + 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, external interest
rate determination in international markets (the small country assumption for financial markets), and
absence of uncertainty (no risk premia). Imperfect substitutability between base money and other assets
is reflected by a conventional transactions-based demand for base money. In turn, 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 mone5 demand (Cagan,
1956):'
(5) hb = it y 2 exp(43i)
where 0P1, O02 2 0, 4)3 & 0.
6 Notice that gross output y differs from conventional national-accounts value added or GDP for two reasons: y is
defined as gross of the value of intermediate imports (c pmr mr) and gross of the value of investment adjustment costs (pi
iac).
I Money demand could be cxplicitly derived hI_.n first principles by bringing money into the utility function (Sidrausky,
1967) or the production function (Fischer, 1974), or by imposing a cash-in-advance transactions technology (Clower, 1967).
Easterly, Mauro and Schmidt-Hebbel (1992) present a generalized cash-in-advance transactions technology (with iso-elastic
substitution of money and bonds) giving rise to a variable elasticity of money demand with respect to inflation, generalizing
the iso-elastic Cagan form. Since each of these options has well-known drawbacks, however, and also to facilitate
comparability with other (simpler) applied macroeconomic models, we choose the standard formulation in equation (5).
-8 -
Arbitrage between domestic and foreign bonds leads to the uncovered interest parity condition:
(6) r = rf + e
e
Similarly, arbitrage between equity and domestic public bonds is reflected by the following
market equilibrium condition for equity prices (Tobin's q):
(7) r q d
Finally, the nominal interest rate is defined by the standard Fisher equation:
(8) i = r + 4/P
Labgr 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 = Id
Tie 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 o with regard to employment). Anticipating the
simulations, the nominal wage equation is written in discrete-time form:
W = exp(tg)1( - w,.
wherewa 0, 0 5 0 s 1.
Using the relation between the nominal wage and the real (product) wage per effective labor unit:
W
= exp(tg t) v
we obtain, after some manipulations, the following real wage equation:
pclIOp-1/p-2 I1-8
(10) V = PC( VE )( ) [ j
PC_l) VPC-2 J lP/F- J -
This wage rule encompasses several interesting cases. First, when X tends to infinity, it collapses
into the neoclassical full employment condition. Second, for finite X and 0 = 1, it represents the case of
real wage resistance. In turn, with finite co and 0 < 1, wages display nominal inertia. Finally, ex-post
inflation can be defined from the relation between real and nominal balances per effective labor unit:8
p hb-I (1+nmg_l)
P -1 hb (1+g)
2.3 Firms
Technology is summarized by a Cobb-Douglas production function for gross output with Harrod-
neutral technical progress, and quadratic adjustment costs for investment. The investment technology
combines domestic and imported final goods according to a Cobb-Douglas specification, which allows
for two-stage budgeting.9
There are two groups of firms. The first group is not subject to liquidity constraints and
determines its investment according to the maximization of market value -- i.e., the present value of
future dividends -- subject to convex adjustment costs. Investment 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 effect whatsoever on investment levels by of unconstrained firms;
for them, 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 Cobb-Douglqs production function,
which allows for substitution between value added (capital and labor) and intermediate imports:
(11) y = do ld"t ka2 mr(1-at-a
where a 2 0, ° S 1' d2S1.
'Notice that, from (8), i-r is a measure of anticipated one-period ahead inflation. Because of the rational expectations
assumption, it will equal actual (one-period ahead) inflation except at times of 'news' about the current and/or future paths
of the exogenous variables.
I Widasin (1984) provides exact conditions under which the investment technology gives rise to a two-stage investment
decision. See also Hayashi and Inoue (1991) for a recent generalization with empirical applications.
10-
investment adjustment costs are defined by:
(12) iac = 4[(inv - (g+6)k)2}
where IA > 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) miV - (g+8)k
Market value maximization for unconstrained firms, as well as current profit maximization for
constrained firms, yields the standard marginal productivity conditions for variable inputs (labor and
imported materials):'"
(14) Id = I v-1 y
(15) mr ( -cal- 00)(e pr)-l y
Investment demand is, as described above, a combination of the market-value maximizing
investment rule of unconstrained firms and the profit-constrained investment of restricted firms:
(16) inv = 1 [k [pi pik + ] [
where P, is the share of non-constrained firms and P. is the marginal propensity of liquidity-
constrained firms to invest out of operational profits; O&,PBlP2s&.
Unconstrained investmnent (the content of the first large right-hand side parenthesis) is derived
from maximization of the value of the firm. This component of aggregate investment demand is geared
to Tobin's marginal q -- i.e., average q minus the present value of the public investment subsidy per
unit of capital"1. 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
cc. trast, the average value of existing capital (i.e., the present value of the dividends associated with an
10 The derivation of these conditions, as weU as of the unconstrained component of investment in equation (16) below,
follows the standard maximization of the value of the firm, subject to equations (11) - (13), not presented here for brevity.
"' The general reasons that cause marginal and average q to diverge are spelled out in Hayashi (1982).
- 11 -
installed unit of capttal) must include the subsidy. In turn, investment by constrained firms (the last term
in the night-hand of (16)) rises one-for-one with the investment subsidy.
The present value of the public investment subsidy is implicitly defined by the dynamic equation:
(17) pvig = (r-g) pvig - pi ig
Aggregate operational profits -- which determine capital formation by liquidity-constrained f;rms
-- are defined as:
(18) op = y - v -e pmr mr
and dividends are the sum of operational profits, net of investment expenditure, the investment subsidy
and the proceeds of new issues of equity:
(19) d = op - piinv - pi iac + piig + q(k + gk)
After determining aggregate investment according to equation (16), the second-stage investment
decision involves allocating investment expenditure between domestic goods and imports, according to
a Cobb-Douglas aggregation which renders constant expenditure shares:
(20) in = y pi inv
(21) im = (1-Y)[ pi inv
le piml
where y is the share of national-goods investment in aggregate investment expenditure, satisfying
0 s y s 1.
Therefore the aggregate investment deflator is a Cobb-Douglas average of national-goods
investment prices and imported investment-goods prices:
(22) pi = (e pim)'')
2.4 Consumers
Consumer preferences also allow two-stage budgeting, distinguishing between intertemporal
aggregate consumption decisions and intratemporal consumption composition choices. Intertemporal
preferences reflect unit intertemporal elasticity of substitution (i.e., logarithmic intertemporal utility);
- 12 -
intra-temporal preferences also display unit elasticity of substitution between domestic and imported
goods.
Private sector non-human wealth includes four assets: base money, domestic public bonds, foreign
assets, and equity claims on the domestic capital stock.
(23) a = hb + bg + e fbp + q(k-fe) - pvihb
where the present value of money holding costs pvihb has to be subtracted from financial wealth; it is
implicitly defined by the dynamic equation:
(24) pvihb = (r-g) pvihb - i hb
Human wealth is the present value of future labor income, net of taxes, and inclusive of current
external transfers'2. Under the assumption that individuals can freely borrow against their future labor
income at the going real interest rate, the path of human wealth is characterized by:
(25) liu = (r-g)hu + [td - vl - e ftrp]
Consumption of non-liquidity constrained consumers is derived from standard maximization of
intertemporal utility over an infinite horizon, subject to the intertemporal budget constraint equivalent of
the private sector flow constraint in equation (3) -- which is exactly consistent with wealth definitions
in equations (23) - (25). Solving the maximization problem yields the standard result that private
consumption of unconstrained households is equal to the subjective discount rate (net of effective labor
growth) times total (human and non-human) wealth.'3
Unconstrained consumers are of course Ricardian, as they internalize the government's
intertemporal budget constraint by anticipating the entire stream of current and future tax payments.
Because liquidity-unconstrained consumers face the same discount rate as the government", they are
indifferent between tax, debt, or money financing. Therefore government debt - although included in
equation (23) -- ultimately "is not wealth" (Barro, 1974).
12 For expositional convenience, aU taxes and transfers have been lumped together in the human capital flow equation.
'' As before, the analytical derivations are standard and can be omitted.
14 The assumption of equal discount rates is crucial for Ricardian equivalence to hold. Higher private sector discount
rates, whether due to finite lifetimes (reflected by a given probability of death, as in Blanchard, 1985) or to a risk premium
on consumers' debt relative to the borrowing cost of the government (e.g., McKibbin and Sachs, 1989) would cause
Ricardian equivalence to break down.
- 13 -
Total private consumption demand is an aggregate of consumption by unconstrained and
constrained consumers, with the latter consuming their current net labor income:'-
(26) cp 12 - g) AK + (1 -Al) hu 2 PC]
I ~~~PCJI [PC PC]
where O s Al 1 is the share of unconstrained consumers, and A. is the subjective discount rate.
Disposable income is deflned by:
(27) yd - v 1 + e ftrp - td
After determining aggregate private consumption levels according to equation (25), the second-
stage private consumption decision allocates it to domestic goods and imports, according to Cobb-Douglas
intratemporal preferences:
(28) Cap = T PCCP
(29) cmp = (1-) Cp
- ~ ~~ Le pcmpj
where 0 s l s 1 is the share of national-goods in aggregate private consumption expenditure.
Therefore the aggregate private consumption deflator is a Cobb-Douglas index of national-goods prices
and imported consumption goods prices:
(30) pc = (e pcmp)(-lq)
2.5 Govemment
The public sector could either determine policy exogenously or derive 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
between taxes, money, domestic debt or external borrowing (or any combination of them).
's Unconstrained consumption is derived from the standard intertemporal utility maximization, subject to the preference
structure mentioned above and an intcrtemporal budget constraint which combines equations (23) - (25). The derivation is
not presented here for brevity. For discussion and empirical analyses of the implications of liquidity constraints for
consumer behavior - as well as for Ricardian equivalence - see Hayashi (1985), Hubbard and Judd (1986), Bcrnheim
(1987) and Leiderman and Blejer (1989).
- 14 -
The accumulation of per capita real balances can be characterized as:
(31) hb = [nmg - (P/P) - g]hb
where it is worth noting that the rate of money growth will be endogenous under money finance of the
deficit and exogenous otherwise.
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) x = p1 (e px)P2 yf PI
where PI. P2, p3 k 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:
(33) fe = e _ 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 = fe d
k
3. STEADY STATE AND STABILITY
3.1 The Steady St
The long run equilibrium of the model is characterized by constant asset stocks in real per capita
terms, constant asset prices (i.e., Tobin's q and the real exchange rate) and constant real wages with full
employment. Thus, the government's budget must be balanced, and the current account deficit- must equal
the exogenously given flow of foreign investment.
- 15 -
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, 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
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 only
cease when per capita consumption equals the per capita return on wealth. But the latter is just (r-g) times
the wealth stock (because of the assumption of perfect asset substitutability), while in the steady-state the
former equals (N2-g) times the wealth stock (from (25)-(27)). Hence, this implies the well-known result
that the rate of time preference 12 must equal the domestic and foreign real interest rates:
(35) .2 = r = rf
Thus we would be left only with the goods market equilibrium condition to determine both wealth
and the real exchange rate. This means that their steady-state values (and hence also those of all 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
time preference and facing perfect capital markets.
Nevertheless, certain important features of the steady state can easily be determined"6. On the
production and investment side, long run equilibrium is characterized by full employment and a constant
capital stock in per capita terms. From (13), gross investment is just inv = (g+5)k, and adjustment costs
are identically zero (from (12)). In turn, from (7), (17), (18) and (19), Tobin's q in steady state is given
by:
(36) q - (rf-g) + pvig/k
where Fk is the marginal productivity of capital. If no firms are liquidity constrained (that is, Bl= 1 in
(16)), then (16) further guarantees that marginal q equals the price of capital goods or, equivalently, that
average q equals the price of capital plus the unit investment subsidy (i.e. q = pi + pvig/k). Thus, from
the above equr in the marginal product of capital equals its user cost:
16"Giavazzi and Wyplosz (1985) provide a method to solve analytically certain linear models with hysteresis. They show
that the long-run equiLibrium depends on initial conditions and on the speed of adjustment of the system. Since our model is
nonlinear, however, a comparable solution technique is not available.
- 16 -
(37) Pk - pi (rf+8)
Notice, however, that pi is an increasing function 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: a real depreciation must reduce the long-
run 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 (i.e., B, < 1) ? The negative long-run relationship
between the capital stock and the real exchange rate is unaltered; however, 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 (12 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) Pk = pi [(rf+8) + fl
where f > 0 is a term that depends positively on the adjustment cost coefficient it and the rate of
depreciation of capital, and negatively on B,, 13 and the investment s5t *.)dy.19 Tobin's q under liquidity
constraints becomes:
(39) q P= [(rf+6) + fl p
(rf +8)
The intuition behind these results is simple: with binding liquidity constraints, finns 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 cost. This implies that, for a given long-run real exchange rate, liquidity
" This is in contrast to similar dynamic models (e.g., Sachs (1983), Giavazzi et al. (1982)), where capital goods have
no import content and thus the steady-state marginal product of capital (as well as the capital stock and real output) depends
only on the relative price of materials in terms of domestic goods (e pmr in our notation). Here the import content of capital
goods creates a negative relationship between the real exchange rate and Pk, even for a given real cost of imported inputs.
Gavin (1991) and Serven (1991) have shown that this has important consequences for the effects of macroeconomic policies
on investment.
' The exact condidon is B2 < (g+S)/(rf+8).
"The exact expression for f is f - P,(tf+8) + (14,) 2. (rf-gXg.6) - (rf+8) , where z is the public
PI + (1-p4) 21& (rf-g)(P2+-!-)
investment/gross output ratio.
- 17 -
constraints will cause the economy to achieve a lower capital stock and output, and a lower real wage
as well, than in the fully unconstrained case.
Using (37) or (38), the steady-state goods market equilibrium condition (4) can be rewritten as:
(40) y(e,...)= ri (rf-g)(a+hu) + cg + y pi (g+8) k(e,...) + x(e,...)
which defines an inverse relationship between the long-run real exchange rate and real wealth: an increase
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 equilibrium.' 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-run 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 cg 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 disturbances have
lor!g-run effects. For the case of fiscal policy, this has been recently highlighted by Turnovsky and Sen
(1991) in a non-monetary model.2" 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-
run wealth and a permanent real depreciation.
3.2 Dynamics. Stability and Model Solution
The precise dynamics of the model depend on the way the public deficit is financed. 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 predetermined variables have to satisfy well-defined initial
21 This is guaanteed by our assumption of constant expenditure shares of domestic goods and imports in private
consumption and investment. With more general specifications allowing lower substitutability between domestic and foreign
goods, a positive association between real wealth and the real exchange rate in steady state (i.e., a 'contractionary
devaluation' of the type analyzed by Krugman and Taylor (1978)) could not in principle be ruled out.
21 Tumovsky and Sen (1991) use a model with intertemporally optimizing consumers to show that transitory fiscal
disturbances have long-run effects. Their result depends criticaUy on the endogeneity of labor supply in their framework,
which makes long-run employment endogenous. In our case, the dependence of the long-run capital stock on the real
exchange rate ensures that transitory fiscal shocks have permanent effects despite the constancy of full employment across
steady states.
n Without liquidity constraints, a monetary acceleration (an increase in nmg) would just amount to a change in the
composition of taxation between the inflation tax and (present or future) direct taxes, without any effect on wealth,
consumption, or any other real variable.
- 18 -
conditions. Under debt (domestic or foreign) finance, a fifth dynamic equation describes the time path
of the relevant debt stock.
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 predetermined by the past and can react
freely to 'news' about the current and future values ol' the 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 hereP.
However, this is not the case for large nonlinear models such as this one4. 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 different techniques exist. One leading example is the "multiple shooting"
method proposed by Lipton et al. (1982), which solves the model over a fixed time horizon starting from
arbitrary guesses for the initial and future values of the jumping 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 until 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 a given
time horizon using multiple shooting. Then we extend the horizon and recompute the solution path until
the resulting changes in the solution trajectory of the endogenous variables fall below a certain
tolerance25, at which time the process stops. In practice, the length of the simulation horizon required
for this procedure to converge is strongly affected by two parameters goveming the speed of adjustment
of the system: the elasticity of real wages to unemployment (i.e., the slope of the augmented Phillips
curve), and the magnitude of adjustment costs associated with investment. Finally, the model is
discretized for the numerical simulations, so for any variable x, x= 1 - X.
2 See Blanchard and Kahn (1980) and Buiter (1982).
2e In principle, we could linearize the system around a steady state to determine the conditions under which the tansition
matrix possesses the saddle-point property. But for a tenth-order system this would be an analytically intractable task.
2s We used a very strict convergence criterion, requiring that the maximum relative change between solutions in any
variable at any time period not exceed one-thousandth of one percent. This typically required a horizon between sixty and
eighty periods for convergence.
-19-
4. SIMULATION RESULTS
This section discusses the dynamic response to external shocks, by presenting simulation results
for the model introduced above. We simulate the dynamic adjustment to a favorable foreign transfer
shock (an external grant) and a favorable terms-of-trade shock (a decline in the price of the intermediate
import used in production, say oil). The first-round magnitude of both shocks is common, equivalent
to a 4% gain of initial steady-state GDP. 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
According to the model structure spelled out above, three economies will be considered. (i) a
neoclassical (NC) benchmark, (ii) an economy with liquidity constraints but 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 (l3 = XI =
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 (w = 1,000)
and indexation to lagged consumer-price inflation is ruled out (O = 1.0). By contrast, wage-setting
behavior in the Keynesian benchmark gives rise to unemployment, as a result of a low employment
elasticity (o = 0.25) and an important role of lagged inflation (E = 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 exhibits a unitary income elasticity. The
inLerest semi-elasticity is 0.5, implying a seignorage-maximizing inflation rate of 200%. The share of
labor, capital and intermediate imports in production (gross 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 interest rate. Export demand exhibits a unitary foreign-income elasticity.
The price elasticity of the 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
is total taxes (td); for the private sector the residual budgetary variable is foreign asset holdings (fbp).Y
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
2 Actual model simulations assume that the private sector intratemporal budget constraint (equation (3)) is the redundant
budget constraint, hence it is excluded from the set of model equations. (Obviously the intertemporal budget constraint is
used in deriving optimal private consumption levels). Hence td and fbp are the endogenous variables associated to the
public sector budget constraint (1) and the external sector budget constraint (2), respectively.
- 20 -
the initial steady state, common to the three economies. While the simulations show the response to a
change in two exogenous variables (foreign transfers and price of Intermediate imports), 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 both foreign and domestic capital markets is 0.30 and 0.20, respectively. Ihe 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 efficiency 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, non.inal 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)27 are reported in table 4. Initial (and
final) steady-state output growth is determined 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 (3.0) 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
output). At non-stationary equilibria, accumulation of money holdings drive 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 (0.10) are financed by foreign transfers (0.03), the net return
(net of growth) on foreign-held assets, which yields 0.017, and direct foreign investment flows (0.005).
27 As discussed in section 3. 1, Tobin's q is higher and investment is lower under binding liquidity constraints than in the
neoclassical economy. In fact, initial steady-state values in the LC economies are 1.479 for q and 0.208 for gross domestic
investment, which can be compared to the stationary 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 more
than offsets lower foreign assets held by the private sector (equal to 0.853 in the LC economies). Hence steady-state total
consumer wealth and consumption are slightly larger in the LC economies. The stationary trade deficit is slightly lower in
the LC economies, as the return on foreign asset holdings has slightly deteriorated due to the lower stock of private foreign
asset holdings. AU other variables remain unchanged in the LC economies as compared to the NC case.
-21 -
The latter flow finances an Initial current account deficit (net of accumulation of foreign assets to maintain
constant asset/output ratios) of 0.005.
The steady-state nominal Interest rate of 8% equals the sum of long-run domestic Inflation sid
the real Interest rate. At a real exchange rate of 1.0. all relative goods prices are also equal to 1.0. The
price of equity in units of national goods (q) 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.
TABLE 2: PARAMETER VALUES FOR SIMULATIONS
Base money demand * 0.16, ' - 1,. Os - O.S
Wage-seting rule - 1,000 (Neolusioal and Liquidity Constaints) or 0.25 (Liquidity
Constraints with Unemployment), e - 1.A (Neoclauioal and Liquidity
Constraints) or 0.5 (Liquidity Constraints with Unemployment)
Production function ao - 0.91, - 0.6, , - 0.3
Investment adjustment costs p - 2.S
Physical capital deprwiation rato 5 - 0.04
Private investment demand B, - 1.0 (Neoclassical) or 0.5 (Liquiity Constrints). 5% - 0.5
Domestio content of investment . - 0.6
Private consumption demand X, 1.0 (Neoclssical) or OS (Liquidity Constrints), )s - 0.06
Domestic content of consumption - 0.9
Export demand p - 0.2. Pa - 15. Ps ' I
TABLE 3: VALUES OF EXOGEtOUS VABIABLES
Incomeg Transfcr and 2ita lows All Pregjgn Price Levels 1.0
Foreign transfor to public sector (ftrg) 0.015 oOl
Foreign transfer to privatc sector (ftrp) 0.015
Foreign income (yf) 1.0 Population growth (pg) 0.02
Foreign direct investment (dri) 0.005 Harrod-neutral technical progrOss (tg) 0.01
Foreign real interoet (ri) 0.06
Slaka Nominal base money growth (nmg) 0.05
Domestic debt of public setor (bg) 0.2
Foreign asses held by public sector (e fbg) -0.3
Good 2jLws
Public national-goods consumption (cnp) 0.15
Public investment subsidy (ig) 0.04
- 22 -
TABLE 4: INMAL StEADY-STATE VALUES OF ENDOgANOUS VARIABLEPS
Income, Canital and Transfer Flows EmflomentS (1) 1.0
Operational profits (op) 0.300 QUtDUt (y) 1.0
Dividends paid (d) 0.260
Taxes (td) 0.183
Privato disposablo income (yd) 0.433
Profit Romittances (prem) 0.01 Nominal interst rate on publio debt (i) 0.08
Real interst rate on publio debt (r) 0.06
Stocks Infation rate 0 02
Total private sector wealth (a+hu) 19.407 All Relative Coods Prioe 1.0
Non-human wealth of private sector (a) 4.990
Stock of domestic equity hold by foreigners (fo) 0.1IS Other Pricae
Domestic base money (hb) 0.1S
Human wealth of private sector (hu) 14.417 Real equity prioe (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 tbp) 0.874
Goods Flows
Private aggregate consumption (op) 0.582
Private imported-goods consumption (cmp) 0.058
Private national-goods consumption (cnp) 0.S24
Gross domestic investment (inv) 0.210
Private national-goods investmont (in) 0.126
Private imported-goods investment (im) 0.084
Investment adjustment costs (iac) 0
Exports (x) 0.20
Intermediate imports (mr) 0.10
Total imports (mr) 0.242
Trade balance -0.042
Current account balane -0.005
- 23 -
The simulations for the foreign-transfer shock below consider three types of shocks: permanent
unanticipated (P) disturbances (hitting the economy from period 1 to terminal period T), transitory
unanticipated (TU) shocks (hitting during periods 1-4), and transitory anticipated (TA) shocks (hitting
during periods 2-5). In the case of the oil price windfall, only a permanent (P) shock will be considered.
The discussion of the simulation results below focuses on the deviations from an initial steady-
state equilibrium (represented by period 0), distinguishing between the impact effects (in 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 three types of shocks (P, TU, and TA ) for the
NC case, and a lower panel which combines the three 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 benchmark economy.
The figures report trajectories of endogenous variables for periods 0 (the initial steady state), 1 to 11, and
T-1 and T. The terminal period T varies between 70, 80, and 90 periods.
4.2 A Foreign Transfer Sbock
The dynamic trajectories of the main endogenous variables in response to a 4%-of-output transfer
from the rest of the world to the public sector (ftrg rises from 0.15 to .055) are shown in Figures 1-10,
for different model categories and types of shocks.
Taxes 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 income and wealth rise accordingly, leading to increased consumption. Higher private
consumption leads to both a real excnange rate appreciation and higher output during period 1 when 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 govermnent's intertemporal budget constraint, anticipating current
and future foreign transfers and corresponding tax cuts. Consumer wealth rises in period 1 (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.'
The consumption-based increase in aggregate demand causes a contemporaneous real appreciation
(Fig. 4)2 and an output expansion (Fig. 3). Higher production in period I is made possible by
I The 0.8% difference is due to the decline by this magnitude of the private consumption deflator, prompted by the real
exchange rate appreciation.
I In figure 4, an appreciation is reprnted by a decline in the value of e, which accords to the model's definition of
the real exchange rate.
- 24 -
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-run level - a result of the gradual supply response that partly offsets
the Initial appreciation. In the new steady-state, the real exchange rate exhibits a 7.4% appreciation as
relative to the initial long-run equilibrium, while output has risen by 2.8%.
With the transition path characterized by a gradual real exchange rate depreciation, the domestic
reda interest rate slightly exceeds its foreign counterpzrt throughout the transition (Fig. 5). Aggregate
private investment is determined by the ratio of Tobin's q (in units of output) to the aggregate investment
price deflator. The decline in the latter - due to chlaper capital goods imports - dominates the
reduction in Tobin's q, and hence the impact effect 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
project and hence investment levels off toward its new long-run 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-l 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
equilibrium level.
An interesting result refers to the current account adjustment between 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 Increas by 0.5 pp. of output in period
I (Fig. 8). T1he initial higher deficit is gradually reversed in subsequent periods as the anticipated output
gains materialize.
Finally, the initial increase in aggregate demand and subsaquent rise in the capital stock stimulate
labor demand. Since labor is fully employed, higher labor demand raises the real wage (Figs. 9 and 10).
T'he new long-run real wage exceeds the initial level by 2.8%.
It Is worth to underscore 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 (CM) foreign transfer in this neoclassical
economy, lasting from periods 1 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 increase only by little. Consequently, all the effects described above occur
with diminished force. The only qualitative difference is that now the current account shows a significant
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 endre future horizon
(see the dashed line in the top panel of Fig. 8).
- 25 -
Consider now the case of a temporary anticipated (TA) shock, which takes place during periods
2 to S. The effects are nearly identical to the unanticipated temporary shock. Consumption rises already
in period 1 in anticipation of future lower taxes.!0 The current account goes initially into deficit,
followed by four periods of surplus while the transfer lasts.
Next we focus on a full-employment 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 they are also sensitive to contemporaneous flow variables (consumer
disposable income and operational profits). For the P shock the dynamic paths of the endogenous
variables are similar to the neoclassical case.
Richer dynamics are observed under temporary shocks in the LCFE economy. 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
bottom panels, Fig. 2). While consumer wealth decjling during the 4 periods of shocks (Fig. 1, bottom
panel), private consumption levels increas 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 stronger than under the comparable temporary shocks in the NC economy, following U
or inverted-U patterns during the 4 periods (bottom panels, Figs. 3 and 4).
The dynamics of the real interest rate, determined by the real exchange rate fluctuations, merit
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 depreciates strongly in period 5 (due to the decline of consumption by liquidity-
constrained agents), and subsequently depreciates again at a low rate until converging to the new long-run
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 starts in period 2. Then the initial real exchange rate appreciation continues through
period 2, only to be reverted in period 3 and thereafter, with a strong depreciation occurring in period
6. Hence the real interest rate exhibits a trough in period 1 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 operational profits increase, aggregate
investment falls during the four periods of shocks.
Inflation falls in the first period, as in all previous cases, due to the adjustment 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 than in the NC economy since
consumption is higher due to the 4-period relaxation of liquidity constraints.
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 full-employment economy (LCFE). The difference
lies in the adjustment path: now real wages do not rise as much in response to higher labor demand, and
30 The nse is slightly smaller than under TU because the temporary tax reduction must be discounted one additional
period.
- 26 -
hence employment initially rises above the full-employment level. Lagged wage indexation introduces
a strongly cyclical pattern of real wages and employment, which is absent in the full-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 period. Consumption rises accordingly, although as
a ratio to (higher) output it remains 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
converging toward its long-run value (which exceeds the levels achieved by the full-employment
economies). The output dynamics are a result of slowly increasing capital and the cyclical pattern of
employment. The latter exhibits a peak of 2.396 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 significantly higher dividends from higher output. Afterwards it starts to decline
toward its lower steady-state value. Investment is accordingly higher than before - although as a ratio
to output it remains at the level of the LCFE economy.
Real wages also exhibit interesting dynamics. In period 2 they fall below the (ow) value of
period 1 - 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 simulation 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 full-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 oil price fall in an oil-importing 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 three economies.
While the first-round magnitude is similar to that of the foreign transfer analyzed above, a lower
pmr entails a production substitution effect in addition to the transfer's income effect. That is, even
before considering second-round income and substitution effects stemming from induced real exchange
rate changes, a lower pmr encourages the substitution of capital and labor by cheaper oil.
-27 -
Again copsider first the NC economy (represented by continuous lines in Figs. 11-15). Consumer
wealth and consumption levels (fig. 11) exhibit a dynamic pattern 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-run levels. Wealth rises by a similar amount than under the transfer shock.
But private consumption increases by much less (long-run consumption as a share of output is now 58:7%
instead of 62. 1% before), due to a strong increas in the private consumption deflator, caused in turn 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 intermediate imports, in response to the lower
international price of the latter. The strong supply expansion causes a 3.5% initial real exchange rate
depreciation, which stands in contrast to the initial appreciatign 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 substitution effect stemming only from the real exchange
rate appreciation. The significant substitution effects - in both cases - reflect the high (unitary)
elasticity 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 transfer shock because of gradual real
exchange depreciation along the transition path. Tobin's q (in units of output) gets a boost in the flrst
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 and 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-run investment 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 difference lies in the magnitude of the period-i
inflation decline. The high output expansion under the oil windfall boosts money demand and therefore
requires a one-period deflation of 3.4%, 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 deflcit, due to the combination of investment adjustment costs (which cause a gradual
capacity expansion) and forward-looking consumers (who anticipate higher future income levels and
therefore raise their current spending).
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 significandy the 2.8% rise observed
under the foreign transfer shock.
- 28 -
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 anticipaton 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 (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
f&ll-employment economies. The reason is a significant transitory output expansion made possible by
over-employment in response to sluggish real wage adjustment. 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 significantly the 5.6%
increase in the full-employment economies. Subsequent catch-up of real wages reduces output (which
reaches a local minimum of 1.066 in period 10) until convergence to its new long-run equilibrium of
1.069. The real exchange rate mimics the cyclical pattern of output.
The swings in the real interest rate - in contrast with its relative flatness in the full-employment
economies - reflect the period-2 real exchange rate depreciation and subsequent- appreciations (until
period 10) and depreciations (thereafter). This causes quite significant short-term fluctuations of the
interest 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 equity, 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
categories and economy types in period 1, when the massive income g .owth 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 rough 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, subsequently returning asymptotically to full employment. Average over-employment is 3.8%
during periods 1 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, we conclude that
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
the real exchange rate, while a foreign transfer implies an income effect which 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.
- 29 -
CONCLUDING REMARKS
This paper has developed a dynamic macroeconomic general equilibrium model for three
economies: a neoclassical case with frictionless, instantaneous clearing in goods, assets and labor markets,
a full-employment economy with groups of liquidity-constrained consumers and investors, and a
Keynesian benchmark with liquidity-constrained agents and wage rigidity giving rise to temporary
deviations from full employment.
The model has been applied to simulate the impact, transitional, and steady-state effects of
permanent, temporary unanticipated, and temporary anticipated external shocks. Two shocks have been
considered: a higher foreign transfer and a lower international price of intermediate imports.
The simulations demonstrate the usefulness of a consistent framework based on first principles
for tracing out and understanding the macroeconomic response to disturbances. The numerical exercises
illustrate three main points. First, due to the import content of production in the model, both permanent
&Ar transitory external shocks lead to long-run changes in productive capacity and real output, as well
as in the other endogenous variables. Second, when favorable permanent shocks lead to higher steady-
state capital and output (as is the case in the simulations above), their short-run effect is to cause a current
account deterioration. The reason is that consumption of unconstrained consumers immediately rises in
response not only to current, 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 dynamic response of the economy to exogenous
disturbances. In contrast with the smooth, monotonic adjustment pattern displayed by the neoclassical
benchmark economy in the simulations above, liquidity constraints or wage rigidity tend to amplify the
cyclical response to external shocks. This suggests that market imperfections could be a major factor
behind the complex dynamic adjustment patterns observed in actual economies.
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- 32 -
Figure 1
Foreign Transfer Shock - Total Wealth
Neoclassical Economy
21.4
21.0 -
20.6
20.2/
19.
1 9.0 .
19.4. |,
° 1 2 3 4 5 6 7 a 9 1o 1 1 *T_,
- Permanent
- - Trmpoarery Unanticipated
l ... Tmporary Anticipated
Non-Neoclassicai Economies
21.4
21.0
20.6
20.2
1 9.4a 1W - _
19.8
- . ._......
I9.0 j. l . ' | ' ' '
o 1 2 .3 4 5 6 7 a 9 10 11 -*T-1
..... . ..._ o4 - nW e
UquI*v Can.lnsw - Pnmmmt
- - - Ta".-MW Une"110*1t.
a. Uq. .... U n - TUUURUw,
v -~ ~~~T-gi Unn,=.
- 33 -
Figure 2
Foreign Transfer Shock - Private Consumption / Output
Neoclassical Economy
0.63 .r l--
0.62
0.61
0.60
0.59
0.58
0 1 2 3 4 5 6 7 8 9 10 11 -T. T.
Non-Neociassical Economies
0.63
0.62
0.61
0.60
o l p ''.
0.58
0.57 .
0 1 2 3 4 5 6 7 8 9 10 11 -T.1* T
- u.h a - rtmful
- -~ ~~~~~ -Tu_v. Amd_.
....... TOW-P &VIr_w
* U.. am h Umumpium m P
- Thmsgt UrtmWPd_
v * - - - - _Tsmn AM.O
- 34 -
Figure 3
Foreign Transfer Shock - Output
Neoclassical Economy
1.035 ,
1.030
1.025
1.020
1.015
1.010
1.005
1.000
0.995.
0 1 2 3 4 5 6 7 8 9 10 11 -T_. T
_ TOMMIPW Unentoe
Non-Neoclassical Economies
1.035 . t . _ .
1.030
1.025 -
1.020 -
1.015
1.0 10
0.995
0.990
0 1 2 3 4 5 6 7 8 9 10 11 -+Tr. T
_ quId1tM Cmmr.sngd - P.iwut
_ _ - Tmupu Uni-AMdt
r-T.Nsm.. A.. r
..- U4q. Cm * UnaflpM - Pewat
0~- - - - Tui,gmway tMmnUatrhd
v- r..gs~ _AMdP2%d
- 35 -
Figure 4
Foreign Transfer Shock - Real Exchange Rate
Neoclassical Economy
1.02
1.00
0.98
0.96
0.94-
0.92
0.90
0 1 2 3 5 6 7 8 9 10 11 -T-1 T
-Permanent
-Temproray Unantielpated
.......T rnporory Anticipaetd
Non-Neociassical Economies
1.02 , '
1.00
0.98 : X
0.96
0.94
0.92 '
0.90
0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T
U4 C.naGMfk- paflefit
- - - T _nut ufffUMIIO
............. - T,WPY Amd
6- 1q.g. Cm . UfkpInrA Pwunmt
_- - Tew4e" UnMdp.a
& - .TMgu"y AntiPd_
- 36 -
Figure 5
Foreign Transfer Shock - Real Interest Rate
Neoclassical Economy
0.080 . , -
0.076
0.072
0.065
0.064
0.060 ._._ .._.-_._.._
0.056
0.052
0.048
0.044
0.040
0 1 2 3 4 5 6 7 B 9 10 11 -T.1 T
_ _ ,_|rompy un.n_pu Id
.... Twwr_ AW4w I
Non-Neoclassical Economies
0.080
0.076
0.072
0.068
0.064
0.060
0.056
0.052 :m
0.04a ;-:.'s
0.044..L e - e
0.040
0 1 2 3 4 S 6 7 8 9 10 11 -T_ T
- - - ruuwmgm U,mmlp_
....mp... An-twFpob
0 - UU. Gen. Unwgievmnt -PuIfNS
_- Trmpemip unidpd
tempomay Ati.pfr
- 37 -
Figure 6
Foreign Transfer Shock - Private Investment / Output
Neoclassical Economy
0.232
0.228
0.224
0.220
0.216
0.212 _
0.208
0.204
0.200 '
0 1 2 3 4 5 6 7 8 9 10 11 -*T-1 T
TnnAwewsr Vl
UncntfeIpct.
Non-Neoclassical Economies
0.232
0.228
0.224
0.220
0.216
0.212
0.208 - .* - T. _
0.204
0.200 j | ! X f
0 1 2 3 4 5 6 7 8 9 10 11 -*T- T
Uqu*ldfy Can.ttahod -Pne
- _-_ - TTnmpamry UnartfPatsd
Tw-,rery Anticipated
- Uq. Can. & Unernpimont - Pemwnent
g - - Temporary UnantSaipated
X - Temporary Antolprted
- 38 -
Figure 7
Foreign Transfer Shock - Inflation
Neoclassical Economy
0.028 . , l
0.024
0.020 - - -
0.01'3
0.012
0.008
0.004
0.00t.
0 1 2 3 4 5 6 7 8 9 10 11 -T.1 T
- Permznent
T- emporary Unanticipated
.Temporary Anticipated
Non-Neoclassical Economies
0.028
0.024
0.020 \ =
C0C012 \t/
0.008
0.004
0.000 1 , I * , , * . .
0 1 2 3 4 5 6 7 8 9 10 11 -PT-, T
UquIdIt Conmtralned - Pmflwfent
-ep-r- Tompamry UnwrelOpated
- Tomporafy AnMiipated
- Uq. Con. * Unhmploynnervt - Pnemont
_ _- - mroporary Unalcpated
& -. TeMporary Antiolcptol
- 39 -
Figure 8
Foreign Transfer Shock - Current Account / Output
Neoclassical Economy
0.04 I , ,
0.03 ...........
0.02
0.00
-0.01
-0.02 I - I i J
0 1 2 3 4 5 6 7 8 9 10 11 .T T
I Pnmn nlt I
- - Tonpemr UnantIped
.......... rb"wMry AnWae
Non-Neoclassical Economies
0.04 I I , ,
0.03
0.02 /
-0.01 __
0.0: mmmm : m .,
-0.02 I . I L ,
0 1 2 3 4 5 6 7 8 9 10 11 -T1 T
- Uuldibt Congifid - P.m,dnflt
- - - ripawy Unwiticlputmd
....-T pIary MIti1paotd
Llq. ~Ch. * Unampwint -Pemlrnant
-T?"perury UnMFtilWetd
......... TMoftfy ATtPiPpated
- 40 -
Figure 9
Foreign Transfer Shock - Real Wage
Neoclassical Economy
0.622 . , ,
0.618
0.614
0.610
0.606
0.602
0.598
0.594 ' ' ' ' ' '
0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T
- Permanent
- - Temporary Unanticipated
.. Teamporary Anticipated
Non-Neoclassical Economies
0.622 . , , , ,
0.618
0.614
0.610
0.606
0.602 M: _ 4--t -_ t.,, _ -
0.598
0.594 , ,.
0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T
- tUuldltty Co wb Ined - Pumgfist
- - - TeSnTpamry Unanilipated
....... Anead- Ttweta ted
e0- Uq. Con. & Unainpiaplnt - Perment
0- - -Taporaruiy Unantlepated
* - Tempormy AntiCipated
- 41 -
Figure 10
Foreign Transfer Shock - Employment
All Economies
1.04
1.03
1.02
1.01
1.00 * \ _ _,,,, ,,,,,,,,,,r,,,,-,, .......~~~~77n...... -.
0.99
0 1 2 3 4 5 6 7 8 9 10 11 -bT1 T
- N*"uggI sad UqLifty Cnlutedr WeI
* - U4. can. U e - Pwm
- - T_n_ r , UrAIPatd
..- T.......i,
- 42 -
Figure 11
Permanent Oil Price Windfall - Total Wealth
All Three Economies
21.4 .
21.4 -...............
21.0
20.6
20.2
19.8
19.4
19.0 .
0 1 2 3 4 5 6 7 8 9 10 11 -T1 T
N eoc loaclea l
- - Uquldity Constrained
.......Uquldity Constrained & Unemployment
Permanent Oil Price Windfall - Private Consumption / Output
All Three Economies
0.590 I l I l x
0.589
0.588 .
0.587 /
0.586
0.5a5
0.583 -
0.582
0.581
0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T
- Neoclassical
- - Liquidity Constrained
.......Liquidity Constrained & Unemployment
- 43 -
Figure 12
Permanent Oil Price Price Windfall - Output
All Three Economies
1.10 I . . .
1.08
,~~~~~~~~~~~~~~~~~~ . . . . . . . . . . . . . . . . . . . . ...... -
1 .06_
1.04 -
1.02
1.00
-0.98
0 1 2 3 4 5 6 7 8 9 10 11 -T_1 T
-Neoolaeaicc
- - iUquidity Constrained
. Liquidity Constrained & Unemployment
Permanent Oil Price Windfall - Real Exchange Rate
All Three Economies
1.07 p I . '
1.06 -
1.04
1.03
1.02
1.00 , . . . . . . . . . .
0 1 2 3 4 5 6 7 8 9 1 0 11 -T-1 T
-Neociammical
- - iUquidity Conctrained
. Uquidity Constrained & Unemployment
- 44 -
Figure 13
Permanent Oil Price Windfall - Real Interest Rate
All Three Economies
0.082 , .
0.078
0.074 ..
0.070
0.066
0.062_
0.058
0.054
0.050
0 1 2 3 4 5 6 7 8 9 1 0 1 1 -T1 T
NeooeIosdiol
- - Liquidity Conntrained
. Uquldity Constraoned & Unemploymant
Permanent Oil Price Windfall - Private Investment / Output
All Three Economies
0.214
0.212
0.210
0.208
0.206 ...............
0.204
0.202
0.200,,,,,,,. L
o 1 2 3 4 5 6 7 8 9 1 0 1 1 *T-1 T
-- Noeloi.Ioleo
- - Liquldity Constrained
. Liquidity Constrained & Unemployment
- 45 -
Figure 14
Permanent Oil Price Windfall - Inflation
All Three Economies
0.04 I
0.02 ~~~~............... .. ...... ...... ....
0.02 -
0.00
-0.02
-0.04
-0.06 5 S e
0 1 2 3 4 5 6 7 a 9 1 0 11 -T.1 T
§-NeodoiaeaI
Uquidity Conhtralned
..-- Uquldity Constrafned & Une-nplym.nt
Permanent Oil Price Windfall - Current Account / Output
All Three Economies
0.000 , I
-0.001
-0.002
-0.003
-0.004
-0.005
-o.oor~~~~~~~~~~~~~~~~~~ .......
-0.007 .......
- 0.00 6 \~~~ ... ............... .
-0.007 \-
-0.009
-0.010 ._. * . . . . . . .
0 1 2 3 4 5 6 7 8 9 10 11 -T-1 T
~--Liquidy Con nmnned
Uquldit Coneftreld a Unemplyment
- 46 -
Figure 15
Permanent Oil Price Windfall - Real Wage
All Three Economies
0.65 . . E I I ,
0.64 -
o.B3~
0.63
0.61
0.60 5
0.60
0 1 2 3 4 5 a 7 E 9 10 11 -IT.1 T
- Nzeolaslcui
Uquldity Constralned
.Uqudity Constined * U
Permanent Oil Price Windfall - Employment
All Three Economies
1.06 . " .
1.04
1.02
1~~~~~~~~~~~~~~~~~~~~.02;............ .... -... ...........
1.00 ... -.
0.98
0.96 * P I p I I p p p p '
0 1 2 3 4 5 6 7 6 9 10 1 1 -T.1 T
Neacolassitai
- - Uqldity Constrained
.... Uquldty Constrained & Unemployment
Policy Research Working Paper Series
Contact
TitA Author Date for paper
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Klaus Schmidt-Hebbel
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Family Planning Program 31091
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Agricultural Investments
WPS1056 Earnings and Education in Latin George Psacharopoulos December 1992 L Longo
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Schooling Investments
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of the Former Soviet Union Division 33706
International Economics
Department
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Emerging Economies Lemma W. Senbet
WPS1059 Political Economy of Policy Reform Ziya 15nis December 1992 S. Gustafson
in Turkey in the 1980s Steven B. Webb 37856
Policy Research Working Paper Series
Contact
Title Author Date for paper
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to the 1987 National Accounts
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