Journal of Monetary

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

Publishing Company

DYNAMIC EFFECTS OF GOVERNMENT POLICIES IN AN OPEN ECONOMY
1

Robert J. HODRICK*

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

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

214

R.. ‘. Hodrick, Dq’namic ef,crs

of goue,vnme,lt policies

government policies on the value of capital per capita as the economy moves from one steady state to another. Brunner and Meltzer (1972, 1976) develop a series of models which address the influence of government policy on output and the price level in both the short run and the long run, first for a closed economy and then in a two country framework with fixed exchange rates. Paralleling this development of the theoretical influence of government policies on macroeconomic variables has been the resurgence of interest in the determination of flexible exchange rates between countries. Recent papers by Frenkel (1976), Dornbusch (1976a, b), Kouri (1976) and Mussa (1976) develop the monetary or portfolio balance approach to exchange rate determination. Stated simply, the theory is that since the exchange rate is the relative price of two monies, it will be in equilibrium when the outstanding stocks of the two monies are willinglg held. Bilson (1978) and Hodrick (1978) have examined the empirical conte:nr of the theory which appears to be a useful way to structure thougi;ts about the often volatile movements in flexible exchange rates. This model analyzes the movement of the exchange rate over time, the path of the accounts of the balance of payments, and the changes in wealth which occur in response to government policies and the perceptions of these policies by the public. A change in the provision of government services. an open market operation, and a change in the rate of growth of government debt are considered. The model gives explicit consideration to the way in which people value t,je services of government, the degree to which government bonds are perceived as net wealth, the effects of expectations of inflation, and the effects of changing the production function of the government sector. The model considers the case of the small country which takes prices of traded goods and assets as given. Three assets are introduced, a traded equity or title to capital, a nominal government bond which is non-traded, and money which is also assumed to be held only by domestic residents. Portfolio equilibrium is maintained throughout, and the movement of the exchange rate is seen to depend on changes in the values of the assets outstanding and in the anticipated rates of return associated with them. A three-sector production technology is introduced, and prices, wages, and factors of production are assumed to be suficiently mobile that full employment maintains throughout. The population or labor force is assumed lo grow at a constant rate d Consequently, the long-run equilibrium condition of the government’s budget constraint and the balance of payments are changed reflecting the need to endow new individuals with the assets of ‘Since the model is a long-run growth model, it is assumed that tile small country s population growth rate is equal to that of the world. If it grew faster for a long enough period. it would outgrow its smallness.

the government and to keep ownership of titles to capital, by both domestic and foreign residents, constant in the steady state. The plan of the paper is ...

-1 -203 -338 -359 -421 -96 -977 .. /c /e 0 01 1 10 100 1095 116 1161 117 1176 127 136 142 15 1571 159 17 1956 196 1965 1969 1971 1972 1973 1974 1975 1976 1976a 1976b 1976c 1977 1978 1980 1j 2 200 21 213 214 218 224 229 23 230 231 239 248 25 255 271 275 280 2k 3 304 309 319 327 345 373 389 3cmay 3cwill 4 4.3 402 403 5 6 628 652 7 77 78 7x/c 8 82 84 8a 9 951 97 a.8 a.h a.s abstract absumpt account accumul acknowledg across activ actual ad adapt add addison addison-wesley address adjust affect aggreg aicrq algebra alib alien allan allow also altern america amount amsterdam analys analysi analyz anoth ant anticip appeal appear approach aqd ar4 arbitrari arc argu argument aspect asset associ assum assumpt attribut aut author avail aver away b bailey balanc bank barr barro begin behavior beneath bergia bergla beyond bilson blattberg blinder block bond bondsmar bracket brunner budget build buiter c cagan cannot capit capita capital-labor capitol caprta captur carnegi carnegie-mellon carnegie-rochest case caus cd central certain cfficicnt chang character chicago chosen claassen clark class classic close cndogen command comment compani competit concern conclus condit conduct confer consequ consid consider consist constant constraint consum consumpgon consumpt cont context contrast contribut control correspond corrupt cost could countri cowid creditor crs current d d.w dale dc debt decis declin decre decreas decumul defens deficit defin degre demand demonstr denni denot depart depend depict deriv desir determin develop differ direct disarray discount discuss dispos distinct distribut divid dividu doctrin dold domest domin dornbusch dot dq draft due dynam e earlier econom economi econor ed educ eect ef effect efkct efkient either empir employ emr4oyed endogen endow enough enter ep eppl equal equilibrium equiti equival error european evalu eventu evid examin exchang exert exist exogen expect expenditur explain explicit explor exponenti export extend f factor fall faster fig fight financ financi fire firm first fiscal fix flexib1.e flexibl float flow focus foley follow forc foreign form format foundat framework fraud frenkel friedman full fuller function futur g garber general generat girton girton-henderson give given go gocern gocerrzmerztseroic good gorern goternmont goue gouernmerrt goverk.ynent govern governmerit greater grew gross grow growth h hansen harper harriv head held help henc henderson high higher hill hodrick hold holder holland homogen homogxr household howev human human-wealth hyperinfl hypothes i-i i.e i5 ideolog iess ievel ii il ilstrict imperfect impli implicit includ inclus incom incrcas increas inde indic individu industri ineffici inflat influenc inform inher initi insid instal institut integr intens interdepend interest interlaken intern introduc introduct invest investig involv isset issu iwel j j.f.o jacob je jf johnson jone journal jump justifi k k-i keep keynesian ki kouri l labor lar larg latin lc7k lead less level liabil licp like linear liti ll lnternat lo locat logu london long long-run lrryumcnt lt m ma macmillan macroeconom made maintain make mani manifest manner margin market matter may mcdiun mcgraw mcgraw-hil mcltzer mdlp mean mellon meltder meltler meltzer mention milton minim minimum minus ml mobil model moment momentari monetar monetari money moni move movement much mussa must n n.y.u namic nation necessari necessarili need negat neo neo-class neo-keynesian net new nomin non non-trad north north-holland note nr o oasia observ obtain occur offset often old one one-to-on open oper order oter outgrow output outstand overal overn own ownership p p.r paper parallel parametr pariti partial particular pate path patinkin pay payment pcnrose penros peopl per perceiv percept perfect period perman pervas peter physic pk place plan plausibl plus pogern polic polici polit poor popul portfolio posit possibl power predetermin prefer present press presumpt previous price prim princip privat pro problem proceed process produc product proof properti proport protect provid provis pubhc public publish purchas pure purpos q qc qe qf qrr quantiti quit qxernment qy r r.j r.m r/i r/p railroad rais rate rather ratio ration rb read reader real reassess recent reduc reduct refer reflect regard regim regress relat remain rememb rental repatri repres request requir research resid resourc respect respons rest restrict result resurg return revel revers review ri richard rise rk rl rnodel robert rochest row run salin satisfi save scandal scandinavian scope second section sector see seen seri servic services.2 servlco set short shown sidrauski sign signific similar simpli sinc size sjaastad small solow sponsor squar stabil state steadi steady-st steel stein sti/c stock stream structur studi subject substitut substitutab suffici sufici suflcient sum superscript supplement suppli support suppress surplus svmbol sweeney switzerl system t0 take tax tax-financ technolog term text theo theoq theorem theoret theori therefor third thougi three three-sector throughout ti tile time titl tobin togeth tot total tractabl trade tradit transact treasuri treat trode true ts turn turnovski two two-class ua uncertain uncertainti uniti univers unless unobserv upon urnal use usl util uzawa v vahr valu vari variabl variat varieti viewpoint vnme vol volatil vote w wage walter washington way wealth welfar well wesley whether willinglg wilt wirh wish within without wl world would written wts x y ybdlp york ys z zero zk ~lsion