A Keynesian Model of a Small Open Economy under a Flexible Exchange Rate

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ABSTRACT

This article considers the international diffusion of business cycles on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler [1] suggests that the employment-isolation effect under the flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model rather than the two-country model of Laursen and Metzler [1], we obtain the following results. (i) The business fluctuation of the world economy diffuses to the small country through a change in the inflation rate caused by the change in the real exchange rate. In this sense, the employment isolation is imperfect. (ii) Domestic monetary expansion has only an effect weaker than that of Mundell [2]-Fleming [3]. This is because a monetary expansion, which always accompanies a fiscal expansion, raises the current domestic price and lowers the inflation rate as long as the purchasing power of money (the inverse of future price) is kept intact. Such disinflation reduces the consumption demand in addition reducing the expansionary multiplier effect.

Cite this paper

M. Otaki, "A Keynesian Model of a Small Open Economy under a Flexible Exchange Rate," Theoretical Economics Letters, Vol. 2 No. 3, 2012, pp. 278-282. doi: 10.4236/tel.2012.23051.

References

[1] S. Laursen and L. Metzler, “Flexible Exchange Rates and the Theory of Employment,” Review of Economics and Statistics, Vol. 32, 1950, pp. 281-299. doi:10.2307/1925577
[2] R. A. Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science, Vol. 29, No. 4, 1963, pp. 475-485. doi:10.2307/139336
[3] J. M. Fleming, “Domestic Fiscal Policies and Floating Exchange Rates,” IMF Staff Papers, Vol. 9, 1962, pp. 369-380. doi:10.2307/3866091
[4] M. Obstfeld and K. Rogoff, “Foundations of International Economics,” MIT Press, Cambridge, 1996.
[5] M. Otaki, “The Dynamically Extended Keynesian Cross and the Welfare-Improving Fiscal Policy,” Economics Letters, Vol. 96, No. 1, 2007, pp. 23-29. doi:10.1016/j.econlet.2006.12.005
[6] M. Otaki, “A Welfare Economics Foundation for the Full-Employment Policy,” Economics Letters, Vol. 102, No. 1, 2009, pp. 1-3. doi:10.1016/j.econlet.2008.08.003
[7] M. Otaki, “A Pure Theory of Aggregate Price Determination,” Theoretical Economics Letters, Vol. 1, No. 3, 2011, pp. 122-128. doi:10.4236/tel.2011.13026
[8] M. Otaki, “On the Function of Key Currency,” DBJ Discussion Paper Series No. 1102, Research Institute of Capital Formation, Development Bank of Japan, Tokyo, 2011.

  
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