OPEN-ECONOMY MACROECONOMICS Open-Economy Macroeconomics

Proceedings ofa Conference held in Vienna by the International Economic Association

Edited by

Helmut Frisch Professor ofEconomics University ofTechnology. Vienna and

Andreas Worgotter Chairman . Department ofEconomics Institute for Advanced Studies. Vienna

Palgrave Macmillan in association with the © International Economic Association 1993 Softcoverreprint ofthe bardeover 1st edition 1993 978-0-333-57313-6 All rights reserved. For information, write: Scholarly and Reference Division, St. Martin's Press, Inc., 175 Fifth Avenue, New York, N.Y. 10010

First published in the United States of America in 1993 ISBN 978-1-349-12886-0 ISBN 978-1-349-12884-6 (eBook) DOI 10.1007/978-1-349-12884-6 Library of Congress Cataloging-in-Publication Data Open-economy macroeconomics: proceedings of a conference held in Vienna by the International Economic Association I edited by Helmut Frisch and Andreas Wörgötter. p. cm. Conference held in May/June 1991. "[Published by] St. Martin's Press, in association with the International Economic Association." ISBN 978-0-312-09015-9 I. Macroeconomics-Congresses. I. Frisch, Helmut. II. Wörgötter, Andreas. 111. International Economic Association. IV. Series. HB 172.5.064 1993 339--dc20 92-26619 CIP Contents

The International Economic Association viii Acknowledgements x List of Contributors and Participants xii Abbreviations and Acronyms xvii Preface xix

Introduction Helmut Frisch and Andreas Worgotter xxi

PART I MONETARY POLICY IN OPEN ECONOMIES

1 Exchange-rate Based Stabilisation under Imperfect Credibility Guillermo A . Calvo and Carlos A. Vegh 3

2 Devaluation, the Terms of Trade and Investment in a Keynesian Economy Michael Gavin 29

3 Sheet Anchors, Fixed Price Anchors and Price Stability in a Monetary Union Andrew J. Hughes Hallett, David Vines and Myrvin Anthony 46

4 Foreign Supply Shocks, Wage Indexation and Optimal Monetary Policy Franz X. Hof 70

PART II DOMESTIC ADJUSTMENT TO FOREIGN SHOCKS

5 The Impact of Fiscal and Productivity Shocks on the Natural Rate of Unemployment in a Two-Country World Hian Teck Hoon and Edmund S. Phelps 95

v vi Contents

6 Shocks and Aggregate Low Frequency VariabUity in a Small Open Economy Christian C. Starck 119

7 Real Shocks and the Real Exchange Rate Emil-Maria Claassen 137

8 Economic Adjustment and Growth in Small Developing Countries DeLisle Worrell 153

PART III LABOUR AND CAPITAL MARKETS IN OPEN ECONOMIES

9 Influence of Fiscal Shocks on Exchange Rate VolatUity under Imperfect Capital MobUity and Asset SubstitutabUity Saziye Gazioglu 167

10 Domestic and Foreign Shocks to Employment and Capital Accumulation in Germany Oliver Landmann and Iiirgen Jerger 186

II Capital Taxation, Housing Investment and Wealth Accumulation in a Small Open Economy Seren B. Nielsen and Peter Birch Serensen 203

12 Underemployment EquUibria in an Empirical Macromodel for Austria Peter Neudorfer and Karl Pichelmann 224

PART IV INTERDEPENDENCE OF OPEN ECONOMIES

13 Measurement Errors and the Convergence Hypothesis Edward E. Leamer 241

14 Three Parity Conditions in International Finance Richard C. Marston 257 Contents vii

IS Endogenous Growth, Convergence and Fiscal PoUcles in an Interdependent World George S. Alogoskoujis and Frederick van der Ploeg 272

16 Consistent Conjectural EquiUbria and Economic Policies Coordination Henri Sterdyniak and Pierre Villa 289

PART V BUBBLES VERSUS FUNDAMENTALS: MODELLING EXCHANGE RATE BEHAVIOUR

17 Stochastic Shocks, Fads and Exchange Rate Fundamentals: an Empirical Evaluation of the Target Zone Proposal Nicos M. Christodoulakis 313

18 The Theory of Exchange Rate Determination and Exchange Rate Forecasting Giancarlo Gandolfo, Pier Carlo Padoan and Giuseppe de Arcangelis 332

19 A Chaotic Monetary Model of the Exchange Rate Paul De Grauwe and Hans Dewachter 353

20 Theories, Consistent Expectations and Exchange Rate Dynamics Michael Goldberg and Roman Frydman 377

21 Bandwagon Effects, or Rational Expectations in the Exchange Rate? Vasumathi Vijayraghavan 400

Index of Names 409 Index of Subjects 413 The International Economic Association

A non-profit organisation with purely scientific aims, the Inter• national Economic Association (lEA) was founded in 1950. It is in fact a federation of national economic associations and at present includes fifty-eight such professional organisations from all parts of the world. Its basic purpose is the development of economics as an intellectual discipline. Its approach recognises a diversity of prob• lems, systems and values in the world and also takes note of method• ological diversities. The lEA has, since its creation, tried to fulfil that purpose by promoting mutual understanding of from the West and the East, as well as from the North and the South, through the organisation of scientific meetings and common research pro• grammes, and by means of publications on problems of current importance. During its forty-odd years of existence, it has organised over 100 round-table conferences for specialists on topics ranging from fundamental theories to methods and tools of analysis and major problems of the present-day world. Nine triennial World Congresses have also been held, which have regularly attracted the participation of a great many economists from all over the world. The Association is governed by a Council, composed of represen• tatives of all member associations, and by a fifteen-member Execu• tive Committee which is elected by the Council. The Executive Committee (1989-92) is composed as follows:

President: Professor Anthony B. Atkinson, UK Vice-President: Professor Luo Yuanzheng, China Treasurer : Professor Alexandre Lamfalussy, Belgium Past President : Professor , India Other Members : Professor Abel Aganbegyan, Russia Professor Kenneth J. Arrow, USA Professor Edmar Lisboa Bacha, Brazil Professor P.R. Brahmananda, India Professor Wolfgang Heinrichs, Germany Professor , France Professor Takashi Negishi, Japan viii The International Economic Association ix

Professor Don Patinkin, Israel Professor Agnar Sandmo, Norway Professor Erich Streissler, Austria Professor Stefano Zamagni, Italy Advisers: Professor Oleg T. Bogomolov, Russia Professor Karel Dyba, Czechoslovakia Professor Mohammed Germouni, Morocco Secretary-General: Professor Jean-Paul Fitoussi, France General Editor : Mr Michael Kaser, UK Adviser to General Editor : Professor Sir , UK

The Association has also been fortunate in having secured the following outstanding economists to serve as President:

Gottfried Haberler (1950-3), Howard S. Ellis (1953-6), (1956-9), E.A.G. Robinson (1959-62), G. Ugo Papi (1962-5), Paul A. Samuelson (1965-8), (1968-71), (1971-4), Edmond Malinvaud (1974-7), (1977-80), Victor L. Urquidi (1980-3), Kenneth J. Arrow (1983-6), Amartya Sen (1986-9).

The activities of the Association are mainly funded from the subscriptions of members and grants from a number of organisations, including continuing support from UNESCO. Acknowledgements

The Vienna Conference of the lEA which took place at the Institute for Advanced Studies, Vienna, Austria, was organised by a local committee with the following members:

Professor Paul De Grauwe, Katholieke Universiteit Leuven, Leuven, Belgium Professor Helmut Frisch, University of Technology, Vienna, Austria Professor Giancarlo Gandolfo , University of Rome 'La Sapienza', Rome , Italy Professor Richard C. Marston , The Wharton School, University of Pennsylvania, Philadelphia, USA Professor Erich Streissler, University of Vienna, Austria Professor Andreas Worgotter, Institute for Advanced Studies, Vienna, Austria

Financial and logistic support was generously provided by local private and public foundations, as well as private firms, and we are especially grateful to:

Austrian National Bank, Vienna , Austria Austria Tabakwerke AG, Vienna, Austria Assocation of Austrian Industrialists, Vienna, Austria Federal Chamber of Commerce, Vienna, Austria Casinos Austria, Vienna, Austria Chamber of Labour, Vienna, Austria Lotto-Toto Gesellschaft, Vienna, Austria Osterreichische Kontrollbank Aktiengesellschaft, Vienna, Austria Osterreichische Postsparkasse , Vienna, Austria Zentralsparkasse und Kommerzialbank Wien AG, Vienna, Austria

We also wish to express our gratitude to all participants whose intellectual engagement ensured the conference's success, and whose discipline made the timely publication of the conference volume possible. We are especially grateful to Maureen Hadfield, who participated at the conference and provided the editors with the necessary support and encouragement to prepare the proceedings for publication. x Acknowledgements xi

The excellent organisation of the conference by the Institute for Advanced Studies, Vienna was much appreciated by the participants, as were the hospitality and social occasions, which encouraged dis• cussions to continue outside the conference venue . The local organis• ing committee was happy and grateful to rely on the organisational talent and efficiency of Beatrix Krones, the conference secretary. Thanks are expressed to the International Social Science Council under whose auspices the publishing programme is carried out and to UNESCO for its financial support. List of Contributors and Participants

George S. A1ogoskoufis, Birkbeck College, London and CEPR

Dr Myrvin Anthony, University of Strathclyde, Glasgow, UK

Professor Ljubisa Adamovic, University of Belgrade, Yugoslavia

Mr Jean Bensaid, INSEE, Paris, France

Professor Fritz Breuss, Austrian Institute for Economic Research, Vienna, Austria

Professor Guillermo A. Calvo, International Monetary Fund, Washing• ton DC, USA

Dr Gunther Chaloupek, Chamber of Labour, Vienna, Austria

Professor Nicos M. Christodoulakis, Athens University of Econ• omics, Greece

Professor Emil-Maria Claassen, University of Paris-Dauphine, Paris, France

Professor Gerhard Clemenz, University of Regensburg, Germany

Professor Giuseppe de Arcangelis, University of Rome 'La Sapien• za', Rome, Italy, and University of Michigan, USA

Professor Paul De Grauwe, Catholic University of Leuven, Belgium

Professor Hans Dewachter, Catholic University of Leuven, Belgium

Dr Wolfgang Duchatczek, Austrian National Bank, Vienna, Austria

Professor Rudolf Eder, University of Economics, Vienna, Austria xii List of Contributors and Participants xiii

Pror~ Bernhard Felden!r, Institute for Advanced Studies, Vienna, Austria

Professor Helmut Frisch, University of Technology, Vienna, Austria

Professor Roman Frydman, University of New Hampshire, USA

Professor Giancarlo Gandolfo, University of Rome 'La Sapienza', Rome, Italy

Professor Michael Gavin, Columbia University, New York, USA

Dr ~aziye Gazioglu, University of Aberdeen, Old Aberdeen, UK

Dr Irene Geldner, Chamber of Labour, Vienna, Austria

Professor Francesco Giavazzi, IGIER, Institute for Economic Re• search, Opera-Milano, Italy

Professor Michael Goldberg, New York University, USA

Dr Alfons Haiden, Zentralsparkasse und Kommerzialbank Wien AG, Vienna, Austria

Dr Heinz Handler, Austrian Institute for Economic Research, Vienna, Austria

Dr Eduard Hochreiter, Austrian National Bank, Vienna, Austria

Professor Franz X. Hof, University of Technology, Vienna, Austria

Dr Hian Teck Hoon, National University of Singapore, Singapore

Dr Gerhard Huemer, Federal Chamber of Commerce and Indus• tries, Vienna, Austria

Professor Andrew J. Hughes Hallett, University of Strathclyde, Glasgow, UK, Princeton University, USA, and CEPR

Professor Otmar Issing, Central Bank of Germany, Frankfurt, Germany xiv List of Contributors and Participants

Dr Albert JAger, Institute for Advanced Studies, Vienna, Austria

Dr Jurgen Jerger, University of Freiburg, Germany

Dr Marianne Kager, Zentralsparkasse und Kommerzialbank Wien AG, Vienna, Austria

Professor Elias Karakitsos, Imperial College, London, UK

Dr Chmtian Karsch, Austrian Insurance Association, Vienna, Austria

Dr Heinz Kessler, President, Association of Austrian Industrialists, Vienna, Austria

Dr Christian Keuschnigg, University of Bonn, Germany

Professor Wilhelm Kohler, University of Innsbruck, Austria

Dr Angela Koppl, Institute for Advanced Studies, Vienna, Austria

Dr Ferdinand Lacina, Minister of Finance, Vienna, Austria

Professor OUver Landmann, University of Freiburg, Germany

Professor Edward E. Leamer, University of California, Los Angeles, USA

Professor MicbaeI Ledig, German Federal Bank, Frankfurt, Germany

Dr Mlkulas Luptacik, University of Technology, Vienna, Austria

Dr Dalia Marin, Institute for Advanced Studies, Vienna, Austria

Professor Richard C. Marston, The Wharton School, University of Pennsylvania, Philadelphia, USA

Professor Gianluigi Mengarelli, Univerista degli Studi, Venice, Italy

Dr Peter Neudorf'er, Institute for Advanced Studies, Vienna, Austria List of Contributors and Participants xv

Prof~ SfM"en Do Nielsen, Copenhagen Business School, Denmark

Dr Thomas Opferkuch, Federal Chamber of Commerce and Indus• tries, Vienna, Austria

Professor Pier Carlo Padoan, University of Urbino, Italy

Dr Karl Pichelmann, Institute for Advanced Studies, Vienna, Austria

Dr Georg Rathwallner, Chamber of Labour, Linz, Austria

Dr Josef Richter, Federal Chamber of Commerce and Industries, Vienna, Austria

Dr Klaus Ritzberger, Institute for Advanced Studies, Vienna, Austria

Professor Friedrich Schneider, University of Linz, Austria

Professor Hans Seidel, Austrian Institute for Economic Research, Vienna, Austria

Dr Alfred Sitz, University of Economics, Vienna, Austria

Professor Alasdair Smith, Universiy of Sussex, Brighton, UK

Professor Peter Birch Serensen, Copenhagen Business School, Denmark

Professor Christian C. Starck, Bank of Finland, Helsinki, Finland

Professor Henri Sterdyniak, OFCE, Paris, France

Professor Erich Streissler, University of Vienna, Austria

Dr Artur Szentgyorgyvari, National Bank of Hungary, Budapest, Hungary

Dr Werner Teufelsbauer, Federal Chamber of Commerce and In• dustries, Vienna, Austria xvi List of Contributors and Participants

Dr Thomas Uri, Institute for Advanced Studies, Vienna, Austria

Professor Frederick van der Ploeg, University of Amsterdam, The Netherlands, and CEPR

Dr Vasumathi Vijayraghavan, University of Paris-Dauphine, Paris, France

Professor Pierre VOla, INSEE, Paris, France

Dr David Vines, University of Glasgow, UK, and CEPR

Dr Franz Vranitzky, Federal Chancellor of Austria, Vienna, Austria

Professor Georg Winckler, University of Vienna, Austria

Professor Andreas Worgotter, Institute for Advanced Studies, Vienna, Austria

Or DeL_ Worrell, Central Bank of Barbados, Bridgetown, Barbados Abbreviations and Acronyms

AAS Alternative assignment scheme ACH Average cost curve of housing ADF Augmented Dickey-Fuller AP Alogoskoufis-Ploeg ARMA Auto regressive moving average CCE Consistent conjectural equilibrium CEPR Centre for Economic Policy Research CES Constant elasticity of substitution CIP Covered interest parity CPE Centrally planned economy CPI Consumer price index CRS Constant returns to scale DF Dornbusch-Frankel ECM Error correction model EMS European monetary system EMU European monetary union ERM Exchange rate mechanism ETZ Extended target zone FB Frenkel-Bilson FEER Fundamental equilibrium exchange rates FIBOR Frankfurt Inter-Bank offered rate FIML Full information maximum likelihood G3 Group of Three: Germany, Japan, USA GDP Gross domestic product GEM Global econometric model GNP Gross national product GPA Gandolfo, Podoan and de Arcangelis HD Harrod-Domar HM Hooper-Morton IMF International Monetary Fund IRP Interest rate parity LDC Less developed country MAE Mean absolute error MCH curve of housing MPC Marginal propensity to consume xvii xviii Abbreviations and Acronyms

NAIRU Non-accelerating inflation rate of unemployment NFA Net foreign assets NNP Net national product NPG 'No-Ponzi-Game' OECD Organisation for Economic Cooperation and Development OLS Ordinary least squares PCOM US$ price of commodities POlL US$ price of oil PPP Purchasing power parity REH Rational expectations hypothesis RIP Real interest parity RMSE Root mean square estimate RR Ramsey-Romer RW Random walk SURE Structural rate of unemployment TCEH Theories consistent expectations hypothesis TCH Total cost curve of housing TVC Time-varying coefficients TZ Target zone VAR Vector auto regression UIP Uncovered interest parity WPI Wholesale price index Preface

The Conference on 'Open-Economy Macroeconomics' was held at the Institute for Advanced Studies, Vienna, under the auspices of the International Economic Association between 30 May and 1 June, 1991. It covered a broad spectrum of issues faced by open economies including their complex relationships with other countries and dem• onstrated the sophistication of today's model building in the field of open-economy macroeconomics. The aim of the organisers was to bring together leading researchers and specialists to provide a balanced view of recent theory and stimulate further research. Twenty-one papers from the conference are included in the present volume. They are presented in the following sections: I. Monetary Policy in Open Economies II. Domestic Adjustment to Foreign Shocks III. Labour and Capital Markets in Open Economies IV. Interdependence in Open Economies V. Bubbles versus Fundamentals: Modelling Exchange Rate Be- haviour The importance of the conference topic for a small open economy like Austria was confirmed by the presence of Dr Franz Vranitzky, Federal Chancellor of.the Republic of Austria. In his opening state• ment he emphasised that for small, highly specialised economies there is a close relationship between a stable international economic order, the opportunity for growth and for improvements in economic welfare. 'Macroeconomic Policy in Austria' was the title of the subsequent panel discussion with Austrian and German economists, policy• makers and leading business executives. The participants agreed on the necessity for pursuing a macroeconomic policy that provided a sound basis for integrating a small economy into the world economy. The organisers are grateful to the participants of the panel dis• cussion for supporting both the conference and the publication of the proceedings. The participants in the panel discussion on 'Macro• economic Policy in Austria' were: Gunther Chaloupek, Chamber of Labour, Vienna. Wolfgang Duchatczek, Austrian National Bank, Vienna. xix xx Preface

Helmut Frisch, Government Debt Committee, Vienna. Alfons Haiden, Chief Executive and Chairman of the Board, Bank Austria AG, Vienna. Otmar Issing, Deutsche Bundesbank, Frankfurt. Heinz Kessler, President, Association of Austrian Industrialists, Vienna. Ferdinand Lacina, Minister of Finance, Vienna. Introduction Helmut Frisch and Andreas Worgotter

This volume collects twenty-one contributions presented at the lEA conference in May 1991 in Vienna on 'Open-Economy Macroecon• omics'. The contributions in this volume have been arranged in five parts so as to emphasise new research as well as facilitate comparison with the more standard macroeconomic issues raised in the literature of the 19705 and 19805. The volume begins with a classic question in Part I, 'Monetary Policy in Open Economies'. The paper by Calvo and Vegh illustrates the importance of the distinction between cred• ible exchange-rate-based stabilisation programmes, which have no output costs, and non-credible stabilisation programmes, which do. A new problem in a more traditional model is investigated by Gavin, who studied the impact of current and anticipated future devaluations on investment decisions in an open economy. The paper by Hughes Hallett, Vines and Anthony examines critically the advantages and disadvantages of the European Monetary System (EMS), while Hof re-examines the controversial issue of whether monetary policy should be accommodating or contractionary in the event of an adverse foreign supply shock. The four contributions in Part II address some of the standard problems of open-economy model-building which were raised in the 19705 and 19805 and are still with us. These are collected under the heading 'Domestic Adjustment to Foreign Shocks'. Hoon and Phelps consider the impact of various macroeconomic shocks on the natural rate of unemployment in the context of a two-country model, while Starck provides empirical evidence for the impact of foreign shocks on real and nominal variables for the Finnish economy. Claassen focuses on the effects of a real demand shock on the real exchange rate and the paper by Worrell on the problems of an 'island economy' characterised by very specialised production closes this section. Part III offers four contributions on different topics of 'Labour and Capital Markets in Open Economies' . Gazioglu investigates the rela- xxi xxii Introduction: Frisch & Worgotter tionship between capital mobility and asset substitution on the one hand and the probability of overshooting exchange rates on the other. Landmann and Jerger confront an open economy model with the German experience. Nielsen and Serensen introduce the housing sector in an open-economy model with overlapping generations and discuss several taxation experiments in the context of this general equilibrium model. Lastly, Neudorfer and Pichelmann present em• pirical results, estimating underemployment equilibria for Austria, followingthe approach of the European Unemployment Programme. The 'Interdependence of Open Economies' is the topic of four papers in Part IV. Leamer examines the 'convergence hypothesis' of international per capita income proposed by Barro. Marston investi• gates the relationship between three parity conditions linking finan• cial or goods markets in different countries: the uncovered interest parity, the purchasing power parity and the real interest parity condi• tion. Alogoskoufis and van der Ploeg investigate effects of fiscal policy measures in a two-country intertemporal equilibrium model with endogenous technical progress. This section ends with a study by Sterdyniak and Villa of the problems of policy coordination among different countries and compares three solution concepts, namely Nash-equilibria, Pareto-equilibria and the new concept of consistent conjectural equilibria (CCE) . Examples of new research are presented in Part V, 'Bubbles versus Fundamentals: Modelling Exchange Rate Behaviour'. The failure of prevailing models to explain exchange rate behaviour is the starting point for the four contributions in this final section. Christodoulakis discusses the costs of misalignments 10 the real exchange rates be• tween major economies and outlines the extended target zone proposal to avoid such misalignments. Three separate papers by Gandolfo, Padoan and de Arcangelis, Goldberg and Frydman and De Grauwe and Dewachter develop new and more sophisticated models to explain the functioning of the exchange market, while Vijayraghavan offers some new empirical research, emphasising the heterogeneity of market participants and informational inequalities in the exchange market. We thought that it would be helpful to the reader to present a brief summary of the contents of each chapter, tracing recent thinking about the development of open economies. In the first section, 'Monetary Policy in Open Economies', we have included four papers, starting with a study of the experience in Latin America. In the late 19708, several Latin American countries ex- Introduction: Frisch & Worgotter xxiii periencing high inflation rates launched stabilisation programmes based on a pre-announced path for the exchange rate that exhibited a declining rate of devaluation. Calvo and Vegh analyse stabilisation policy under predetermined exchange rates in a cash-in-advance, staggered-prices model. Under full credibility, inflation falls instan• taneously. A non-credible stabilisation policy results in an initial boom in spite of an appreciating real exchange rate. Later in the programme output falls below its full-employment level. The use of the money supply as an additional nominal anchor is also studied by assuming that the money supply is predetermined at each point in time due to the presence of capital controls, and that controlling the money supply can be effective in avoiding the initial boom in the non-traded goods market. Money as an additional anchor may help to insure a reduction in the inflation rate of non-tradables even, if the programme of stabilisation enjoys little credibility. Gavin investigates the impact of current and anticipated future devaluations in a macroeconomic model that incorporates the assumption of rational investment decisions in a world in which investment goods can be imported. Contrary to conventional wis• dom, a devaluation will lead to a reduction in domestic investment if the share of imports in total investment expenditure is high enough and Keynesian , nominal price rigidities vanish slowlyenough. Other• wise investment will increase after devaluation. In either case antici• pated future devaluation has an unambiguous negative effect on investment. The reason for this result is that the anticipated de• terioration in the terms of trade implied by the expected future devaluation reduces the asset value of capital to produce domestic output. However , until the devaluation actually arrives there are no offsetting effects on the costs of purchasing capital goods. Hughes Hallett, Vines and Anthony examine critically the advan• tages and problems of the European monetary system (EMS). While there is not much debate about the advantages (reduction of transac- . tion costs and exchange rate uncertainties), the problems are less obvious. The authors specially emphasise the increasing burden on the flexibility of fiscal policy. As long as external shocks to EMS member economies are different in structure across countries, the adjustment costs will also vary. With monetary policy tied to the EMS regulations , only a flexible fiscal policy may help to adjust to foreign shocks. Finally the authors point out that EMS alone does not ensure overall price stability. In the chapter by Hof, he re-examines the question of whether xxiv Introduction: Frisch & Worgotter monetary policy should be accommodating, or contractionary, in the event of adverse foreign supply shocks, using a simple open-economy model in which (i) the purchasing power parity holds, (ii) the produc• tion function including labour and imported energy is of the Cobb• Douglas type, and (iii) the monetary authorities aim at eliminating the distortions due to indexed nominal wage contracts. Aizenman and Frenkel (1986) showed that the optimal monetary reaction to an adverse foreign supply shock may be of either sign. Contrary to Aizenman and Frenkel, Hof assumes that (i) domestic and foreign final goods are imperfect substitutes, and (ii) the production function takes a separable form including a CES function. Hof shows that some of the original results regarding the optimal design of monetary policy are altered qualitatively by these modifications. The dramatic increase in real interest rates in the early 19808 following the two oil-shocks of 1975 and 1980 led to a rise in the domestic price level, a slowdown in the growth of output and capital formation and an increase in unemployment in many OECD coun• tries. A number of contributions study the problems which open econ• omies face when adjusting to those adverse foreign shocks, grouped together in a section called 'Domestic Adjustment to Foreign Shocks'. The paper by Hoon and Phelps studies the impact of various mac• roeconomic shocks on the natural rate of unemployment in the context of a two-country model. Two Salop-type economies are linked through perfect international capital markets. In this world a debt-financed fiscal expansion is contractionary for the world econ• omy rather than expansionary as in the standard Mundell-Fleming model. The argument is that rising interest rates lead to a sharp decline in the number of workers that firms find it profitable to train (assuming a convex training cost function) and to an increase in unemployment. An interesting point is the discussion of a sudden in• crease in the size of the labour force, as for example a massive immigra• tion from eastern Europe to western Europe. This leads to a decline in the job quitting rate in western Europe and an increase in the asset value of a trained worker so that firms increase their investment in new workers until the original unemployment rate is attained. Starck provides empirical evidence on the impact of domestic and foreign shocks on real and nominal variables. A structural VAR model is estimated using monthly data from 1960 to 1988 for the Finnish economy. While in the long run nominal shocks have no significant real effect, considerable overshooting and non-neutrality effects may arise in the short run. Domestic inflation is found to be Introduction: Frisch & Worgotter xxv determined by foreign inflation. These results have been thoroughly checked using sensitivity analyses (structural stability; causality tests; exogeneity tests; number of cointegrating vectors) and were found to be in line with the predictions of a Dornbusch-type model of small open economies with two types of variables: asset prices adjusting rapidly to their equilibrium values, whereas goods and factor prices needed time to adjust. Claassen examines the effects of a real demand shock on the real exchange rate in a textbook open-economy model. The paper intro• duces a more general concept of the real exchange rate, defined as the relationship between three relative prices: the relative price of foreign and domestic tradables, of domestic tradables and domestic non-tradables, and foreign tradables and foreign non-tradables, The paper focuses on the question of how the necessary change in the real exchange rate can be explained by the interaction of the three relative prices. The short-run change in the real exchange rate results from the immediate clearing of the goods market. The long-run effect takes into account the wealth implications which an unbalanced current account has for the demand for domestic goods. Worrell deals with adjustment and growth in small open econ• omies. He is particularly concerned with an 'island economy' charac• terised by a very specialised output and a high ratio of imported consumer goods. He favours a policy mix with fixed exchange rates, providing a nominal anchor for the economy, fiscalpolicy in line with a stable current account and investment promotion in the specialised tradables sector. In the section entitled 'Labour and Capital Markets in Open Econ• omies', Gazioglu analyses the relationship between capital mobility and asset substitutability on the one hand and the probability of overshooting exchange rates on the other. She uses a Dornbusch• type model with staggered wage contracts and explicit consideration of the accumulation of foreign assets. Her results are derived from simulation experiments. She demonstrates that demand shocks, like money supply shocks, may also cause overshooting . High capital mobility willincrease the probability of overshooting, while low asset substitutability in combination with low capital mobility will reduce the short-run exchange rate response to monetary and demand shocks and therefore stabilise exchange rate dynamics. The chapter by Landmann and Jerger presents a dynamic model of capital formation and employment in an open economy and com• pares it with the German experience . The qualitative predictions of xxvi Introduction: Frisch & W6rg6tter the model conform to the broad features of the German employment and investment record in that the model integrates components of the mainstream 'hysteresis hypothesis' to explain persistent unemploy• ment and the 'transatlantic crowding out' hypothesis advanced by Fitoussi and Phelps (1988). Particular attention is devoted to the concept of the real wage gap which is widely used to appraise the consistency of wage behaviour with the requirement of full employ• ment . The fact that the wage gap has fallen since the second half of the 19708 while the unemployment rate doubled is often regarded as puzzling, but can be satisfactorily explained within the framework of the above model. Nielsen and Serensen introduce the housing sector in an open• economy model with overlapping generations. Within the framework of an applied general equilibrium model several taxation experiments are worked out. The results are in general ambiguous and depend on the parameters of the model. An increase in capital income taxation may, for instance, cause a fall in the stock of residential capital despite declining user costs of housing. Similarly an increase in the tax on imputed rents on housing may increase the stock of housing and improve the net foreign asset position . A shift in preferences towards housing will unambiguously increase foreign indebtedness. Neudorfer and Pichelmann present empirical results for Austria estimating underemployment equilibria in an empirical macro-model for a small open economy. Their approach closely follows the meth• odology adopted by Dreze and Bean (1990) and used for the European Unemployment Programme.' This model explicitly allows them to distinguish between the three well-known regimes of Keynesian un• employment, classical unemployment and general excess demand. The most important empirical results of the paper indicate the his• torical importance" of Keynesian unemployment in Austria. Fur• thermore a high rate of real wage flexibility is found to support the relatively low unemployment levels. A special feature of the small open-economy character of the Austrian economy is the empirical observation that excess demand causes the current account to de• teriorate, but does not stimulate inflation. In Section IV, entitled the 'Interdependence of Open Economies', one of the most controversial and frequently investigated hypotheses in international economics refers to the question of whether per capita incomes exhibit a tendency to converge or not. In this sense the gap between the average per capita income at home and worldwide could be interpreted as a 'shock' and the convergence process can be Introduction: Frisch & W6rg6ner xxvii seen as the adjustment to this shock. Leamer investigates the con• vergence hypothesis results derived by Barro (1991). Using a battery of models intended to treat errors in variable problems, he finds that the original data set implies greater reliability for developing relative to developed economies. This counter-intuitive result can be related to a violation of assumptions behind the convergence hypothesis. Two important assumptions made by Barro are the equality of regres• sion coefficients across developed and developing countries and the diagonal form of the measurement error covariance matrix. This contribution once again demonstrates the need for sensitivity analysis in empirical studies. International finance often focuses on parity conditions linking financial or goods markets in different countries. Marston examines three parity conditions, namely, the uncovered interest parity (UIP), the purchasing power parity (PPP) and the real interest parity (RIP), using recent data for 1966 to 1989 for the major European industrial countries. The study shows that the real interest differentials, that is, the eurodollar rate minus another eurocurrency rate can be broken down into nominal interest differentials and deviations from the PPP. The resulting differentials can be attributed primarily to deviations from the PPP and not to UIP differentials. There is no financial transaction that can eliminate such differentials, so that the differen• tials will persist as long as PPP fails to hold. Over the long run the PPP differentials averaged close to one per cent, so real interest differentials were correspondingly small. Alogoskoufis and van der Ploeg investigate the effects of fiscal policy measures in a one-good , two-country , inter-temporal equilib• rium model with endogenous technicalprogress, under the assump• tion that the technical progress is induced by external spillovers from domestic and foreign capital accumulation. They find that govern• ment debt variations are definitely not neutral. A worldwide increase in the ratio of government debt to GDP will reduce savings, capital accumulation and growth. A relative rise of the debt/GDP ratio will cause the net foreign asset position of the home country to deterio• rate. The main results of this model are in line with the observations of the 19805. Government debt/GOP ratios have been increasing, while the growth of world output has been declining. The relatively expansive fiscal policy in the USA has been followed by a pro• nounced decline in the net foreign asset position of the US economy. The literature on economic policy coordination usually focuses on the comparison between Nash-equilibria and Pareto-equilibria, xxviii Introduction: Frisch & Worgotter obtained when different countries cooperate efficiently. The notion of Nash-equilibria, however, has one unsatisfactory drawback: the policy-makers are supposed to assume that their partners do not react to their actions even though in practice they do. Sterdyniak and Villa introduce the concept of consistent conjectural equilibrium (CCE) where each player (country) takes perfect account of the way the other player reacts. With this new concept the authors examine three cases of economic policy coordination in the context of a two country model: fiscal policy, monetary policy and exchange rate regimes. They show that the CCE is not always more efficient than the Nash• equilibrium, however, in most cases it does rule out part of the inefficiency of non-cooperate economic policy, such that the ad• ditional gain from cooperation can become very small. The last section has been called 'Bubbles versus Fundamentals: Modelling Exchange Rate Behaviour'. Real exchange rate misalign• ments between the G3 economies, that is, deviations from what is considered 'normal', have always attracted attention in the discussion of international policy coordination. The paper by Christodoulakis investigates the extended target zone (ETZ) proposal, first suggested by Williamson and Miller (1987) in an empirical model with forward• looking expectations and various types of stochastic disturbances. The main idea of ETZ is to adopt real exchange rate targets that ensure current account equilibria in the long run. Those targets are pursued by ETZ optimal monetary and fiscal policy rules. The simulation results show a welfare improvement for each currency 'bloc' when employing the optimal ETZ scheme to face stochastic shocks. The main gain comes from the virtual elimination of real exchange rate misalignments, in contrast to the no-rule case. The poor out-of-sample forecasts by structural models of exchange rate determination are confirmed by Gandolfo, Padoan and de Arcangelis (GPA) in the case of the lira/dollar exchange rate. Several possible causes for the failure of the structural models are discussed. GPA refuse the explanation that the coefficients of the exchange-rate equation are not stable over time. In order to outperform the random-walk model in exchange rate forecasting, they demonstrate that it is necessary to move away from simple single equation, semi• reduced form models towards a more complex economy-wide macro• economic model, and show that their continuous time macroecon• omic model, a non-linear dynamic disequilibrium model of the Italian economy, greatly outperforms the random-walk model. In addition, Introduction: Frisch & Worgotter xxix

the predictive performance of the GPA model improves with the lengthening of the time horizon whereas the performance of the random-walk model deteriorates. Recent developments in financial market research have focused on such irrationalities as chaos, bubbles and fads. The heterogeneity of market participants has been emphasised, manifesting primarily in• formational inequalities. Following Frankel and Froot (1986), De Grauwe and Dewachter present a non-linear model of speculative dynamics in which two classes of speculators, 'chartists' and 'fun• damentalists', interact in the market. The 'chartists' are assumed to extrapolate recent movements in the exchange rate using a moving average procedure, while the fundamentalists base their expectations on a simple PPP calculation. The authors show that the speculative dynamics produced by the interaction of speculators using different pieces of information are capable of generating 'chaotic' behaviour of the exchange rate, which is unpredictable even in the absence of random shocks. The model can be considered to provide a synthesis view of the 'news' model to explain changes in the exchange rate and the view that exchange rate movements are driven by speculative dynamics. The failure of the standard asset market models to explain ex• change rate behaviour is also the starting point for Goldberg and Frydman. These models are usually solved using the rational expecta• tions hypothesis (REH) and it seems natural to inquire whether the problem lies in part with the expectational assumption . While the REH implies that the agents' forecasting functions are the same as the reduced form of the analysts' model, the theories consistentexpecta• tions hypothesis (TCEH) proposed by Goldberg and Frydman recog• nises the existence of a pluralism of theories describing exchange rate dynamics and allows agents to base their forecast on more than one of the existing theories. The exchange rate market is described by a composite model consisting of three different types of monetary models of the ex• change rate . The forecasting function is a linear function of the variables of these models where the coefficients attached to each variable will be consistent in sign with at least one of the theories included in the model. The exchange rate dynamics emerging from the TCEH are characterised by persistent movements in both nom• inal and real variables of the system. In addition the persistent movements will be inherently unstable in that movements 'too' far xxx Introduction: Frisch & Worgotter away from natural levels will cause agents to switch their expectations functions or will cause policy officials to intervene from the outside. The authors emphasise that the TCEH explains many 'abnormalities' in the exchange market reported in recent empirical studies. While De Grauwe and Dewachter present a theoretical model, Vijayraghavan tries to measure the weights of the different traders in the market for foreign exchange. The model distinguishes four classes of trader: 'rational expectation' traders; 'informed' fundamentalists; 'uninformed' fundamentalists and chartists - equal to feedback traders. Following a model by Cutler, Poterba and Summers (1990) this paper provides empirical evidence that 'uninformed' fun• damentalists predominate among the different type of traders; the chartists constitute the second most important group, while the in• formed fundamentalists seem to be the least important in the foreign exchange market. Research in the field of macroeconomic theory of the open econ• omy led to significant contributions during the 19705 and 19805, in part as a response to economic events, such as the two oil shocks and experimentation with different exchange rate regimes by various countries . Some of the important developments of this research are reflected in this volume . Indeed the vitality of open economy macroeconomic thinking is confirmed by the recent publication of two further volumes of essays, 'International Aspects of Fiscal Poli• cies' edited by Frenkel (1988) and 'International Economic Policy Coordination' by Buiter and Marston (1988) . If we include the pre• sent volume with the two above, the three together offer the reader a comprehensive overview of the state of the a11 of open economy macroeconomic issues.

Notes 1. The output of this research is published in a special issue of Economica (1986) vol. 53. 2. The share of demand constrained firms shows two maxima following the two oil-price shocks of 1973/74 and 1980181. Since 1983 the share of demand constrained firms has been reduced by 50 per cent. Introduction: Frisch & Worgotter xxxi

References

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