Fiscal and Monetary Policies in a Flexible Exchange Rate Model with Full Employment and Static Expectations

Abstract

In an important paper Tobin and Buiter (1976) pursued the pioneering work of Blinder and Solow (1973) and (1974) further to confirm the Blinder and Solow key result that bond-financed fiscal expansions have permanent effects on aggregate demand. When Tobin and Buiter considered such a fiscal expansion in the context of a fully employed, closed economy, with flexible prices a very strong result was shown to emerge: the steady-state output increased through capital deepening. Unfortunately this result can be accepted only if price expectations adapt fairly quickly to price experience because only then is their model stable. Under static expectations their model is unstable. In this chapter we generalise the full-employment model with static expectations presented by Tobin and Buiter in two important respects. First we ‘open up’ the economy to trade in commodities and securities with the rest of the world in a regime of perfectly flexible exchange rates. Second, we discard the restrictive assumption that bonds and capital are perfect substitutes in portfolios by allowing for imperfect substitution. In turn, we use our model to reconsider the effects of a bond-financed fiscal expansion and we also use it to study the effects of an open-market operation.