Asset Prices, the Real Exchange Rate, and Unemployment in a Small Open Economy: A Medium-Run Structuralist Perspective

Abstract

The second half of the nineties saw a number of industrial economies experiencing a steady decline in the rate of unemployment and real exchange rate appreciation together with a stock market boom, brought about by anticipation of higher productivity fueling an increased future need for capital, unaccompanied by rising inflation (Phelps and Zoega, 2001). How well does the open-economy Keynesian model (Mundell, 1962, Mundell, 1963) explain this phenomenon? In the small open economy version of this model with a given external real rate of interest under freely fluctuating exchange rates and perfect international capital mobility, the stock market boom increases both investment and consumer spending, thus aggregate demand. The expanded demand, however, puts an upward pressure on the domestic interest rate, which leads to a massive inflow of capital and consequently a real exchange rate appreciation. The result is that export demand is fully crowded out so as to leave output and employment unchanged. In a large open economy, the increased aggregate demand pushes up the world interest rate so that the higher velocity of money pulls up domestic output and employment (above the natural level), creating inflationary pressures.