Abstract
This chapter reviews important paradigms that heavily influence the architecture of MM. We commence with some well known contributions to the pure theory of macroeconomics; in particular, we focus on the work of Mundell and Fleming and on Dornbusch’s model of overshooting exchange rates. Some brief attention is paid also to the open-economy macro models that were developed during the 1980s; a characteristic of the latter is the incorporation of a binding intertemporal budget constraint on the actions of governments.
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References
Readers well versed in the Mundell-Fleming and Dornbusch models may prefer to start this chapter at section 3.4, returning to earlier material only as necessary.
Those wishing to revise the concepts of structural and reduced forms, and/or the underpinnings of IS curves, could either ‘fastforward’ to subsection 3.3(b), and then return to the present section; or, alternatively, take the current material ‘on faith’ with the assurance that an explanation is immanent.
In some accounts, bonds denominated in domestic and in foreign currency are reckoned as separate assets, bringing the total to three. In view of the interest parity condition (3.2.8), however, the two types of bonds are perfect substitutes, and are treated here as a single asset. Later (on p.20) we briefly reintroduce the distinction between these two types of bonds.
The equilibrium version of Walras’ Law states that if (n-1) items in a closed n-item market are in equilibrium, then so also must be the last one.
20 Although DBM is a one-commodity model, net exports are recognized as a component of final demand and are responsive to the ratio of the foreign price level to the domestic price level (converted at the current exchange rate).
Readers familiar with the assumptions underlying IS-LM analysis should skip this subsection, and move immediately to (c) below.
In general, predetermined variables include exogenous and/or lagged endogenous variables.
The concept of a ‘normal’ rate of utilization of the workforce may be identified with an unemployment rate equal to the NAIRU (the non-accelerating-infiation rate of unemployment).
This addition is done in real terms: this is possible because only one type of commodity, a traded good, is formally recognized in DBM — as in many small theoretical macro models, the lack of an obvious motivation for international trade and the failure of the ‘law of one price’ remain as liabilities of the method. (In microeconomics, if two items are the same commodity, they are perfect substitutes by definition; it then follows that they must command the same price.) The justification for keeping the macro analysis at such a high level of aggregation is that qualitatively similar results are obtained with a disaggregated model, which is algebraically a good deal more complex.
There is one exception: it is assumed that the percentage response in money demand to a one percentage point change in the interest rate is constant.
Note that the assumption of constant elasticities for the IS curve is only a local approximation; from (3.3.1), A is globally linear in the levels of its components; it cannot, therefore, be log-linear in the variables determining its components.
Logarithms throughout this book are on the natural base, e.
An elementary but more detailed explanation of uncovered interest parity may be found in Chapter 23, section 23.3, which can be read independently of the remainder of that chapter.
30 In technical language, (3.3.11) introduces a zero root into the first-order dynamical system (3.3.9)-(3.3.13). Potentially unstable dynamics are avoided by setting the initial value of p exogenously. This endows the system with one stable root.
Alternatively, under rational expectations in financial markets, the initial value of the exchange rate e may be specified exogenously; this is sufficient to endogenize the initial value of p. The key to understanding this results is to recognize that x and [-ė ] are equal under rational expectations.
This subsection could be omitted at a fiist reading: most of the results in later subsections will remain intelligible.
The corresponding equations in MM are explicit.
As we have seen above, this is an example of the operation of Walras’ Law, the equilibrium version of which states that if (n-1) items in a closed n-item market are in equilibrium, then so also must be the remaining one.
Keep in mind that there is only one commodity in DBM. This makes it reasonable for the law of one price to reign in the long run (but does not help to motivate the departures from this rule in the short run that are a crucial mechanism of the model).
Keep in mind that e is the logarithm of a ratio like: 0.75 US dollars per Australian dollar. If the long-run equilibrium rate were (say) 68 US cents per Australian dollar, then according to equation (3.3.51) the number of US cents per local dollar would be falling over time.
Strictly speaking, balanced growth path.
The representative consumer in a net creditor country will enter the model’s steady state deriving a constant fraction of its income from foreign interest payments.
In fact, the financial decision makes no difference at all if capital markets are perfect. This is a consequence of the Modigliani-Miller (1958) theorem. Blanchard and Fischer (1989, Chapter 6) provide a discussion of this point.
The results reported in this section are based on an updated reestimation of MM to reflect the rebased national account statistics released in March 1993. At the level of detail here reported the simulation results would be almost indistinguishable from those based on the slightly earlier version of MM on which the rest of this book is based.
Technological improvement in fact allows real wages per person (but not per efficiency unit of labour) to grow in the steady state. This complication, which may be ignored for present purposes, is explained below in Chapter 5.
The real exchange rate here can be defined as the ratio of the product of the foreign price level P* times the reciprocal (1/E) of the nominal exchange rate to the domestic price level P.
In technical use the term overshooting is usually restricted to the initial (contemporaneous) response to the shock. Our usage here is less technical.
50 The NAIRU (non-accelerating inflation rate of unemployment) is the long-run equilibrium rate of unemployment in MM and in many other macro models; if you are unfamiliar with it, glance ahead at page 106.
The exogenous real variables in MM are employment, real spending by general government, and real imports by the rest of the world.
By the terms of trade we mean the ratio of the foreign-currency price of the home country’s exports to the foreign-currency price of its imports. If the foreign demand curve for exports and the supply of imports curves are flat (as in HSM), the terms of trade are fully exogenous. To see what is meant by art endogenous comportent of the terms of trade, consider the situation in which the imports supply function is flat, but the export demand curve is downward sloping (i.e., the home country has some market power). Then the endogenous component of the terms of trade is defined as the movement along a given export demand curve in response to changing levels of exports of the home country. The exogenous component of the terms of trade is the change in the export/import price ratio due to shifts in the position of one or both of the export demand and/or import supply schedules.
By ‘atemporal we mean ‘at a given point of Urne’. The discrete-time analogue is ‘withinperiod’. This concept is in contradistinction to ‘intertemporal’ decision making which involves decisions relating to more than one point (or, in the discrete case, interval) of time. —
The ‘appropriate units’ in the case of labour are ‘units of constant efficiency’ (explained below).
The line between parameters and variables which are always set exogenously is arbitrary. for example, L0 and Mo could equally well be classified as exogenous variables of the model.
Optional exercise: Verify that the alternative approach leads to the same result.
See also Parsell, Powell and Wilcoxen (1991).
The concept of parametric change in a Cobb-Douglas production function is discussed in detail in Chapter 5, section 5.2.
Exercise 3.11: Derive equation (3.6.57).
Harrod neutrality is explained in detail in Chapter 5, section 5.3. for present purposes, labour augmentation à la (3.6.2) will serve as a working definition.
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© 1995 Springer-Verlag Berlin Heidelberg
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Powell, A.A., Murphy, C.W. (1995). Principal Mechanisms in MM. In: Inside a Modern Macroeconometric Model. Lecture Notes in Economics and Mathematical Systems, vol 428. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-662-00771-6_3
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DOI: https://doi.org/10.1007/978-3-662-00771-6_3
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