This paper is a chapter in the forthcoming Handbook of International Economics. It surveys the literature on the specification of models of asset markets and the implications of differences in specification for the macroeconomic adjustment process. Builders of portfolio balance models have generally employed tpostulated asset demand functions, rather than deriving these directly from micro foundations. The first major section of the paper lays out a postulated general specification of asset markets and summarizes the fundamental short-run results of portfolio balance models using a very basic specification of asset markets. Then, rudimentary specifications of a balance of payments equation and goods market equilibrium conditions are supplied, so that the dynamic distribution effects of the trade account under static and rational expectations with both fixed goods prices and flexible goods prices can be analyzed.The second major section of the paper surveys and analyzes micro foundation models of asset demands using stochastic calculus. The microeconomic theory of asset demands implies some but not all of the properties of the basic specification of postulated asset demands at the macro level. Since the conclusions of macroeconomic analysis depend crucially on the form of asset demand functions, it is important to continue to explore the implications of micro foundations for macro specification.

This paper presents a model that integrates money, relative prices, and the current account balance as factors explaining movements in nominal (effective) exchange rates. Thus money and the current account are the proximate determinants of changes in real (effective) rates. The basic model is first analyzed under static expectations. It is an extension of to include explicitly exogenous disturbances to the current account. Next, rational expectations are introduced, and it is shown that the nominal (and real) rate should be expected to jump instantaneously in response to new information or "innovations" in money, the current account, and relative prices.The model is applied to the quarterly data on effective exchange rates, relative prices, money and the current account for four countries--the U.S., the U.K., Germany and Japan--since 1973. First the time-series properties of the data are described. All are approximately first-order autocorrelations except all relative prices and Japan's effective exchange rate and current account balance. These are second-order autocorrelations. Then vector autoregressions (VARs) are estimated among the four variables for each country. The residuals from these equations are the "innovations" in the data--the current movements not predicted by the past. The correlations amongst these innovations are consistent with the theory.Thus the broad conclusion from the paper is that the theoretical model which integrates money, the balance on current account and relative prices, is consistent with movements in these variables since 1973. Real exchange rates adjust to real disturbances in the current account, and time-series innovations in the current account seem to signal the need for adjustment.

opened with a bang and closed with a whimper. In January, the European monetary system (EMS) celebrated five years of exchange rate stability: sixty full months without a realignment. The month before, the representatives of European Community (EC) member-states initialed the Treaty on Economic and Monetary Union concluded at Maastricht in the Netherlands. The transition to European monetary union (EMU) appeared to be fully underway. By the end of the year, the European monetary system had enduredindeed, was continuing to experience-the most severe crisis in its fourteen-year history. Two of ten currencies, the Italian lira and the British For help with data, we thank Samuel Bentolila,

WHEN the Brookings panel first met ten years ago, the U.S. governments managers of aggregate demand were cooling an economy suffering from an inflation 4 points higher than ten years before. The unemployment rate was 4.5 percent. Four years later, at the time of the panel's thirteenth meeting, the demand managers were cooling an economy suffering from an inflation 6 points higher still. The unemployment rate was 5 percent. As the panel meets today, the government's managers of aggregate demand are cooling an economy suffering from an inflation 7 points higher than ten years before. The unemployment rate is 7 percent and rising. Higher inflation, higher unemployment-the relentless combination frustrated policymakers, forecasters, and theorists throughout tLhe decade. The disarray in diagnosing stagflation and prescribing a cure makes any appraisal of the theory and practice of macroeconomic stabilization as of 1980 a foolhardy venture. The patent breakdown of consensus spares me the task of seeking and describing collective views. I will just give my own observations and confess my own puzzlements. In one respect demand-management policies worked as intended in the 1970s. On each of the occasions I described at the beginning, the man-I am grateful to my colleagues at Yale and to members of the Brookings panel for comments on the original version, to Ray C. Fair also for the use of his model reported in the paper, and especially to members of the panel for many discussions of substance and for painstaking guidance of the revision. Bret Bertolin and Kathleen K. Donahoo provided efficient statistical and editorial assistance. Laura Harrison and other Cowles Foundation staff miraculously produced the typescripts under deadline pressures of my own making. The work was in part supported by the National Science Foundation and the Cowles Foundation.

Policy and Performance Links between LDC Debtors and Industrial Nations IN 1984 spokesmen for heavily indebted developing nations complained about the sharp interest rate increases that had come in the wake of the U.S. economic recovery. Emphasizing that the U.S. recovery had also spilled over into record export growth rates for developing countries, President Reagan commented on the trade-offs in the following terms: We sometimes hear complaints about U.S. interest rates, particularly by debtor nations, which are legitimately concerned about the additional debt service costs they must bear. But not enough mention is made of trade and the far greater benefits developing countries receive from renewed economic growth and open market policies of the United States. For the U.S. alone, imports from the non-Opec LDC's during the first seven months of this year increased by more than $12 billion over the amount during the same period last year. By comparison, a 1 percent increase in interest rates would increase net interest payments by the non-Opec LDC's by only $2.5 billion. ' This paper investigates the impact of macroeconomic developments in the industrialized nations on LDCs, in part to assess such trade-offs as that between increased LDC exports and higher interest rates resulting from U.S. growth. Such assessments will help in understanding the sharply divergent economic performance of LDCs and in judging whether the current debt crisis can be expected to disappear through the I am indebted to members of the Brookings Panel for helpful comments and suggestions. David Wilcox provided research assistance. Data Resources, Inc., generously made available computing facilities. 1. Reported in the New York Times, September 26, 1984, p. D5. 303 304 Brookings Papers on Economic Activity, 2:1985 mere passage of time or only through major and painful adjustments on the part of LDCs, for which some may be better equipped or positioned than others. A starting point is a comparison of recent growth performance among LDCs in Asia and in Latin America. Shown below are growth rates in real income pet capita for the period 1980-84 (1980-83 in the case of Indonesia) for several countries. Annual rate of growth (percent)

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Where Do We Stand? THE BROOKINGS PANEL on Economic Activity for the past ten years has mirrored much of the exciting theory and empirical work in open-economy macroeconomics. In the spirit of Brookings, the papers have explored what issues openness raises for macroeconomic management. The range of interests has been quite broad, beginning with William Branson's "new view of international capital movements" and including Marina Whitman's dismissal of "global monetarism" and many of the topics of the day from trade equations and oil to commodity booms, debt, and portfolio selection.' The questions have been similar-how much independence there is for macroeconomic policy in an interdependent world; how important monetary factors are; or how can the interest rate be kept lower than the market will bear. The papers have emphasized the evolution of open-economy macroeconomics from the structure of the 1960s-the Mundell-Fleming model-to a framework better suited to the analysis of inflation, expectations, and portfolio substitution. This paper maintains the tradition of asking how international interdependence has impinged on macroeconomic variables and policy options. The paper takes as its frame of reference the experience with floating ex-I am grateful for comments from members of the Brookings panel and from Stanley Fischer. Robert E. Cumby made many suggestions and provided generous research assistance. Financial support was provided by a grant from the National Science Foundation. 1.

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