Non‐traded Goods and the Long‐run Effects of Macroeconomic Policy Under Alternative Exchange Rate Regimes

Abstract

Until recently, little attention has been paid to the supply side of the goods and labour markets in analysing the effects of macroeconomic policy in small open economies. The path-breaking paper by Mundell(1963) considered only the demand side of the goods market, assuming the supply of goods to be inhitely clastic at ruling prices. More recently, McKinnon (1976) has explicitly considered the role of supply in the goods market. He assumed less than infinite elasticity of supply arid concluded that if an economy only produced one traded good, the price of which is fixed in terms of foreign currency, fiscsl policy would have no effect on domestic output irrespective of whether the exchange rate were fixed or floating.The assumption of infinitely elastic demand for the country's good is crucial to McKinnon's result, as also is his assumption of fixed nominal wages. Exchange rate changes are necessary to produce output changes in his model but these are effectively ruled out if, as he assumes, interest rates arc fixed a t world levcls and thux, in the absence of shifts in liquidity preference, a fixed money stock implies a fixed nominal value of output.1 I n a recent paper-Riley (1980)-I have examined a model which relaxes these assumptions. Allowing a less than infinite elasticity of demand for the country's good +Manuscript received 6.4.81 ; final version received 15.7.82. tTho views oxpressed in this papor are those of the author, and not necessarily of the Treasury. I am grateful for helpful comments on an earlier version by my colleague, Peter Spencer, and two anonymous referees.1The assumption of fixed nominal wagos sits uneasily with that of fixed interest rates. The former is likely to be valid only, if a t all, in the short run, but expectations of exchange rate movements are particularly likely in the short run, in which case domoetic and world interest rates need not be equal. 206