Exchange rates, capital, output and debt when nominal interest rates are policy parameters

The Economic and Social Review, Vol. 22, No. 1, October, 1990, pp. 1-23

Exchange Rates, Capital, Output and Debt

When Nominal Interest Rates are Policy

Parameters

P.J.N. S I N C L A I R *

Brasenose College, Oxford and Queen's University, Canada

I I N T R O D U C T I O N

R

ecent years have witnessed a growing number o f attempts t o reduce i n f l a t i o n by a p o l i c y o f raising n o m i n a l interest rates. Since 1988, such measures have been particularly pronounced i n Australia, Canada and the U n i t e d K i n g d o m . I t is i m p o r t a n t t o ask h o w higher interest rates can help t o lower i n f l a t i o n , w h a t factors determine the speed and reliability o f the mechanisms involved, and, above a l l , w h a t the side-effects o f such policies may be.

The purpose o f this paper is t o explore various mechanisms t h r o u g h w h i c h n o m i n a l interest rates may affect the course o f i n f l a t i o n , i n the c o n t e x t o f an open economy m o d e l where exchange rates are freely floating. The m a i n focus o f a t t e n t i o n is u p o n h o w o u t p u t and income react, i n the short r u n and the l o n g , to a change i n the n o m i n a l rate o f interest. This calls for an e x p l i c i t treatment o f the markets for capital and labour, as well as for m o n e y . None of these markets is assumed to clear instantaneously. I n t e r n a t i o n a l capital m o b i l i t y , and the authorities' a b i l i t y t o influence the e v o l u t i o n o f the n o m i n a l

Dublin Economics Workshop Guest Lecture, Fourth Annual Conference of the Irish Economics Associ­ ation, Kilkenny, 18-20 May 1990.

m o n e y stock, are b o t h taken t o be qualified rather than perfect.This paper aims t o incorporate i m p o r t a n t features o f the w o r l d i n t o the story. The task o f keeping matters as simple as possible has necessitated a somewhat cavalier treat­ ment o f m i c r o f o u n d a t i o n s . Rational expectations and optimising behaviour are n o t w h o l l y absent, b u t play a l i m i t e d role. The c o m p l e x i t y o f the m o d e l makes i t appropriate to concentrate chiefly o n the impact and steady-state effects o f p o l i c y changes, b u t there is some discussion o f the character o f the transition between t h e m .

I n f l a t i o n cannot persist indefinitely w i t h o u t some accommodating increases i n the n o m i n a l money supply. To the extent that sustained i n f l a t i o n depends u l t i m a t e l y o n the g r o w t h rate o f the n o m i n a l stock o f m o n e y , this paper argues that there are t w o possible routes f r o m a higher n o m i n a l rate o f interest to slower i n f l a t i o n . One takes the f o r m o f a negative effect from the real rate of interest o n the rate o f monetary g r o w t h . We m i g h t t h i n k o f the central bank b u y i n g indexed bonds, for example: such open market operations w o u l d tend t o exert d o w n w a r d pressure on real interest rates and, at least tempor­ a r i l y , raise the n o m i n a l m o n e y g r o w t h rate. Some commentators have argued that the great post-World War I I i n f l a t i o n is u l t i m a t e l y traceable to central bank attempts t o h o l d interest rates d o w n i n the 1950s and 1960s. T o this " W i c k s e l l i a n " view we may add a second, rival account o f h o w higher interest rates c o u l d depress m o n e y g r o w t h . This postulates that the money market need n o t clear instantaneously. I n accordance w i t h the monetary approach to the balance o f payments, or the buffer stock theory o f m o n e y , money demand and m o n e y supply may t e m p o r a r i l y diverge. A n increase i n the n o m i n a l rate o f interest should l o w e r money demand. I f an excess supply of money results, the money supply g r o w t h rate may shrink. A different, b u t similar agument is t r a d i t i o n a l l y p r o p o u n d e d by the Bank o f England: c u t t i n g the g r o w t h o f monetary aggregates calls for r e d u c t i o n i n the g r o w t h of banks' assets, and this i n t u r n requires a higher rate o f interest to cut the demand for loans and advances. I n this paper, b o t h mechanisms are allowed for.

wage rates i n the face o f u n e m p l o y m e n t , b u t boosted b y d o w n w a r d pressure on the exchange rate.

The paper is organised as follows. Section I I discusses a number o f features o f standard simple exchange rate models w h i c h appear at variance w i t h the facts o f the w o r l d , and i n need o f m o d i f i c a t i o n . Section I I I then proceeds t o lay o u t the equations o f a m o d e l designed t o reflect those concerns, and i n w h i c h , i n particular, the domestic n o m i n a l interest rate becomes a p o l i c y parameter. Section I V examines the long-run solutions o f the m o d e l i n the steady state. I n Section V , a t t e n t i o n switches t o the i m p a c t effects o n the key variables o f interest, and t o the t r a n s i t i o n . Section V I offers some i m p o r ­ tant qualifications and concludes.

I I SOME F A C T O R S T H A T A M O D E L O F F L O A T I N G R A T E S N E E D S T O T A K E I N T O A C C O U N T

Standard exchange rate models that allow for sluggish price adjustment (such as Dornbusch (1976) and Buiter and M i l l e r (1981)) have many virtues. B u t some o f their features are controversial. Here is a list o f nine respects i n w h i c h there is a case f o r seeking t o generalise t h e m :

(a) The n o m i n a l m o n e y supply is treated as a p o l i c y parameter, that can be set costlessly b y the authorities at any desired level. This assump­ t i o n was regarded as innocuous i n the 1970s. B u t the 1980s saw a major shift away from m o n e t a r y targetry towards interest rate mani­ p u l a t i o n i n m a n y financial centres. The collapse, i n 1 9 8 2 , o f the Fed's N e w Operating Procedures w h i c h had been i n t r o d u c e d i n 1979, is perhaps the most celebrated example o f this.

(b) Factor markets are o n l y i m p l i c i t i n the standard models. There is a need to incorporate markets for capital and labour, and hence pro­ d u c t i o n functions. Once money wage rates make their appearance, i t seems desirable t o a l l o w for possible (at least partial) i n d e x a t i o n , and also hysteresis effects that associate m o n e y wage g r o w t h t o the rate of change, and n o t j u s t the level, o f u n e m p l o y m e n t .

(c) The standard models treat " n a t u r a l o u t p u t " , or productive p o t e n t i a l , as exogenous, and t y p i c a l l y constant over t i m e . O n the other hand, aggregate demand is deemed t o fall as interest rates rise. The p r o b l e m here is that i f i t is investment t h a t responds to interest rates, and natural o u t p u t varies w i t h the stock o f capital, natural o u t p u t m u s t become endogenous.

m o n e y demand, and, perhaps, money wage rates reacts, needs t o dis­ play a l i n k w i t h the home currency value o f foreign goods prices. A t one extreme, one m i g h t wish t o allow the possibility o f inertia i n the c o n s u m p t i o n real wage rate, for instance.

(e) I n t e r n a t i o n a l capital m o b i l i t y is deemed to be perfect. I t seems wise t o allow this t o be high b u t f i n i t e , and n o t necessarily i n f i n i t e . (f) The interest p a r i t y c o n d i t i o n is generally assumed independent o f

the home country's net foreign asset p o s i t i o n . B u t countries deep i n external debt may have t o offer a p r e m i u m on their interest rates. (g) The trade balance is o n l y i m p l i c i t , and the role o f net interest, profits

and dividends i n the current account o f the balance o f payments is ignored. There is a case for m o d e l l i n g the trade account e x p l i c i t l y , and adding net interest flows t o i t .

(h) When f o r w a r d exchange rates are i n t r o d u c e d , the p r e m i u m o n f o r w a r d foreign currency is taken t o reflect agents' expectations o f the spot exchange rate d r i f t perfectly. B u t bankers often claim that f o r w a r d foreign exchange premia are aligned o n interest differentials (to t h w a r t arbitrage), rather than the reverse, and particularly so i n the thinner and longer markets.

(i) The price o f (domestically produced) goods is assumed sluggish, to reflect sluggishness i n money wage rates that are o n l y i m p l i c i t . I n practice, there seems m u c h to be said for the view that goods prices adjust faster than money wage rates, and some case for e x p l o r i n g the idea that goods prices are " j u m p " variables while money wage rates are n o t . " M e n u costs" appear to be most serious i n labour markets.

What follows is a m o d e l that tries t o extend the standard story t o allow for these nine issues.

I l l T H E M O D E L

The m o d e l proposed here consists o f fifteen equations. Unless specified to the c o n t r a r y , upper case R o m a n letters refer to levels o f variables, and lower case t o their natural logarithms, while Greek l o w e r case letters denote par­ ameters. A n overdot is a time derivative. A n asterisk denotes overseas, w i t h the value o f the variable defined i n foreign currency. Overbars and tildes are defined as they occur.

Q ( t ) = Q ( t ) + K ( t ) + B ( t ) + e ( ms- md) (2)

c o n s u m p t i o n : Q ( t ) + e ( ms- md) e > 0.

K ( t ) = 0 K ( p - R ) = 0 ( a Q ( t ) - R K ( t ) ) (3)

d > 0. p : rate o f p r o f i t (= a Q / K f r o m p r o d u c t i o n f u n c t i o n ( 9 ) ) .

B ( t ) = ^ c ( t ) - 02( Q ( t ) - Q ( t ) ) - R Z ( t ) (4)

j3j,|32 > 0. Z ( t ) : net overseas debts (real).

" d W = + " i ^ O - T ? 2r + P W + U - ^ M O (5)

p = 0p + ( l - 0 ) ( p * + s ) = p + ( l - 0 ) c • (6)

(c(t) = p * ( t ) + s(t) - p ( t ) ) .

Q ( t ) = Y K ^ ^ N1- " (7)

Q(°°) = Y Ka( ° ° ) N1-a (8)

Q ( t ) = Y K ^ t j N W1- " (9)

w - p = l n ( l - a ) + q - n = I n ( l - a ) + ( y + a ( k - q ) ) / ( l - a ) (10)

w - p : l o g p r o d u c t real wage; k , n logs o f current capital and e m p l o y m e n t ; y : l o g technology index.

w ( t ) = w0( t ) + / c j ( p ( t ) + ( l - 0 ) c ( t ) ) + K2n ( t ) (11)

K j : i n d e x a t i o n coefficient; K 2 : hysteresis coefficient.

1 > KL > 0; K2 > 0.

w0( t ) = (1-Kl)n + 6 ( n ( t ) - n ) (12)

£(t) = f ( r - r * - f ( t ) -7Z ( t ) ) (13)

f > 0. f = f o r w a r d p r e m i u m on foreign exchange.

f ( t ) = + x ( c ( - ) - c ( t ) ) ) + ( l - X ) ( r - r * - T ? ( t ) ) (14)

B ( t ) + £ ( t ) = 0. (15)

E q u a t i o n (1) describes the e v o l u t i o n o f the money supply. I t specifies the g r o w t h rate o f the n o m i n a l money supply ( Ms; ms i n logs) i n terms o f the real rate o f interest, R, and the money market disequilibrium (as reflected by the difference between ms and md, the l o g a r i t h m o f n o m i n a l money demand). E q u a t i o n (2) closely resembles the short-run money demand g r o w t h equation postulated, and very successfully estimated for the U n i t e d States, by Baba, H e n d r y and Starr (1990). The disequilibrium term is an error correction mechanism. I t captures the idea that money supply g r o w t h rises when there is excess demand for m o n e y , and more slowly i n the presence o f excess supply. The money supply g r o w t h rate is assumed to fall i f the real interest rate goes u p ; as we shall see later, t h a t w i l l happen f o l l o w i n g a rise i n the n o m i n a l rate of interest. So (1) is b u i l t on the n o t i o n that raising the n o m i n a l rate o f interest w i l l succeed i n c u t t i n g money supply g r o w t h , at least i n the long r u n .

E q u a t i o n (2) defines the level o f real aggregate demand ( Q ( t ) at date t ) . This consists o f domestic c o n s u m p t i o n and investment spending (the latter equals K ( t ) : capital does n o t depreciate, so that gross and net investment are equal, and government current and capital spending, i f any, is aggregated w i t h the private sector's) and the current account surplus, B ( t ) . Consumption spending is modelled as current natural o u t p u t w i t h the current value of the capital stock ( Q ( t ) ) , w h i c h is a m y o p i c f o r m o f permanent income. ( I t is m y o p i c i n that households are n o t assumed to l o o k ahead to future levels o f natural o u t p u t when the capital stocks may differ.) Consumption is also assumed t o react to money market d i s e q u i l i b r i u m .

Investment is given by E q u a t i o n (3). Here I f o l l o w T o b i n ( 1 9 6 9 ) . Invest­ ment is taken t o be p r o p o r t i o n a l t o the gap between the current rate o f p r o f i t (the marginal p r o d u c t o f capital, derived f r o m the Cobb-Douglas p r o d u c t i o n f u n c t i o n ) and the real rate o f interest. E q u a t i o n (4) presents the current account surplus, B ( t ) , w h i c h includes real interest income on net overseas assets ( - R Z ( t ) ) , and the trade surplus. The trade surplus is deemed to be linear i n t w o variables — the log o f competitiveness (c(t)), and the difference between current real aggregate demand, Q ( t ) , and its current e q u i l i b r i u m value of natural o u t p u t , Q ( t ) . This gap can be thought of as the imbalance i n the p r o d u c t market.

Equations (7), (8) and (9) all give different p r o d u c t i o n functions for out­ p u t . A l l are based o n the Cobb-Douglas, i n constant returns f o r m . E q u a t i o n

(7) defines current productive p o t e n t i a l i n terms o f current capital ( K ( t ) ) , and the supply o f labour, N , w h i c h is taken t o be stationary and exogenous. E q u a t i o n (9) relates actual current o u t p u t t o current capital and current e m p l o y m e n t , N ( t ) . The demand for labour and the supply o f labour can differ. By contrast, (8) describes long r u n productive p o t e n t i a l , Q(°°), w h i c h relates o u t p u t i n the l o n g r u n t o the long-run capital stock, K(°°) and the supply o f labour N .

Various features o f the labour m a r k e t appear i n the n e x t three equations, (10), (11) and (12). E q u a t i o n (10) defines the p r o d u c t real wage c o n f r o n t i n g producers, o n the assumption o f perfect c o m p e t i t i o n . I n (11), the money wage rate ( w ( t ) at t i n logs) has a core element, wQ (t), and may also vary w i t h the expenditure price index t o allow for possible i n d e x a t i o n , and w i t h the level o f e m p l o y m e n t . This last t e r m introduces a possible hysteresis effect. Hysteresis i n the labour market is m o d e l l e d most simply by the n o t i o n that the rate o f increase i n money wage rates may vary w i t h the rate of change, and n o t j u s t the level, o f u n e m p l o y m e n t . I f this relationship is linear, i t can be integrated i n t o a l i n k between the levels o f the money wage and employ­ ment. Finally, (12) gives the dynamics o f the core element o f the money wage rate, i n terms o f domestic goods price i n f l a t i o n (ir) and the excess supply o f labour, n - n ( t ) i n logs.

The last three equations r e t u r n t o external aspects o f the system. Equa­ t i o n (13) gives the net i n f l o w o f international capital, the surplus o n the capital account o f the balance o f payments. The parameter f reflects the interest-elasticity o f capital flows. I t embraces the standard case o f perfect international capital m o b i l i t y at one extreme (f = °°) as well as t o t a l i m m o b i l i t y at the other (f = 0). The parameter 7 captures, i n the simplest linear fashion, the risk p r e m i u m coefficient t o be attached to a c o u n t r y w i t h a negative net foreign asset p o s i t i o n . The variable f ( t ) is the f o r w a r d p r e m i u m on foreign exchange, w h i c h is defined by (14). Here, the parameter X denotes the extent t o w h i c h the f o r w a r d p r e m i u m is governed by expectations o f relative i n f l a t i o n and the e v o l u t i o n o f competitiveness. I n the standard models, X is set i m p l i c i t l y at u n i t y . But (14) allows X t o fall below u n i t y , t o reflect the "bankers' s t o r y " described i n p o i n t (h) above: according t o that account, f o r w a r d rates are simply aligned on interest differentials. Lastly, (15) states that the exchange rate is freely floating w i t h no i n t e r v e n t i o n o n the part o f the authorities (other than i n the f o r m o f interest rate m a n i p u l a t i o n ) .

I V L O N G R U N A N A L Y S I S

i n the n o m i n a l rate o f interest. I n the long r u n , the gap between the supply of labour and the demand for labour ( n - n ) disappears. So does that between aggregate demand ( Q ( t ) ) and long-run productive p o t e n t i a l (Q(°°)). The capital stock adjusts t o set the rate o f p r o f i t equal t o the real rate o f interest. So K vanishes, as does Z .

I t follows that the m o n e y supply g r o w t h rate, rh, equals the rate o f infla­ t i o n . There is no d r i f t i n technology, labour supply or capital, so that Q(°°) is stationary. Because (1) implies that

m = ~ M r - w )

once the m o n e y m a r k e t imbalance vanishes, the rate o f i n f l a t i o n settles d o w n

to ( M0- M1r ) / ( 1_M1) , and the real interest rate t o ( r - j u0) / ( l - j U j ) . Since

1 > ^1 b y assumption, i n f l a t i o n and m o n e y g r o w t h b o t h decrease i n the n o m i n a l interest rate, and the real rate o f interest increases i n the n o m i n a l rate.

The increased n o m i n a l rate o f interest therefore raises the real rate o f interest. This means that the long-run stock of capital, and hence the long-run level of o u t p u t , b o t h d r o p . K = Oimplies, f r o m (2), t h a t a Q ( ° ° ) = R K ( ° ° ) . Hence

K ( ~ ) = N C a Y / R ^ / U - o O and Q(°°) = Y ^ a Y / R )0"1"0 0' . T u r n i n g t o the ex­

ternal variables, begin b y c o m b i n i n g (13) and (14) to y i e l d

Z ( t ) = r X ( r - r * - 7 Z ( t ) - r r + 7 T * -X( c ( a ) - c ( t ) ) ) (16)

N e x t define R*, the foreign real rate o f interest, as r*-n*, and set c ( t ) equal to c(°°). N o w make Z vanish, as i t must i n the steady state. E q u a t i o n (16) n o w furnishes solutions for the long-run values of net debts, Z , and the l o g a r i t h m of competitiveness: Z = ( R - R * ) / ? and c(°°) = RZ/(3j). This implies that our increased n o m i n a l rate o f interest w i l l serve to raise net overseas debts and depress the real exchange rate i n the long r u n . (The first o f these results always happens; the second, p r o v i d e d only that the domestic real interest rate is at least half as great as the overseas real rate, a c o n d i t i o n guaranteed unless the home c o u n t r y has sufficiently large net overseas assets.) The reasoning for this is clear: a higher n o m i n a l interest rate attracts capital f r o m overseas, as w e l l as m a k i n g existing debts more expensive t o service. So i t tends to drive d o w n the real exchange rate i n the long r u n , i n order to generate the neces­ sary trade balance i m p r o v e m e n t required t o make r o o m for the enhanced debt servicing costs.

Figure 1 illustrates some o f these relationships. The lower r i g h t quadrant

depicts the negative l i n k between TI and r. This line slopes up given that

1 > j U j , w i t h a gradient o f n1l(l~n1 ). The lower left quadrant portrays the

Figure 1: The Long-Run Links Between Nominal and Real Interest Rates, Inflation, and Domestic and National Product.

Q - R Z [ = G N P ]

/ Q[=GDP]

/ /

Q (output); Q - R Z (national income)

/

/

//

R *

R (real rate of interest) r (nominal rate

of interest)

/

/

gradient o f - (1-Mj )• I n the upper left quadrant the negative influence o f the real rate o f interest o n long-run domestic p r o d u c t , Q(°°), appears as an un­ b r o k e n curve, while that for national p r o d u c t ( Q ( ° ° ) - R Z ) as a b r o k e n one. The t w o curves intersect where R = R * , since at this p o i n t net overseas debts, and hence debt servicing costs, vanish. C o m b i n i n g these three relationships r u n n i n g f r o m the n o m i n a l rate o f interest.to domestic p r o d u c t establishes a d o w n w a r d sloping curve, w h i c h presents itself i n the upper right quadrant. Its elasticity is - a r / ( l - a ) ( l - j U j ) ( r - j uQ) .

These long-run effects o f a permanent rise i n the home country's n o m i n a l rate o f interest are essentially ceteris paribus. That is t o say, that is w h a t happens w h e n other variables are kept fixed. I n particular, the values o f f iQ

(the constant t e r m o n the m o n e y g r o w t h equation) and R * (the foreign real rate o f interest) have been h e l d constant. There are t w o i m p o r t a n t cases where some o f the effects o f a higher n o m i n a l rate o f interest are neutralised. One o f these arises w h e n the j u m p i n domestic interest rates matches rises i n over­ seas rates. Suppose R * increases, once and for all, by a given a m o u n t , and that r is raised enough t o bring R up by the same a m o u n t , so that R = R * through­ o u t . I n this case, none o f the external effects materialise. N e t overseas debts, and the real exchange rate remain unchanged. B u t the internal effects con­ tinue t o operate. I n f l a t i o n drops. The real cost o f capital facing domestic firms has risen. So the domestic stock o f capital keeps d w i n d l i n g u n t i l the rate o f p r o f i t has climbed up to i t . O u t p u t ( b o t h domestic and national, for they are equal n o w ) must also go d o w n as a result o f the squeeze o n capital.

I n the second case, neither the internal nor the external repercussions o f the higher domestic n o m i n a l interest rate arise. This is so, at least, for the

real variables i n the system. T h a t is the p o s i t i o n when the j u m p i n the home

1 n o m i n a l rate o f interest offsets a parallel rise i n nQ, the autonomous intercept

on the money supply g r o w t h equation. I n that event, the real rate o f interest stays unchanged. So there is n o alteration i n the e q u i l i b r i u m values o f capital or natural o u t p u t , and no effect, either, o n long-run competitiveness or net indebtedness. There is some effect, however, o n the n o m i n a l variables. The steady state rate o f i n f l a t i o n rises by the increase i n I t w o u l d have gone up still more had r n o t increased. The n o m i n a l exchange rate w i l l depreciate faster, or appreciate slower, to match the higher domestic i n f l a t i o n rate. B u t , as (16) testifies, n o t h i n g happens t o the capital account o f the balance o f payments, at least i n the longer r u n , since the changes i n r and TT offset each other exactly. On the other hand, had the level o f r been raised enough to keep i n f l a t i o n constant, the real r a t e ' o f interest w o u l d have gone up, w i t h qualitative effects o n the real variables i n the system resembling w h a t hap­ pened i n the i n i t i a l case where j uQ and R* were given.

eco-n o m y models. The classic paper to display a positive loeco-ng-rueco-n l i eco-n k betweeeco-n the rate o f m o n e y g r o w t h and the level o f real o u t p u t is T o b i n ( 1 9 6 5 ) . There, faster m o n e y g r o w t h tilts p o r t f o l i o s i n favour o f real as opposed t o financial assets, and stimulates savings, so that the capital-output r a t i o rises and the real rate o f interest declines. Hence, a r e d u c t i o n i n steady state i n f l a t i o n is associated w i t h a rise i n the real interest rate and a squeeze o n o u t p u t . The o n l y difference between our results and Tobin's is the fact that T o b i n makes the rate o f n o m i n a l m o n e y g r o w t h the key p o l i c y parameter, while the n o m i n a l rate o f interest is assumed independent o f the rate o f i n f l a t i o n . I n the present m o d e l , o f course, m o n e y supply g r o w t h is endogenous, and i n f l a t i o n is governed, i n the long r u n , by the n o m i n a l rate o f interest.

I n the O p t i m u m Q u a n t i t y o f M o n e y family o f models that begin w i t h Friedman ( 1 9 6 9 ) , o n the other hand, the real rate o f interest is generally governed independently o f monetary variables by the forces o f demography, p r o d u c t i v i t y and t h r i f t . The n o m i n a l rate o f interest diverges f r o m i t by an a m o u n t necessarily equal to expected i n f l a t i o n , i f foresight is perfect. I n a steady state that obeys the golden r u l e , the n o m i n a l interest rate equals the rate o f money g r o w t h ; and the latter is o f course taken t o be exogenous. When labour supply is endogenous i n a Ramsey-type m o d e l o f i n t e r t e m p o r a l o p t i m i s a t i o n w i t h m o n e y , faster m o n e y g r o w t h t y p i c a l l y lowers o u t p u t . I f the government finances its spending f r o m seignorage and other forms o f distortionary t a x a t i o n , as i n Poterba and Rotemberg ( 1 9 9 0 ) or Sinclair ( 1 9 9 0 ) , the door is left ajar for the possibility that o u t p u t and i n f l a t i o n rise together i n the long r u n , so l o n g as the rate o f i n f l a t i o n is l o w enough. B u t a l o w n o m i n a l interest rate is always associated w i t h l o w money g r o w t h . The benefits o f p l e n t i f u l real balances to w h i c h i t gives rise are the r e w a r d for sus­ tained abstinence i n the money g r o w t h rate. A high n o m i n a l interest rate indicates r a p i d i n f l a t i o n . I t is n o t a device for reducing i t . This is essentially the view that predominates, also, i n recent w o r k on interest rate targeting, such as Barro ( 1 9 8 9 ) .

I n practice, the n o m i n a l interest rate is b o t h an i n d i c a t o r o f anticipated i n f l a t i o n and an instrument for c u t t i n g actual i n f l a t i o n . The t e r m structure o f interest rates provides a f o r u m w i t h i n w h i c h this paradox can be resolved. A d o w n w a r d sloping y i e l d curve on unindexed bonds, for example, can p o i n t t o t i g h t monetary p o l i c y being applied n o w t o cut i n f l a t i o n , a p o l i c y t h a t agents believe w i l l succeed. Nearly all the existing literature concentrates o n the n o m i n a l interest rate's role as p o i n t e r t o future i n f l a t i o n . Buiter and M i l l e r (1981) is a rare e x c e p t i o n : for t h e m , a high n o m i n a l interest rate generally reflects a reduced m o n e y g r o w t h rate, rather than a high one. I f the present paper errs i n stressing the i n f l a t i o n brake role o f n o m i n a l interest rates too strongly, I can plead that this view requires more exposure and detailed analysis,

before w o r k can proceed o n a richer m o d e l w i t h an e x p l i c i t t e r m structure

that allows one to study both roles together.

V T H E I M P A C T E F F E C T S

This section moves f r o m the steady state to the impact effects o f an increase i n the n o m i n a l rate o f interest. I shall assume that the n o m i n a l rate is raised once and for a l l , and unexpectedly. Agents have enough knowledge o f the m o d e l to infer the long-run consequences this w i l l have for the real rate and the real exchange rate, c(°°). Investment proceeds according to E q u a t i o n (3) above, subject t o the proviso that R is the steady state real cost o f capital (and n o t r less the current, or anticipated immediate rate o f i n f l a t i o n as cap­ t u r e d b y p ) . This assumption allows us t o c o m p u t e the impact effects o f the rise i n r d i r e c t l y , w i t h o u t having t o solve backwards for the course o f antici­ pated i n f l a t i o n . I n its defence, i t can be said that the absence o f depreciation makes a " p e r m a n e n t " cost o f capital concept a l i t t l e more palatable.

Start w i t h Equations (2) t o (4). T o t a l d i f f e r e n t i a t i o n establishes that

( l - a 0 + j 32) d Q = - ( 0 K + Z ) d R - e d md + ^ d c . (17)

We m a y t h i n k o f (17) as an IS curve i n derivative f o r m . Given that r (and R ) are n o w parametric, i t w o u l d be w r o n g to go o n t o eliminate d R f r o m (17) to establish an expression for aggregate demand, as one w o u l d w i t h Dornbusch (1976) for example. What has to be eliminated f r o m (17) is the money demand t e r m (we have assumed, i n deriving ( 1 7 ) , that the money supply level was n o t affected i m m e d i a t e l y by the higher r ) . E q u a t i o n (5) implies

d md = 171 dq - i ?2d r + dp + ( l - 0 ) d c . ( 1 8 )

» The short r u n supply side o f the system can be gleaned f r o m (10) and ( 1 1 ) . They i m p l y

( 1 - Kx) d p = d q + K l( l - 0 ) d c . \l9)

Meanwhile, the key competitiveness — o u t p u t — interest rate links can be set out f r o m ( 4 ) , (15) and ( 1 6 ) , w h i c h together y i e l d

(0X +xfX)dc = 02d Q + ( Z - f A ) d R + x f X d c M . (20 )

N e x t , recall the long-run results f r o m Section I V . These tell us that d R =

2 R - R *

(20) i n terms o f Q and r alone, w h i l e (17)-(19) can be c o m b i n e d t o eliminate

dp and d md and o b t a i n a second equation l i n k i n g c to Q and r. Remember

that the price o f domestically produced goods is a j u m p variable, n o t a pre­ determined sluggard as i n Dornbusch ( 1 9 7 6 ) . The end result is a system

d Q dc dp _dp_

w h i c h gives the i m p a c t effects u p o n the domestic goods price level, p , and the domestic expenditure price index, p , as w e l l as domestic o u t p u t and the

real exchange rate. I n ( 2 1 ) , A} = ( x5- X j X4) / ( 1 - J U j ) ( j 32X j + x2+ x3) ; A2 =

( p ^ + x j a - M j V C ^ + x r X ) ; A3 = A1(a+ K2) / Q ( l - a ) ( l - K1) + A ^ f l - * ) /

(1-K j ) and A4 = A3 + A2 ( 1 - 0 ) ; and X j t o x5 are defined as:

= e ( l - 0 ) / ( l -K l) - p x

x2 = 1-aO + j32

a + K2

6 Q ( l - a ) ( l -K l)

x4 = Z - f X ( l -x( 2 R - R * ) / V )

x5 = er)2(l-vl) - OK - Z .

The immediate impression one gains f r o m inspecting (21) is t h a t p r e t t y well a n y t h i n g can happen. This is true. Domestic o u t p u t , competitiveness, and the price level — w i t h or w i t h o u t the foreign goods — can go up or d o w n on i m p a c t f o l l o w i n g a j u m p i n the n o m i n a l rate o f interest. B u t the results are easier to understand and i n t e r p r e t than may seem at first sight.

Begin w i t h A j , the coefficient that tells us h o w domestic o u t p u t reacts t o the higher n o m i n a l rate o f interest. There are five channels o f influence r u n ­ n i n g f r o m r t o Q:

(a) via investment, K

(b) via debt charges and competitiveness

(c) via capital inflows and competitiveness

(d) f r o m foreseen steady state competitiveness to competitiveness n o w (the c(°°) t e r m )

(e) via the imbalance i n the m o n e y market created by higher r. This chan­ nel can be subdivided i n t o :

(e(i)): a direct c o n s u m p t i o n effect

(e(ii)): an i n d i r e c t consumption effect r u n n i n g f r o m debt charges to competitiveness and the expenditure price index

(e(iii)): as (e(ii)), b u t originating from the change i n capital i n f l o w (e(iv)): as (e(ii)), b u t originating f r o m the foreseen change i n steady

state competitiveness.

Each o f these channels needs t o be explained i n t u r n . Channel (a) is simple. The higher n o m i n a l interest rate betokens a permanently higher real cost o f capital. T h a t n o w stands above the current rate o f p r o f i t , i f they were pre­ v i o u s l y equal. So there w i l l be d o w n w a r d pressure on investment, depressing

aggregate demand i n the short r u n . Channel (b) squeezes aggregate demand directly i f the c o u n t r y has net foreign debts: a higher real interest rate o n these debts worsens the current account o f the balance o f payments. Chan­ nel (c) is also straightforward. Higher interest attracts capital f r o m abroad, i m p r o v i n g the capital account o f the balance o f payments at the previous exchange rate: and, since there is free floating, the spot exchange rate should tend t o appreciate. The consequent r e d u c t i o n i n competitiveness worsens the trade balance and squeezes aggregate demand. Channel (d) is a l i t t l e harder to grasp. We k n o w that the higher interest rate w i l l increase the country's net overseas debts, and that servicing them w i l l call u l t i m a t e l y for a lower real exchange rate i n order to generate the necessary improvement i n the trade balance. We k n o w this; and the agents i n the m o d e l are also assumed to k n o w this. So, depending o n the magnitude of--the parameter x (which is the coef­ ficient on the current/long-run exchange rate discrepancy i n the f o r w a r d p r e m i u m equation, ( 1 4 ) ) , there w i l l have t o be some negative pressure on the real exchange rate n o w i n a n t i c i p a t i o n o f the long-run effect. A n y tendency for depreciation n o w qualifies, or even reverses, the mechanism o u t l i n e d for channel ( c ) : the trade balance improves, and aggregate demand recovers.

We n o w get to the most intricate part o f the story, the various effects operating under channel (e). The central idea is that domestic expenditure is boosted w h e n there is an excess supply o f m o n e y . This is not the same t h i n g as a real balance effect, which w o u l d make consumption react t o m - p or m - p . N o w a j u m p i n the n o m i n a l rate o f interest cuts money demand

finally on aggregate demand via c o n s u m p t i o n , b u t the way i n w h i c h they generate changes i n excess money balances differs. A l l o f them affect the excess supply o f money t h r o u g h the price level. So e(ii), w h i c h induces d o w n ­ w a r d pressure on the exchange rate i f the c o u n t r y has negative net overseas assets, acts t o squeeze c o n s u m p t i o n by boosting the price level (expenditure d e f i n i t i o n , p ) and m a k i n g for an excess demand for m o n e y . The same happens w i t h e(iv): the expectation o f higher future debt charges acts t o depress the exchange rate n o w , w i t h similar consequences. B u t e(iii) runs i n the opposite d i r e c t i o n : a capital i n f l o w worsens competitiveness, t r i m m i n g p and m a k i n g for an excess supply o f m o n e y . None o f these four mechanisms under the (e) heading operates i f e vanishes. Effect e(ii) is the excess money balances counter­ part o f channel ( b ) , e(iii) o f channel (c), and e(iv) o f channel (d).

The next task is to i d e n t i f y each o f these effects and channels w i t h par­ ticular terms i n Ax, the coefficient for dQ i n (21). Channel (a) can be p i n ­ p o i n t e d as the - OK term i n xg. I t is clear that this imparts a negative influence on Q. Channel (b) operates t h r o u g h the - Z t e r m i n x5, again an unambigu­ ously negative effect;1 this is qualified, b u t never reversed, by the p r o d u c t o f Z i n x4 w i t h - ( l + x f V ^ i ) ~ 1 t e r m i n X j . Channel (c) is captured by the pro­ duct o f - f X i n x4 and the same term i n X j , and (d) by the p r o d u c t o f t h a t same term i n Xj w i t h the expression xf^(2R-r*)/j3j 7 i n x4. I t is clear that channel (c) imparts a negative influence o f r on Q, and (d) a positive one. F i n a l l y , the (e) channel. This is identifiable t o all terms i n A j that c o n t a i n the parameter e. Effect e(i) operates through the er)2(l-iiy) t e r m i n x5; e(ii) can be traced to the p r o d u c t o f Z i n x4 w i t h the e term i n X j , and e(iii) and e(iv) likewise to the other elements i n x4 m u l t i p l i e d by that term i n X j . We have focused u p o n the numerator o f A j i n this discussion; the denomin­ ator is j u s t the familiar m u l t i p l i e r , w h i c h has t o be positive for stability.

The coefficients A2, A3, and A4, w h i c h tell us h o w competitiveness, and the home country's factor cost and expenditure price indices react t o the higher rate o f interest, are easier t o i n t e r p r e t . The numerator o f A2 contains t w o terms: a direct effect, x4( l - / U j )_ 1, w h i c h we saw operating i n channels (b), (c) and ( d ) , and an i n d i r e c t effect, |32 A j , w h i c h reflects the fact that i f Q rises (falls), the trade balance w i l l worsen ( i m p r o v e ) , so that a cleanly floating exchange rate w i l l have t o depreciate (appreciate). The denominator of A2 reminds us that the magnitude o f all these competitiveness effects w i l l be smaller, the greater the international m o b i l i t y o f capital (the higher is f ) , the more the f o r w a r d rate reflects expectations o f future exchange rate changes (the higher is X) and the faster the process o f convergence on the steady state (the higher is x)- The home goods price index p rises or falls w i t h

domestic o u t p u t , as the A j t e r m testifies; we can interpret (a+n 2) / ( l - a ) ( l - K t)

as the reciprocal o f the elasticity of aggregate supply. B o t h the i n d e x a t i o n

coefficient K l and the hysteresis coefficient K 2 serve t o make home supply

less price elastic. B u t there is also a second t e r m i n A3, w h i c h reflects the

i n d e x a t i o n l i n k from foreign goods prices i n home currency and the level o f domestic money wage rates. Lastly, the home country's expenditure price index, p , is a l i t t l e more sensitive t o r than p , b y virtue o f the exchange rate

t e r m A2 ( 1 - 0 ) that is added to i t : often, n o t always, A2 and A3 w i l l have the

same sign.

I t is interesting t o examine the roles played i n shaping these results by the exotic parameters w h i c h are absent f r o m simple, standard models. They i n c l u d e :

the interest-sensitivity o f international capital flows

the sensitivity o f the forward p r e m i u m o n foreign exchange t o the expected exchange rate t r e n d

the m o n e y wage i n d e x a t i o n coefficient the m o n e y wage hysteresis coefficient

the coefficient o f the exchange rate d r i f t o n the gap between the cur­ rent and long-run expected exchange rates

the sensitivity o f spending t o excess money the real-interest sensitivity o f money g r o w t h

the sensitivity o f investment t o the p r o f i t / i n t e r e s t gap.

The i m p a c t o f these parameters is as follows. We shall focus a t t e n t i o n on the implications each o f them has for the magnitude and sign o f the short-run effect o f the rate o f interest o n Q, given by the value o f A j i n E q u a t i o n ( 2 1 ) . First, f and X. These t w o parameters have qualitatively identical effects, since they o n l y enter as a p r o d u c t . Greater i n t e r n a t i o n a l capital m o b i l i t y (J) therefore has j u s t the same implications as an increase i n the sensitivity o f the f o r w a r d rate to the expected exchange rate t r e n d (X). The sign o f dQ/dr res­ ponds ambiguously to a rise i n f or X. There are t w o things that matter here. First, whether the exchange rate is driven up or d o w n by the increase i n the rate o f interest. T h a t depends on whether x ( 2 R - R * ) exceeds or falls short o f j 3 j 7 . I f i t exceeds i t , the depressive effect o f the knowledge o f a lower long-run exchange rate — w h i c h has t o d r o p , to improve the trade balance enough to defray the higher debt charges — dominates the direct effect, and depreci­ ation ensues. B u t w i t h l o w enough x , there w i l l be appreciation. The other factor w h i c h matters here is h o w o u t p u t reacts t o an exchange rate change. I f the exchange rate appreciates, competitiveness declines; that hurts the trade balance; and domestic aggregate demand goes d o w n . O n the other hand, appreciation pushes d o w n the cost o f living (since foreign goods become

cheaper i n domestic currency). I f money wage rates are l i n k e d to the cost o f living by a p o w e r f u l i n d e x a t i o n scheme, this effect w i l l be all the stronger, since the prices o f home produced goods w i l l tend t o be forced d o w n t o o , b u t i t w i l l be present even w i t h o u t i n d e x a t i o n . The drop i n the cost o f living w i l l cut the domestic demand for m o n e y , and that i n t u r n generates an excess supply o f m o n e y i f the m o n e y m a r k e t i n i t i a l l y cleared; and so long as e > 0 that implies higher aggregate demand. The n o r m a l view is that higher interest rates at home induce the exchange rate to appreciate and this w i l l be defla­ t i o n a r y for o u t p u t . I n that case, higher f or X make for an increased l i k e l i h o o d of a negative effect o f r on Q. This w i l l also be so i f the exchange rate falls (in a n t i c i p a t i o n o f those higher future debt charges) and aggregate demand is squeezed by the m o n e y market effects o f higher prices at home. B u t i f either the exchange rate depreciates or appreciation is expansionary for aggregate demand (and o n l y one o f these conditions applies), raising f or X w i l l make d Q / d r likelier to be positive. Finally, f and X also appear o n the denominator of A j ; here, their role is to dampen (enhance) the value o f the m u l t i p l i e r depending o n whether e ( l - 0 ) > ( < ) (3j ( 1 - K j ) .

N e x t , coefficients Kj and K2, w h i c h capture the way money wage rates

respond t o the cost o f living p , and the level o f e m p l o y m e n t . We have termed t h e m the " i n d e x a t i o n " and "hysteresis" coefficients. The i n d e x a t i o n coef­ ficient makes the supply o f domestic goods less elastic. A rise i n the price level gets transmitted i n t o m o n e y wage rates, and so prices rise even further. The i m p l i c a t i o n o f this is that the size o f the m u l t i p l i e r for Q is cut. So m u c h

is plain f r o m one o f the ways K1 enters the denominator o f A1 (in the term

x3 ). T o this extent, K J lowers the size o f | A j |. I t also plays a second role, so

long as e > 0. A higher value o f the i n d e x a t i o n coefficient makes i t likelier that a real exchange rate depreciation cuts o u t p u t , b y raising the price level more — and hence money demand more — than w o u l d have occurred other­ wise. Increased money demand means lower spending, given that e > 0. This effect is evident f r o m the numerator o f A j , and also its denominator.

The hysteresis coefficient, K2, simply makes supply less elastic. A n increase

i n domestic e m p l o y m e n t pushes up wage rates. (The hysteresis effect is more familiar i n the time derivatives, as a l i n k between money wage g r o w t h and

the rate o f change i n u n e m p l o y m e n t . ) So the result o f raising «2 is t o reduce

the size o f the m u l t i p l i e r for Q. This can be seen f r o m its presence i n the x3

term i n the denominator o f A j .

slowly towards their long-run e q u i l i b r i u m levels. I n our m o d e l , the really i m p o r t a n t effect o f raising the value o f x is t o make depreciation likelier w h e n the interest rate goes u p . This is so because o f the negative long-run l i n k between the rate o f interest and the real exchange rate (higher interest means higher debt charges, hence a larger trade surplus, w h i c h can o n l y be engineered in the l o n g r u n by increasing competitiveness). Higher x strengthens the p u l l of this long-run effect o n the current value o f the exchange rate. That result — higher x makes for an increased change o f depreciation after a j u m p i n interest rates — assumes that the real interest rate at home is no less than half its foreign value. N o w whether an increased chance o f depreciation makes i t likelier that o u t p u t goes up turns o n the relative size o f e ( l - 0 ) - ^ ( l - K j ) , as we saw i n our discussion o f J and X.

The n e x t parameter to consider is e. This gives the sensitivity o f spending to excess m o n e y balances. I f e were zero, a higher rate o f interest w o u l d almost certainly i m p l y a lower level o f Q. The o n l y force tending t o raise out­ put i n such circumstances is the d o w n w a r d pressure on the exchange rate that w o u l d come through a n t i c i p a t i o n o f higher future long-run debt charges. So the chief significance o f e is t o make i t m u c h likelier that a higher rate o f interest has a perverse, positive i m p a c t o n aggregate demand. The simplest

: way this can happen is t h r o u g h r e d u c t i o n i n money demand stemming directly

f r o m the higher rate o f interest (effect (e(i)) above). Higher e also makes i t more probable that depreciation squeezes aggregate demand, as we have seen; and since the exchange rate impact o f higher r is uncertain, the significance of that effect for the sign o f dQ/dr is uncertain.

. N e x t , n j . This coefficient captures the feedback f r o m the real rate o f interest o n the rate o f m o n e y g r o w t h . I t shapes the l i n k between the n o m i n a l and real rates o f interest. Higher jUj means that the long-run i n f l a t i o n rate drops more — and that the real interest rate therefore goes up more — f o l l o w ­ ing a given j u m p i n the n o m i n a l rate. U n l i k e the other parameters considered here, /Xj has i m p o r t a n t long-run implications, and plays o n l y a m i n o r role i n the short r u n . The other parameters have bearing o n l y o n the short r u n .

F i n a l l y , 6, the coefficient i n the investment equation. Increasing the value o f 8 means m a k i n g the capital stock close the gap between the rate o f p r o f i t and the cost o f capital more q u i c k l y . The role o f 0 is a simple one. I t deter­ mines the size o f the direct, negative effect o f a higher rate of interest on aggregate demand r u n n i n g through investment. So higher 6 must make a negative value o f A j likelier.

We k n o w f r o m Section I V that o u t p u t and capital b o t h have to fall i n the l o n g r u n as a consequence o f a higher rate o f interest. We also k n o w that out­ p u t can rise or fall i n the short r u n . For the transition t o display rising levels o f o u t p u t , i t is sufficient that aggregate demand should decline i n the short r u n by more than i n the long. Is this case o f " o u t p u t o v e r s h o o t i n g " possible? The answer is yes. I t is possible for the j u m p i n the rate o f interest t o force aggregate demand d o w n so m u c h at once that i t then goes up subsequently. A comparison o f the long-run results for Q i n . Section I V w i t h A j i n (21) reveals t h a t this is likeliest w h e n t w o parameters are particularly high (j3j, the derivative o f the trade balance w i t h respect to l o g competitiveness, a n d 0 , the m u l t i p l i c a t i v e constant i n the investment e q u a t i o n ) , given that the exchange rate appreciates i n i t i a l l y . The precise c o n d i t i o n for this to happen simplifies, when b o t h e and x go to zero, t o 00j > 1 - j 3 j f X ( l - a ) / K . I n these c i r c u m ­ stances, the levels o f o u t p u t and e m p l o y m e n t rise over t i m e during the tran­ s i t i o n , while the capital stock shrinks. The fact that e m p l o y m e n t collapses early and climbs back later means that money wage increases fall away very q u i c k l y , and tend t o rise a l i t t l e later. The appreciation i n the exchange rate w h i c h occurs at once, and is subsequently u n w o u n d , also imparts a negative influence o n i n f l a t i o n early and a positive one later. So this is a case where the good and the bad news f r o m the higher rate o f interest are concentrated right at the beginning.

I t is also possible for aggregate demand t o j u m p so m u c h o n i m p a c t that the stock o f capital actually rises i n i t i a l l y . For this t o occur, the positive pres­ sure f r o m higher o u t p u t o n the rate o f p r o f i t must exceed the increase i n the real cost o f capital t o w h i c h the higher rate o f interest gives rise. This state o f affairs is n o t probable, b u t i t can happen. I t is at its likeliest w h e n the interest-elasticity o f money demand is m u c h greater than the income interest-elasticity, aggre­ gate supply is price elastic, and spending is highly sensitive t o excess m o n e y . The exact c o n d i t i o n for investment t o rise i n the short t e r m , i n the face o f the higher rate o f interest, is

a + K„ aA j 02e ( l - 0 )

R T? 1( 1 - / X , ) > T? 9 + — ? + — Y1/ *1" " ) [ 1 + - ^ - ]

'll Mi ; '2 ( 1 - 0 0 ( 1 - * ! ) Re M l " " ! )

when the i n i t i a l value o f Z is zero. The i n t u i t i o n here is n o t hard:.the higher rate o f interest creates a big excess supply o f m o n e y , boosting spending, and the size o f this effect is greatest w h e n money demand is highly interest elastic and spending reacts strongly t o excess m o n e y .

liable t o delay. The c o n d i t i o n for the capital stock to rise i n i t i a l l y is a great deal more stringent than for a positive i m p a c t effect o n o u t p u t . The latter is necessary b u t n o t sufficient for the former. A variety o f possible time paths for domestic o u t p u t and the stock o f capital are illustrated i n the different panels o f Figure 2.

We have seen t h a t o u t p u t can e x h i b i t overshooting behaviour, changing o n impact by more than is needed t o achieve long-run e q u i l i b r i u m . Is the same true o f the real exchange rate? I t turns o u t that competitiveness can go up on i m p a c t b y more than the long-run e q u i l i b r i u m requires. The idea here is that the higher rate o f interest generates a large excess supply o f money, w h i c h

calls for a high value of T J2, the interest semi-elasticity o f money demand.

Spending then j u m p s sharply. The parameter 02, w h i c h does d u t y for the

"marginal propensity t o i m p o r t " i n standard Keynesian models, is big enough t o ensure a major surge i n i m p o r t s . This imparts negative pressure o n the spot exchange rate, and all the more so i f f and X are small (so that i t is largely the current account o f the balance o f payments, n o t the capital account, that ' determines the exchange rate). For the real exchange rate t o overshoot, the effect j u s t described has to dominate the various other mechanisms at w o r k . When the i n i t i a l value o f Z is zero, real exchange rate overshooting w i l l arise i f and o n l y i f

02e ( W )

/ 32e T? 2( l -Ju1) > 0 K | 32 + r X ( x2+ X 3 ) + ( R /7) [ l - a 0 + x3 + ] .

Pi (1 K-i )

Except i n this strange and somewhat u n l i k e l y case, the real exchange rate depreciates during the transition to long-run e q u i l i b r i u m . This tends to raise the rate o f i n f l a t i o n d u r i n g the t r a n s i t i o n , and especially so when ( 1 - 0 ) , the

expenditure weight for foreign goods, and nl, the i n d e x a t i o n coefficient, are

b o t h large. There is another factor w o r k i n g i n the same d i r e c t i o n . The stock o f capital is shrinking. This exerts u p w a r d pressure on the price level o f domestically p r o d u c e d goods, relative to the money wage rate. However, transitional i n f l a t i o n is l o w e r e d by t w o other mechanisms. U n e m p l o y m e n t is inevitable at some stage i n the transition, and quite likely t h r o u g h o u t i t ; this cuts the g r o w t h o f m o n e y wage rates. A n d the higher rate o f interest leads at once t o an excess supply o f m o n e y . That automatically lowers the

rate o f m o n e y g r o w t h , as long as i t lasts, via parameter f i2.

V I C O N C L U S I O N S A N D Q U A L I F I C A T I O N S

Figure 2: Various Possible Time Paths for Capital and Domestic Output Following a Rise in the Nominal Rate of Interest 0

K, stock of capital case a: the normal case: Q falls on impact, and Q and K both

fall in the transition

K, stock of capital case b: output overshooting (Q falls on impact by more than

the long run requires, so it recovers during the transition)

K , stock of capital case c: impact effect on Q positive, but Q and K both fall in

the transition

of direct capital account effects p o i n t i n g i n that direction). I t is also widely believed that the rate o f monetary g r o w t h has negligible long-run real effects i n either open or closed economies.

I n the f r a m e w o r k o f the m o d e l proposed i n this paper, all these propositions become d o u b t f u l , and three o f them are definitely controverted. A higher rate o f interest does n o t boost savings; i f a n y t h i n g , i t tends t o squeeze t h e m , t e m p o r a r i l y , by inducing an excess supply o f m o n e y . The short-run impact of a higher rate o f interest u p o n investment is qualitatively ambiguous: i t is j u s t possible that the j u m p i n c o n s u m p t i o n lifts the rate o f p r o f i t enough t o offset — however briefly — the rise i n the cost o f capital. I f that happens, investment goes up i n i t i a l l y . Far f r o m i m p r o v i n g the current account of the balance o f payments, the higher rate o f interest w i l l almost certainly worsen i t i n the short r u n (it must do so i f the c o u n t r y has negative net overseas assets) t h r o u g h a number o f mechanisms: higher debt charges; pressure o n the exchange rate, w h i c h may well result i n l o w e r competitiveness; the stimulus to consumer spending via excess m o n e y . Recent experience i n Australia and the U n i t e d K i n g d o m , where policies o f high interest rates have failed to lower massive current account balance of payments deficits, or dent private sector spending, seem t o corroborate these findings w e l l . I n the long r u n , a higher rate o f interest w i l l definitely lead to a lower real exchange rate (in order to improve competitiveness enough t o provide the trade surplus that defray the extra overseas debt servicing costs). A n d there are real long-run effects f r o m the p o l i c y o f higher interest rates and lower monetary g r o w t h : an unambigu­ ous decline i n the domestic capital stock, domestic o u t p u t , net overseas assets and national income.

These are among the paper's key findings. What should be said by way o f qualification? The most serious l i m i t a t i o n o f the analysis, i n the author's view, is that we have been l o o k i n g o n l y at the effect o f permanent changes i n the domestic n o m i n a l rate o f interest. A temporary rise i n the interest rate, subsequently undone, should leave no enduring legacy. The fall i n capital and rise i n debt w i l l eventually be reversed. So w i l l the effects i t may have on

the rate o f i n f l a t i o n .

and o p t i m i s a t i o n t h a t ought t o precede i t . Some o f these shortcomings the author hopes t o s u r m o u n t i n later w o r k .

What this paper has aimed t o do, however, is t o enlarge the standard approach t o open economy macroeconomic and exchange rate m o d e l l i n g by t a k i n g e x p l i c i t account o f several issues o f b o t h theoretical and practical i m p o r t a n c e . These include the need t o move away f r o m treating the m o n e y stock, or its g r o w t h rate, as a p o l i c y parameter, and instead t o regard n o m i n a l interest rates as p o l i c y instruments; the need t o endogenise " n a t u r a l o u t p u t " by i n c o r p o r a t i n g e x p l i c i t factor markets and a mechanism t o drive the dynamics o f the capital stock; the need t o bring hysteresis and i n d e x a t i o n i n t o the behaviour o f wages; and the need t o allow for the possibilities o f less than perfect i n t e r n a t i o n a l capital m o b i l i t y and imperfect foresight i n for­ w a r d foreign exchange markets. We have seen t h a t these various factors can be c o m b i n e d i n a f o r m a l setting, and that the resulting model's i m p l i c a t i o n s differ considerably f r o m those o f standard models.

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