A Basic Model of a Flexible Exchange Rate System Under Perfect Capital Mobility

Abstract

This chapter constructs a basic model of a flexible exchange rate system and considers the international diffusion of business cycle on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler (1950) suggests that the employment isolation effect under a flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model instead of the two-country model of Laursen and Metzler (1950), the following results are obtained: (i) the business fluctuations in the world economy diffuse to a small country through changes in the inflation rate that result from changes in real exchange rates. In this sense, the employment isolation is imperfect; and (ii) domestic monetary expansion has a weaker effect than in the Mundell (1963) or Fleming (1962) models. This is because monetary expansion, which always accompanies fiscal expansion, raises current domestic prices and lowers the inflation rate as long as the purchasing power of money (the inverse of future price) is kept intact. Such disinflation reduces consumption demand despite the expansionary multiplier effect.