Abstract
This article considers the international diffusion of business cycles on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler [1] suggests that the employment-isolation effect under the flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model rather than the two-country model of Laursen and Metzler [1], we obtain the following results. (i) The business fluctuation of the world economy diffuses to the small country through a change in the inflation rate caused by the change in the real exchange rate. In this sense, the employment isolation is imperfect. (ii) Domestic monetary expansion has only an effect weaker than that of Mundell [2]-Fleming [3]. This is because a monetary expansion, which always accompanies a fiscal expansion, raises the current domestic price and lowers the inflation rate as long as the purchasing power of money (the inverse of future price) is kept intact. Such disinflation reduces the consumption demand in addition reducing the expansionary multiplier effect.
Highlights
The international transmission of business cycles is a serious problem under the flexible exchange rate system
This article considers the international diffusion of business cycles on the basis of a rigorous dynamic microeconomic foundation
1) The business fluctuation of the world economy diffuses to the small country through a change in the inflation rate caused by the change in the real exchange rate
Summary
The international transmission of business cycles is a serious problem under the flexible exchange rate system. This movement of nominal wages is consistent with that of the price level dominated by its marginal costs This accelerated inflation stimulates the consumption of the current goods under some plausible assumption concerning the utility function, thereby increasing employment. The foreign business cycle diffuses into the domestic economy with the change in consumption caused by the terms of trade effect (i.e., the Laursen-Metzler effect), even if the international capital movement is infeasible. A monetary expansion raises the current domestic price and decreases the inflation rate as long as money is credible. This incentives the younger generation to save and lessens their consumption.
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