Capital Mobility and Endogenous Stablization Policy under Flexible Exchange Rates

Abstract

In 1954 Phillips [5] demonstrated that stabilization policy of a particular kind, which he termed stabilization policy, can produce explosive movements in real output in a closed economy. These movements can arise when there exist inside and outside lags that are ignored by the policy makers, who are reacting only to current levels of real output. In the absence of these lags, the instability created by policy in a closed economy disappears. The objective of this paper is to determine whether the instability produced by integral stabilization policy also disappears in the absence of inside and outside lags in an open economy under a floating exchange rate system. An affirmative finding would suggest that there is nothing inherent in a flexible exchange rate system that would interfere with successful stabilization policy.l However, under flexible exchange rates changes in interest rates produce stock adjustment capital flows which in turn affect exchange rates and economic activity. Therefore, stabilization policy partly operates through an unusual transmission mechanism, and it is essential to determine whether this mechanism is destabilizing. To this end I have constructed a simple neo-Keynesian single country model with endogenous integral stabilization policy. The model contains no lags, and furthermore I have assumed neutral exchange rate expectations in order to rule out speculative capital movements and thereby isolate interest sensitive stock adjustment