Abstract

This paper develops a stochastic two-country perpetual youth Dynamic New Keynesian model of the international business cycle with incomplete international financial markets and stationary net foreign assets. The model allows for a thorough analysis of the interaction of endogenous monetary policy with endogenous, non-balanced budget policy. We derive the dynamic and cyclical properties of deficit feedback rules under alternative monetary regimes, discuss the international transmission of productivity shocks, and the implications for net foreign assets and exchange rate dynamics. Our results imply that the degree of fiscal discipline, i.e. the extent to which the rule responds to debt dynamics, is crucial for the dynamics of net foreign assets. We show that under low discipline (characterizing most industrialized countries, first and foremost the U.S.) temporary positive productivity shocks may result in highly persistent deteriorations of the external position in the medium run. Our results also suggest that any attempt by monetary policy alone to stabilize the dynamics of net foreign assets would induce excessive and costly fluctuations of the exchange rate.

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