Government Policies and Secular Inflation under Flexible Exchange Rates

Abstract

The early theoretical approaches to the problem of internal and external balance in small open economies, for example those of Swan [33], Salter [28], and Corden [5], require substantial modification in the light of recent experience. For global inflation has persisted for nearly a decade now; the world's capital markets have become increasingly integrated; and industrial countries have increasingly adopted flexible exchange rates, thereby attempting to secure (among other objectives) a measure of insulation from foreign disturbances. Broadly speaking, the theoretical literature which builds on the early contributions, yet is able to encompass these recent developments, has adopted one of two approaches. First, there is the traditional Keynesian or what might now be more appropriately referred to as the KeynesPhillips approach; as shown by Takayama [35], Helliwell [16], and more recently, Turnovsky and Kaspura [42]. These models tend to be shortrun (or at least one-period) and to focus usually on the price level rather than the inflation rate, insofar as they seek to examine the question of insulation from foreign disturbances such as global price instability. On the other hand, there is the recent approach. Contributions within this framework which deal with the case of flexible exchange rates include Johnson [17], Kouri [19], and Dornbusch [7; 8]. It differs from the Keynesian approach in two essential respects. First, central to it is the notion that the exchange rate, being a relative price of monies, is basically a monetary phenomenon. Secondly, it tends to focus much more on stock rather than flow equilibrium relationships, and on the accumulation of assets, part of which takes place through the current account of the balance of payments. Most of the existing literature deals with a non-inflationary world in the sense that the