KOHL, REAGAN, AND OPEN ECONOMY MACROECONOMICS: REVISITING RULES FOR FISCAL AND MONETARY POLICY

Abstract

THIS PAPER models three alternative policy strategies for an open economy and evaluates their performance. By doing this we revisit an old debate which was popular in the mid-80s, when tight monetary policies in the US and the UK brought down inflation but also appreciated the exchange rate and helped to cause large current account deficits. This issue may re-emerge in new guise in Europe. The current German fiscal situation post unification bears an uncanny resemblance to the Reagonomics of a decade ago. Moreover the tight monetary policy of the Bundesbank has generated a DM appreciation which, some have argued, is a misalignment that will undermine competitiveness.' These policies are examples of what we call open economy monetarism: national monetary policies used to achieve domestic price stability, without any supporting fiscal policy, and without any concern for external balance. Williamson (1987) argued that such policies may cause real exchange rate misalignments and unsustainable trade imbalances, and proposed that monetary policy should aim to achieve external balance by ensuring that exchange rates are moved towards the fundamental equilibrium values necessary to generate current account balance. In this second framework fiscal policy would at the same time aim to achieve internal balance, including domestic price stability. This proposal took the old Mundell assignment prescription for a fixed exchange rate world and applied it to a world of flexible exchange rates. We label this view the 'orthodox assignment'.2 By contrast Boughton (1989) and Genberg and Svoboda (1988) saw no need to disengage monetary policy from the pursuit of price stability, but argued that governments should be concerned with current account imbalances, in as much as they imply suboptimal national savings. In this third policy strategy the Williamson assignment would be exactly transposed. This has become known as the 'reversed assignment'.