Monetary Policy Devaluation and Capital Accumulation in an Open Developing Economy with Fixed Exchange Rates

Abstract

Tobin has pointed out that in an economy with n assets, Walras Law allows only for n — 1 independent market equilibrium equations linking the n corresponding real rates of return. If the real rate of return on money is fixed and the price level is fixed then asset markets can adjust to monetary policy only through changes in the real rates of return on the [n — 1) other assets. However one of the other assets is physical capital. Everything else equal, its rate of return is inversely related to its valuation relative to its replacement cost. Therefore the adjustment to monetary policy requires a departure of the real rate of return from the value of the marginal productivity of capital or a divergence of the market valuation from the reproduction cost of capital. In turn the latter divergence makes the production of new capital more or less profitable and leads to a change in the level of gross investment which in turn may alter real national income and will necessarily alter the rate of accumulation of capital. In the long run this may lead to a change in the demand for real money balances because of the change in the marginal productivity of capital and in the total wealth. Therefore in the long run if the price level is allowed to change, the price level may not change in the way predicted by classical economics (new and old). In this paper we attempt to detail this process in the case of a small open developing economy with fixed exchange rates and two sectors, the sector of traded goods whose inter national price is given and a home good with a flexible price. Since the exchange rate is fixed the domestic price of the traded goods is also fixed and we used this price to deflate nominal money balances. This world is not unlike that of a fixed price world. In addition we assume that the economy does not produce capital