Open economy macroeconomics of credit, employment and growth: A structuralist approach

Abstract

In the context of the increasing size and integration of capital markets consisting of bonds, equity, foreign exchange, and financial derivatives and financial intermediaries namely, banks, investment funds, insurance and pension companies; two alternative sources of finance, viz. bank credit and equity finance can be identified to study how the interaction between the real sector and the financial sector occurs and plays an important role in shaping macroeconomic developments. The financial structure of a typical developing country is one in which bank credit plays an important role in the transmission of structural shocks to the macro economy. In this paper we build up a dynamic structuralist macroeconomic model focusing on interaction between the real sector and the monetary sector in an open economy. In its orientation the paper is close to the Blinder-Bernanke (1988) model. In particular we examine both short run and long run effects of expansionary fiscal and monetary policies, capital account liberalization captured by autonomous increase in net capital flow and devaluation. The paper differs from the flexible price, full employment models of open economy macroeconomics. If empirics indicate that financial variables are important for the determination of the real variables such as employment, output and current account, the existence of nominal rigidities provides an explanation for such real effects. Accordingly, we introduce wage indexation which generates unemployment in the long run. The major findings of the paper are these. Capital inflow and monetary expansion may produce favorable macroeconomic outcome, devaluation and fiscal expansion may have deleterious effect on growth potential of a developing country. Moreover the paper establishes conflict between short run and long run effects of policy changes alongside ambiguous relationships between policy shocks and macroeconomic variables. For example a fiscal expansion entails a positive effect on output in the short run and it reduces capital stock and real monetary base over time which nullifies the favorable short run effects. The paper suggests that design of macroeconomic policies is a difficult exercise for a developing country embedded in a globalised world. Given the policy objectives to control inflation, to reduce unemployment and to boost the growth potential of an economy, easy money policy is a viable option since it reduces the bank rate of interest and hence cost of working capital. Though capital account liberalization is a chancy proposition for a developing country we show that it works perfectly well by increasing capital stock.