Real effects of demand- and supply-side policies in interdependent economies

Abstract

This paper formulates various small scale two-country models with a well developed supply side as well as a demand side for economies with flexible exchange rates and perfect capital mobility. In relies on a supply side based on imperfect competition and nominal wage rigidity or overlapping wage contracts, so that in the short run fiscal and monetary policies have real effects. In the long run monetary policies have no real effects, although fiscal expansion do have real effects as the associated appreciation of the real exchange rate reduces the wedge between the producers' and consumers' wage. It follows that fiscal expansion is in the long run a ‘beggar-thy-neighbour’ policy, although supply-side policies do improve foreign output. The transient effects of supply-side, fiscal and monetary policies are analysed with the aid of numerical rational expectations simulations. The conclusions briefly comment on the effects of tight monetary and loose fiscal US policies on the European economies and consider the merits of a proposal to cure stagflation in Western Europe by means of a combination of supply-side policies and an expansion of aggregate demand.