Reviving the Salter-Swan small open economy model

Abstract

This paper provides microfoundations to the Salter-Swan policy framework, a graphical apparatus designed to ascertain the exchange-rate and fiscal stance of a policymaker with internal and external economic targets. The environment is an infinite-horizon small open economy producing tradable and nontradable goods that takes world prices and world interest rates as given and is populated by optimizing households and firms. The economy is subject to terms of trade, interest rate, and discount factor shocks. The internal target of the government is the unemployment rate and the external target is the current account. Downward nominal wage rigidity and financial frictions serve as the rationale for meaningful policy intervention.