Stabilization policy, exchange rate expectations, and international transmission

Abstract

This paper analyzes the transmission effects of monetary and fiscal policy in a large country on output abroad using a two-country sticky-price monetary model with adjustment lags incorporated into the goods sectors of the countries. In addition, the paper considers alternative models of exchange rate expectations and examines their influence on the transmission process. In the case of monetary expansion in the home country, the general result for all expectations models is that the foreign country may experience either expansion or contraction. The reason is that the foreign country is exposed to two conflicting effects, a positive trade linkage effect coming from the home country and a loss of competitiveness due to the depreciation of home country's currency. Moreover, the final outcome depends critically on the sensitivity of the trade balance to the exchange rate because the lower this sensitivity, the smaller the loss of competitiveness due to the depreciation of home country's currency. In the case of fiscal expansion in the home country, the normal result for all expectations models is that output expands in the foreign country. The reason is that the foreign country experiences a positive trade linkage effect coming from the home country, and in the case of perfect foresight and regressive exchange rate expectations, the home currency normally appreciates, increasing the foreign country's competitiveness. However, if the semi-interest elasticity of money demand is sufficiently larger in the home country, it is possible for the home country's currency to depreciate, causing a loss of competitiveness in the foreign country, and the overall effect on the foreign country could be contractionary. Finally, in the case of adaptive and distributed lag expectations, fiscal expansion in the home country has no impact effect on the exchange rate, and the foreign country experiences only the positive trade linkage effect coming from the home country.