Abstract
The dynamics of the real exchange rate and the price of equity for a small open economy are analyzed using an optimizing model in which the process of capital accumulation entails adjustment costs. The analysis demonstrates how changes in fiscal policies or world interest rates can generate sustained movements in real exchange rates and equity prices simply because investment requires scarce resources. Interpreting such movements as evidence of market inefficiencies would be incorrect since adjustment is driven entirely by equilibrium in asset and goods markets. The results, however, do indicate that a stable and consistent set of fiscal policies can help reduce unnecessary volatility in real exchange rates and equity prices. (This abstract was borrowed from another version of this item.)
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