Supply Shocks in a Two Country World with Wage and Price Rigidities

Abstract

The implications of quantity adjustments in the face of sticky prices in open economy macroeconomic models have been introduced by Dixit (I978), Neary (I980), and Dixit and Norman (I980). The first two employ the small country assumption that the foreign price level is an exogenous variable, with the latter including a non-traded good into the discussion. Dixit and Norman introduce a two country, one good model and only consider a generalised Keynesian outcome under fixed exchange rates. In this paper, we analyse a two country-two good model and consider the international link between unemployment in both countries, with special emphasis on supply shock originated disequilibria under fixed and flexible exchange rates. Naturally, the terms of trade become an important transmission mechanism in a two good model under flexible exchange rates. The work of Barro and Grossman (I976), Malinvaud (I977) et al. for closed economies has shown that temporary equilibria in a closed economy can be classified into regions of Keynesian Unemployment, Classical Unemployment, Repressed Inflation (and under-Consumption). When two countries linked by trade are discussed, the classification of international temporary equilibria multiplies accordingly. We choose a small subset of these possibilities, focusing on those that are likely to be associated with supply shocks; i.e. combinations of Keynesian and Classical unemployment. Two country models have been extensively studied under Walrasian and simple Keynesian specifications (see for instance Laursen and Metzler (I950), Harberger (I95I), Meade (I95I), Mundell (I968), Swoboda and Dornbusch (I973) and Mussa (I979)). We consider these models briefly in Section III, emphasising their micro-foundations and general equilibrium properties. Stability of both fixed and flexible exchange rates regimes for Walrasian and Keynesian equilibria revolves around some form of the Marshall-Lerner conditions being satisfied. The problem of competitive devaluations to export unemployment in a Keynesian world is discussed. While a Keynesian outcome for both countries applies for some configurations of wages and product prices (and exchange rates), this is not true for all configurations. Hence with sticky prices, monetary deflation in both countries should lead to Keynesian unemployment in both. But when negative supply shocks reduce national labour demands and output supplies, Keynesian aggregate demands cease to determine the levels of economic activity and employment appropriately.