THE EFFECTS OF DEMAND DISTURBANCES UNDER ALTERNATIVE EXCHANGE-RATE REGIMES

Abstract

THIS paper analyzes the short-run macroeconomic impact of autonomous demand disturbances under alternative regimes of free and fixed exchange rates. The vehicle for analysis is a simplified extension of the BarroGrossman fix-price macroeconomic model to a small open economy with traded and nontraded goods. In particular, it is assumed that prices of traded goods are fixed in world markets and consequently, demand deficiency in traded goods is ruled out. However a lack of demand for nontraded goods may develop if wages and nontraded goods prices fail to respond quickly to autonomous demand disturbances. The distinction between traded and nontraded goods also yields a classification of autonomous disturbances by type-aggregate or relative-as well as by origin-internal or external.' As shown below, the distinction between aggregate and relative disturbances is an important one for analyzing the relative insulating properties of the two regimes. In particular, while we obtain the traditional result that free rates provide complete insulation against aggregate external disturbances, we demonstrate that free rates will provide complete insulation against relative external disturbances only if the price elasticity of import demand is unity. We also demonstrate that if the price elasticity of import demand exceeds unity, then it is possible that a decline in the world price of the export good actually can stimulate total employment under a free exchange rate regime. These and other results suggest that the degree of substitutability between traded and nontraded goods is an important factor to consider in a comparison of the performances of alternative exchange rate regimes. This emphasis on the distinction between relative and aggregate disturbances and the degree of goods substitutability is in sharp contrast to many