Abstract
An updated version of Krugman's 1993 MMF framework is used to consider the implications of buoyant domestic demand for the real exchange rate and debt dynamics. The updating includes a Taylor rule for monetary policy and explicit treatment of external assets and liabilities. In response to an exogenous rise in the aggregate demand, short-run appreciation of the real exchange rate is followed by a prolonged decline as external debt accumulates and net wealth deteriorates. Whether in equilibrium the real exchange rate is stronger or weaker depends crucially on a comparison of real interest rates and the growth rate. If the domestic growth rate is higher than global real interest rates, the currency may strengthen in the long run despite the deterioration of net external assets. To see whether the strength of sterling is sustainable, the analysis is briefly calibrated to UK data over the last decade. Blanchard et al. (The US current account and the dollar. CEPR DP no 4888, 2005) suggest that international liabilities to be treated as imperfect substitutes: so we check to see how this would affect our results.
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