TITLE:
A Keynesian Model of a Small Open Economy under a Flexible Exchange Rate
AUTHORS:
Masayuki Otaki
KEYWORDS:
Employment-Isolation Effect; Laursen-Metzler Effect; An Open Macroeconomic Model with Analytical and Dynamic Microeconomic Foundation
JOURNAL NAME:
Theoretical Economics Letters,
Vol.2 No.3,
August
2,
2012
ABSTRACT: This article considers the international diffusion of business cycles on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler [1] suggests that the employment-isolation effect under the flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model rather than the two-country model of Laursen and Metzler [1], we obtain the following results. (i) The business fluctuation of the world economy diffuses to the small country through a change in the inflation rate caused by the change in the real exchange rate. In this sense, the employment isolation is imperfect. (ii) Domestic monetary expansion has only an effect weaker than that of Mundell [2]-Fleming [3]. This is because a monetary expansion, which always accompanies a fiscal expansion, raises the current domestic price and lowers the inflation rate as long as the purchasing power of money (the inverse of future price) is kept intact. Such disinflation reduces the consumption demand in addition reducing the expansionary multiplier effect.