Dynamic adjustment and debt accumulation in a small open economy (Q582191)

The paper presents a dynamic model of a small open economy. Starting point is an economy consisting of one representative consumer and one representative firm, both having perfect foresight and each agent maximising an intertemporal objective. Four markets are considered, a goods, a labour, a money, and a share market. The system's dynamics results from dividend payments and wealth effects induced by share holding or, respectively, debt accumulation, from capital accumulation, and from imperfect adjustment in the labour market. First, the closed economy is analysed. The model is opened by employing the concept of the small open economy, assuming purchasing power parity and (uncovered) interest parity. The consumption good and shares of firms, denominated in foreign and domestic currency, are traded internationally. It appears that the steady state of the open model cannot be derived from the equations but is sensitive to the history of the economy, a phenomenon called hysteresis. Therefore, numerical simulations are used first to compare the closed and the open model and second to examine the influence of different (monetary and technological) exogenous shocks on the adjustment path and the stationary state. Although the outcome in each of the cases considered is crucially dependent on the assumptions and the specification of the utility function, one interesting result should be mentioned. In the open model with sluggish wage adjustment money is non-neutral even in the long run.