Heijdra Foundations of Modern Macroeconomics (Oxford, 2002)

to the utility funCtion,

G 1-1 /E3

1 - 1/6	3 ) '	(10.71'

which is defined as:

(10.7*'

me the household could have )d 1 and by supplying the

lump-sum taxes is:

I-

(10.74)

ced by the revenue from the indirect utility of the repre-

- ernment budget restriction n is:

/V21 (10.75)

n g by the household, K2 FE ated with the government

r the policy maker's problem

I

(10.76)

(10.77)

(10.78)

ons can be rewritten in the

(10.79)

(10.80)

(10.81)

Chapter 10: Macroeconomic Policy, Credibility, and Politics

where EL is the uncompensated wage elasticity of labour supply (EL >0), EK is the uncompensated interest elasticity of gross saving (EK > 0), and 77 ,u/(aviaiF ) is the

marginal cost of public funds (MCPF). Intuitively, the MCPF measures how much it

"costs" to raise a guilder of public revenue. If there are non-distorting taxes it costs exactly one guilder to raise a guilder, and the MCPF is unity. On the other hand, if taxes distort real decisions by the private sector, it costs more than one guilder to raise one guilder of public revenue and the MCPF exceeds unity.

Equation (10.79) is the modified Samuelson rule for the optimal provision of public goods (see Atkinson and Stern, 1974). In words, (10.79) says that the marginal benefits of public goods (the left-hand side of (10.79)) should be equated to the marginal cost of financing these public goods, i.e. the MCPF. If there are nondistorting taxes, 77 = 1, and society can afford the first-best optimum level of public consumption. With distorting taxes, > 1, and fewer public goods are provided. Equations (10.80)-(10.81) determine the optimal mix of taxes. Indeed, by rewriting (10.80)-(10.81) we obtain:

(1 —	I,	(10.82)
1—	71 EL
tK = 1	1), 1	(10.83)
1 — tK	rl EK

Equations (10.82)-(10.83) are expressions for the so-called Ramsey taxes on capital and labour (named after the British economist Frank Ramsey). Intuitively, these taxes raise a given amount of government revenue in the least distorting fashion. In order to facilitate the interpretation of (10.82)-(10.83), suppose that labour supply is perfectly inelastic (i.e. EL = 0). Then we know that a tax on labour income works exactly like a (non-distorting) lump-sum tax. Equation (10.80) says that in that case the MCPF is unity, so that (10.83) says that capital should not be taxed at all, and the entire revenue should be raised by means of the labour tax. The reverse case holds if the savings function is very interest inelastic and the labour supply is very wage elastic. In that case capital should be taxed heavily and labour should be taxed lightly. In the general case, however, (10.82)-(10.83) say that both tax rates should be set at some positive level.

10.3.3 Dynamic inconsistency of the optimal tax plan

The problem with the optimal tax plan calculated in the previous section is that it is dynamically inconsistent. In the first period the policy maker announces that it will tax both labour income and capital income in the second period. But it turns out that once the second period has commenced it is no longer optimal for the policy maker to stick to its plan. This can easily be demonstrated with the aid of the model. At the beginning of the second period, the representative household has a

255

the fact th

and nc

(using rr,

The Foundation of Modern Macroeconomics

capital stock of K2 and chooses C2 and N2 to maximize remaining lifetime utility,

U2 --=- C2 + a ( (1 - N2 ) 1-1 /E2 )			(10.84)
1 - 1/E2	) +18 (1 - 1/E3
subject to the budget restriction:
C2 = a(1 - tON2 + [1 +	- 40]-K2.		(10.85)
Following the usual steps, the solutions for C2 and N2 are obtained:
C2 = a(1 - + [1 + b(1 - tK)] K2 — otE2 [a(1 -		62	(10.86)
(a(1 tL))-E2			(10.87)
1 — N2 =

By substituting (10.86)-(10.87) into (10.84) the indirect utility function for period 2 is obtained:

V2 := [a(1 - tL) + [1 + b(1 - tK)] K2]

( a (L))1	-"	+ p (G21-11"	(10.88)
a(1 - t )
E2 - 1		- 1/E3 ) •

Obviously, (10.86)-(10.87) coincide with the expressions given in (10.70)-(10.71), respectively, if the policy maker keeps his word and produces the tax rates as given

in (10.82)-(10.83).

The problem is that, from the perspective of period 2, the policy maker will set different tax rates. Intuitively, the reason is that once the capital stock K2 is in place, taxing capital income is non-distorting (since the capital income is like a "sitting duck") and the optimal Ramsey tax solution is to set tL = 0 (since the labour tax is distorting) and tK > 0.9 As a result of this, the optimal tax rates as given in (10.82)-(10.83) are not believed by the public.

Of course, there is a consistent solution to the problem. This solution is obtained by working backwards in time, starting in period 2. The public knows that the government will set tL = 0 in period 2 and raise its revenue by means of the tax on capital income only. The public also knows that G2 will be set according to the level given in (10.54) because the policy maker has a non-distorting tax at its disposal in period 2. As a result of the higher level of public spending and the higher capital tax, the public will save less in period 1.

9 Formally, the policy maker chooses G2, tL, and tK in order to maximize (10.88) subject to the government budget restriction (10.74). By following the same steps as before it can be shown that these results follow. Notice also that the government's plan regarding public goods provision is also dynamically inconsistent. Provided enough revenue can be raised from the capital income tax, the policy maker will set G2 at the first-best optimum level as given in (10.54). This is a higher level than was announced in the first period.

Chz

10.4 Punchlines

I

The discussion in this c tency. The classic exams can be traced to the a.. study examples of dyna study three examples, policy.

To prepare for the fin simple model in which U attempts to steer output 1 inflation rate

the policy maker depenki and on the inflation rate, policy maker against in:.. shall call the policy make the policy maker can obi Lucas supply curve but ti policy is effective at influe rational expectations. 41

We can distinguish du problem. Under the dis. thus output) in each pen they can compute the r feeds back into the Luc discretionary policy has t tively on the output ambi employment output) any accommodation of su

,)n on the political oriei,, policy maker cares little :viations in output fa , The discretionary soluu steer closer to its bliss po:

• Aution is as follows. Th, a monetary policy rule wt believed that the policy m would also be zero

The problem with inconsistent. A policy mai, based on zero expected modating surprise infl,.:ir its name from

256

e remaining lifetime utility,

(10.84)

(10.85)

are obtained:

(10.86)

(10.87)

I

t utility function for period 2

(10.88)

given in (10.70)—(10.71), )cluces the tax rates as given

2. the policy maker will set e capital stock K2 is in place, i I income is like a "sitting = 0 (since the labour tax mal tax rates as given in

m. This solution is obtained The public knows that the nue by means of the tax on set according to the level ,torting tax at its disposal in ding and the higher capital

maximize (10.88) subject to the as before it can be shown that public goods provision is also

,m the capital income tax, the 54). This is a higher level than

Chapter 10: Macroeconomic Policy, Credibility, and Politics

10.4 Punchlines

The discussion in this chapter focuses on the phenomenon of dynamic inconsistency. The classic example of dynamic inconsistency and its potential resolution can be traced to the ancient Greek author Homer. In this chapter, however, we study examples of dynamic inconsistency in governmental economic policy. We study three examples, two of which deal with monetary policy and one with fiscal policy.

To prepare for the first two examples of dynamic inconsistency we develop a simple model in which the policy maker faces a (stochastic) Lucas supply curve and attempts to steer output towards a higher than full employment level by setting the inflation rate (using monetary policy instruments to do so). The cost function of the policy maker depends positively on the deviation of output from its target level and on the inflation rate. A simple parameter measures the relative aversion of the policy maker against inflation. The higher this parameter the more "right wing" we shall call the policy maker. There is informational asymmetry in the model because the policy maker can observe the realization of the stochastic supply shock in the Lucas supply curve but the public cannot. As a result of this asymmetry, monetary policy is effective at influencing output despite the fact that private agents formulate rational expectations.

We can distinguish three different solutions to the policy maker's optimization problem. Under the discretionary solution, the policy maker chooses inflation (and thus output) in each period. Since private agents know the structure of the model they can compute the rational expectations solution under discretion which then feeds back into the Lucas supply curve. The rational expectations solution for the discretionary policy has two features. First, the chosen inflation rate depends positively on the output ambition of the policy maker (the gap between target and full employment output) and negatively on the supply shock. Second, the degree of accommodation of supply shocks by monetary policy depends in an intuitive fashion on the political orientation of the policy maker. Indeed, a left-wing (right-wing) policy maker cares little (strongly) about inflation and cares strongly (little) about deviations in output from full employment.

The discretionary solution is suboptimal, however, in that the policy' maker can steer closer to its bliss point under an alternative rule-based solution. The rule-based solution is as follows. The policy maker announces to the public that it will follow a monetary policy rule which produces zero inflation in every period. If the public believed that the policy maker would stick to its promise the expected inflation rate would also be zero and no output stabilization would take place.

The problem with the rule-based solution is, however, that it is dynamically inconsistent. A policy maker has a strong incentive to exploit the Lucas supply curve based on zero expected inflation and to accommodate supply shocks by accommodating surprise inflation. This is the so-called cheating solution which derives its name from the fact that the policy maker does not stick to its promises of no

257

The Foundation of Modern Macroeconomics

inflation. The cheating solution is closest to the policy maker's bliss point but it violates the rational expectations assumption.

The upshot of the discussion so far is that the only policy which is both believed by private agents (and is said to be credible) and is consistent with rational expectations is the discretionary policy. Of all policies considered however, the discretionary policy yields the policy maker the lowest level of welfare (i.e. the highest level of social cost). It would seem that the economy gets stuck with the worst possible outcome.

In an ingenious paper, Barro and Gordon have shown that the reputation of the policy maker can act as an enforcement device, making it possible that the superior rule-based equilibrium is credibly selected in equilibrium. These authors proxy the policy maker's reputation as follows. If the policy maker has kept its promise (whatever it was) in the previous period then the public will believe the policy maker's announcement that it will follow the monetary rule in the present period. In contrast, if the policy maker did not keep its promise in the previous period, the public discounts the policy maker's reputation and expects that the discretionary solution will be selected in the present period. This is an example of a "tit-for-tat" strategy adopted by the private agents in their repeated prisoner's dilemma game with the policy maker. The approach implies that a rule-based solution may be enforceable which features a positive inflation rate.

In the remainder of this chapter we give two more examples of dynamic inconsistency (and its possible resolution). In the first of these we show that in a voting model, the median voter will elect somebody to act as the central banker who is more conservative (and has a higher aversion against inflation) than he is himself. In doing so, the median voter commits himself to a lower inflation rate than he would have chosen had he himself been the monetary policy maker.

In the final example we develop a simple toy model of optimal taxation of labour and capital income when lump-sum taxes are not available. Two key results are derived. First, abstracting from issues of dynamic inconsistency, the optimal tax rates on both labour and capital are non-zero and these rates depend on the elasticities of the respective tax bases. Second, the optimal taxes are dynamically inconsistent. Once the future capital stock is in place, the tax base for capital income tax is inelastic and the policy maker can raise public revenue in a non-distorting fashion by not taxing labour income and taxing capital income as much as possible.

Further Reading

The key references to the reputational model of inflation are Barro and Gordon (1983a, 1983b), and Backus and Driffill (1985). See also Cukierman and Meltzer (1986) and Cukierman (1992). Persson and Tabellini (1994b) present a collection of the most important articles. Recently a number of monographs have appeared on the political economy

Chap

approach to economic poll, Tabellini (2000), and Draze (2000). Readers interested Stiglitz (1980). Persson and sentative democracy. Van de fiscal policy in a dynamic :

Appendix

Derivation of equatioi

Equation (10.80) is derived function given in (10.72). 1

av	a ± a
atL	i+p +p

where we have used (10.71) i

(	a	N2 ± a N2
	p)
kt(1 p) [1		( 1 tL
where	,u(1 p) is the n

elasticity of labour supply:

aN2	a(1 — tL
EL = aci(1 — tL)	N2

where coti m- (1 — N2)/N2 is tt obtained.

Equation (10.81) is obt,...

indirect utility function give

av =	b
ati<	1 +p (1± b)K1
	b
	[C1 — (1
	1 p

where we have used (10.69 (A10.4) into (10.78) we ob

b) K2 + libK2 r '

+p

it(1+ p)[1

(1 tittK)

258

is the leisure/work ratio. By rewriting (A10.2), equation (10.80) is

)licy maker's bliss point but it

oolicy which is both believed by `.ent with rational expectations ?d however, the discretionary 'Hare (i.e. the highest level of stuck with the worst possible

)wn that the reputation of the ng it possible that the superior urn. These authors proxy the Ler has kept its promise (whatvill believe the policy maker's in the present period. In conhe previous period, the public

at the discretionary solution rnple of a "tit-for-tat" strategy 'lees dilemma game with the i solution may be enforceable

examples of dynamic inconlese we show that in a voting as the central banker who is inflation) than he is himself. i lower inflation rate than he y policy maker.

lode! of optimal taxation of not available. Two key results c inconsistency, the optimal id these rates depend on the i mal taxes are dynamically he tax base for capital income revenue in a non-distorting l income as much as possible.

Barro and Gordon (1983a, man and Meltzer (1986) and collection of the most impor- d the political economy

Chapter 10: Macroeconomic Policy, Credibility, and Politics

approach to economic policy-see Persson and Tabellini (1989), Dixit (1996), Persson and Tabellini (2000), and Drazen (2000). For a review of the last two books, see Saint-Paul 2000). Readers interested in the optimal taxation literature are referred to Atkinson and Stiglitz (1980). Persson and Tabellini (1994a) study capital taxation in a model of a representative democracy. Van der Ploeg (1995) studies the political economy of monetary and fiscal policy in a dynamic macroeconomic model.

Appendix

Derivation of equations (10.80)—(10.81)

Equation (10.80) is derived as follows. First, we calculate avot-L from the indirect utility function given in (10.72).

ay —	a + a	( a(1 — ti.)1E2	( a )	N2,	(A10.1)
atL	1 +p 1+p	a )	1 + p

where we have used (10.71) in the final step. By substituting (A10.1) into (10.77) we obtain:

(1 P) i,2 + ..taN2[1±	aN2 ]
	N2 at-L = 0

			tL	(A10.2)
	p (1	+ p)[1 (	1 - tL ) EL] = 1,

where ri bc(1 p) is the marginal cost of public funds, and EL is the uncompensated wage elasticity of labour supply:

EL	aN2 a(1 -	)	-	)	a N2 tL		(A10.3)
					ati,	— = HE2 >
	aa(1 - 1-1,) N2					N2

where coif (1 - N2)/N2

obtained.

Equation (10.81) is obtained in a similar fashion. First, we calculate indirect utility function given in (10.72).

av	b		b(11+ - tK)\ - "
atK	(1 + b)Ki +			1 + p )
	1+p	1 + p
	b )	[C (1 + b)K11 =		b
= (1 + p				1 + p)

aviatK from the

(A10.4)

where we have used (10.69) and the definition of K2 in the two final steps. By substituting (A10.4) into (10.78) we obtain:

b	+ p,bK2 [1 +	tK aK2	= 0
1 + p		a tK
µ (1 + p)[1		1,	(A10.5)
	(1 -4( tK) Ed =
			259

The Foundation of Modern Macroeconomics

where EK is the uncompensated interest elasticity of gross saving:

EK =	aK2 b(1 — tK)	(1 —tK	aK2 tK	0,
	aba — tK) K2	tK	1- v = (OCE1 >
			a LK

where we is defined as:

b(1 — tK)C1 (DC = [1 + b(1 — tK)]K2 .

By rewriting (A10.5), equation (10.81) is obtained.

(A10.6)

(A10.7)

The Open

purpose of this chapl i

1.How do we add contribution.

2.What are the

How do the degree conclusions?

3.How are shocks tram coordination work?

4.How can we intro&

11.1The Internati

11.1.1Some bookkee

..7om national income ac

.8ate output can be v

Y:.=_C+I+G+(E.X.

here Y is aggregate out"

is on, EX is exports, and

.--ed absorption and 1 , absorption in the calculal ods, but imports :

.And G) does not lead to

260

11

The Open Economy

,e purpose of this chapter is to discuss the following issues:

1.How do we add the international sector to the IS-LM model? The Mundell-Fleming contribution.

2.What are the implications of openness on the effects of fiscal and monetary policy? How do the degree of capital mobility and the exchange rate system affect the conclusions?

3.How are shocks transmitted across countries and how does international policy coordination work?

4.How can we introduce forward-looking behaviour into the model?

11.1 The International Sector in the IS-LM Model

11.1.1 Some bookkeeping

From national income accounting principles we know that for the open economy aggregate output can be written as:

where Y is aggregate output, C is private consumption, G is government consumption, EX is exports, and IM are imports. Aggregate spending by domestic residents is called absorption and is defined as A -m C + G. Exports are added to domestic absorption in the calculation of aggregate output because foreigners also spend on our goods, but imports must be deducted because what we import (i.e. parts of C, I, and G) does not lead to domestic production.

accounting. In

T — G.

S Y + TR — T —

The Foundation of Modern Macroeconomics

In view of the definition of absorption A, (11.1) can also be written as:

Y -= A + (EX — IM),

(11.2)

which says that income equals aggregate spending by domestic residents plus net exports.

We also recall that aggregate output in an economy can be measured in different manners. Particularly, total output produced within the country is measured by gross domestic product (GDP), whereas total output produced by residents of the country (anywhere in the world) is measured by gross national product (GNP). For the first definition the relevant criterion is "where is it produced" and for the second definition "who produces it". The difference between GNP and GDP therefore depends on net factor payments received from abroad (such as income from capital in the form of interest and dividends, and labour income received by domestic residents from abroad). In practice we shall ignore the difference between the two concepts regarding aggregate output.

Yet another definition is obtained from (11.1) by adding international transfer receipts TR and deducting net taxes T (total taxes minus domestic transfers) on both sides:

Y+TR—TC+I+(G—T)+(EX+TR—IM),

(11.3)

where the left-hand side of (11.3) gives the definition of disposable income of residents. By noting that aggregate saving by the private sector S is defined as

C, equation (11.3) can be written as:

(S — I) + (T — G) (EX + TR — IM) CA.

(11.4)

The current account surplus CA is identically equal to the private sector savings surplus S — I plus the government budget surplus The current account surplus measures the rate at which the aggregate economy is adding to its net external assets: by spending less than your income (as a nation) you build up claims on the rest of the world. Hence, ignoring valuation changes of the existing stock of net foreign assets (NFA) we have:

ANFA CA,	(11.5)
or, equivalently,
ANFA (S — I) + (T — G).	(11.6)

Hence, a country for which S = I and G > T is of necessity running down its stock of net foreign assets (it is "borrowing from the rest of the world").

As a final step we must link the situation of the balance of payments to what happens in the financial sector by means of some elementary money

Ba .-,ce

Assets

Net for,-;

Dome,-

I

I

...ion (11.6)th,

..her all sectors 1 imeasury, and the na

s net foreign

Gin be written (in st

re NFAcb includ aoikiers, and DC incl

And other credit. I' ncy in the ha: wink RE (so that H

By taking first d,i; t the change in 1 difference betN%

Domestic credit creal

NFA th - OH -

I

...ion (11.7) d,.: century Scottish phi!,

--*rvenes in the f

stock of net fuik. gooney changes as "

• automatic,,.. the money multiplie

The monetary a .. 4.1 NFA" by engu,

entral bank can s.

.pulating dom

central bank sells tO1 C' , Iv uses an ex:

en 'lie open

.n AH = 0.

In a fractional rL uaction of their dept

262

ANFAcb <

'co be written as:

(11.2)

omestic residents plus net

can be measured in differthe country is measured by oduced by residents of the ional product (GNP). For produced" and for the sec- en GNP and GDP therefore (such as income from capicome received by domestic ' • fference between the two

I

ding international transfer nus domestic transfers) on

111

(11.3)

of disposable income of ite sector S is defined as

(11.4)

the private sector savings "-e current account surplus ng to its net external assets: ild up claims on the rest of ,zing stock of net foreign

(11.5)

(11.6)

running down its stock e world").

ince of payments to what

• ,.ry money accounting. In

Chapter 11: The Open Economy

Balance sheet of the central bank

Assets		Liabilities
Net foreign assets NFAth
Domestic credit	DC	High powered money H

equation (11.6) the aggregate change in net foreign assets is determined (i.e. lumping together all sectors of the economy such as the central bank, commercial banks, treasury, and the non-bank private sector). We denote what happens to the central bank's net foreign asset position by ANFAcb . The monetary authority's balance sheet can be written (in stylized form) as above.

Here NFAth includes foreign exchange reserves less liabilities to foreign official holders, and DC includes securities held by the central bank (such as T-bills), loans, and other credit. High powered money consists of currency CP (cash in vaults and currency in the hands of the public) plus commercial bank deposits at the central bank RE (so that H CP + RE). High powered money is often referred to as "base money".

By taking first differences we can derive from the central bank's balance sheet that the change in the net foreign asset position of the central bank is equal to the difference between the rate of high powered money creation minus the rate of domestic credit creation:

ANFAcb AH — ADC. (11.7)

Equation (11.7) demonstrates an important mechanism due to the eighteenthcentury Scottish philosopher and economist David Hume. If the monetary authority intervenes in the foreign exchange market (by buying or selling foreign exchange) the stock of net foreign assets changes and, by (11.7), the stock of high powered money changes as well, i.e. AH = ANFAcb . Hence, foreign exchange sales (purchases) automatically reduce (increase) the stock of high powered money (and, by the money multiplier, the money stock as well; see below).

The monetary authority can (temporarily) break this automatic link between H and NFAch by engaging in so-called sterilization operations. In terms of (11.7) the central bank can sterilize the effect of changes in its net foreign asset position by manipulating domestic credit, i.e. AH = 0 if ADC = — ANFAth . For example, if the central bank sells foreign exchange reserves (so that 0) and simultaneously uses an expansionary open market operation (a purchase of domestic bonds on the open market) of appropriate magnitude, so that ADC = — ANFAcb > 0, then AH = 0.

In a fractional reserve banking system commercial banks are required to hold a fraction of their deposits in the form of reserves with the central bank. The money

263

reserve requirement

264

or a lower desired

A (1 + C2)I(C1+ c2) >

and H = (ci +c2)D,

(1 + c2)D

RE= ci D,

The Foundation of Modern Macroeconomics

stock, Ms , as measured by the sum of deposits, D, at the commercial banks plus currency, CP, is then a multiple of the stock of high powered money:

Ms = D CP = ,uH <#. OMs = ,u6R,

(11.8)

where ,u > 1 is the money multiplier. 1

11.1.2 The modified IS-LM model for a small open economy

Up to this point all we have done is manipulate some unexciting (but rather essential) identities. We can give the story some theoretical content by specifying the behavioural equations of the model. First, we write (11.2) in the form of a condition for spending equilibrium in the aggregate goods market as:

Y = A(r, Y) + G X(Y , Q),

(11.9)

where A(r, Y) is the part of domestic absorption that depends on the rate of interest r and the level of aggregate output Y, G is the exogenous level of government spending, and X(Y , Q) is net exports (--= EX - IM) as a function of output and the relative price of foreign goods Q EP* /P, where E is the nominal exchange rate (domestic currency per unit of foreign currency), P* is the foreign price level, and P is the domestic price level. In view of the definition of the exchange rate, a depreciation (or devaluation) of the domestic currency is represented by an increase in E.

Since investment depends negatively on the interest rate and the marginal propensity to consume out of current income is between zero and unity, we have that Ar < 0 and 0 < A y < 1. Furthermore, the net export function satisfies Xy < 0 (since imports depend positively on income) and XQ > 0 (as it is assumed that the Marshall-Lerner condition holds). Equation (11.9) is the open economy IS curve. Like its closed economy counterpart, it is downward sloping in (r, Y) space, but the import leakage makes it steeper than for the closed economy.

The money market can be modelled in the standard fashion.

MD /P L(r, Y),	(11.10)
Ms = ,u, [NFAth + DC] ,	(11.11)
mD = mS = m	(11.12)

with Lr < 0 and L y > 0 (see Chapter 1). Equations (11.10)-(11.11) define the open economy LM curve, which is upward sloping in (r, Y) space. The modification brought about by the recognition of the openness of the economy consists of

1 Assume that the commercial banks are required by law to hold a fraction c1 of their deposits as reserves with the central bank, where 0 < c1 < 1. Suppose furthermore that the public desires

a constant ratio between currency holdings and deposits, say C/D = c2. Then, since Ms D + CP = we can derive that Ms = ittH, where 1. A higher legal

currency-deposits ratio both decrease the money multiplier.

the potential end( net foreign assets of th domestic and foreign p by making an assumi,..

11.1.3 Capital mobi

We can distinguish Sr can be assumed that tii with the rest of the N , immobility. This case countries had capital cc cial capital is perfectly I yield. Domestic and fon instantaneous so that to be relevant to the

is referred to as one of i The balance of pays zile capital account. Ign

the trade account:

B X(Y , Q) K1 r

here B is the balance

rate in the ROW. If KI

7" ore financial assets i■OW. In that case the three assumptions

be made more precise. that balance of paymei

count, i.e. B = 4:oitrage in the capital always, which can be 1

of imperfect capita in equilibrium and 0 - curves in (r, Y) space fu; by differentiating (11.1:

( dr

dY) B=o