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A Small Open Economy with Staggered Wage Setting and Intertemporal Optimization: The Basic Analytics
Author(s) -
Fender John,
Rankin Neil
Publication year - 2003
Publication title -
the manchester school
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.361
H-Index - 42
eISSN - 1467-9957
pISSN - 1463-6786
DOI - 10.1111/1467-9957.00353
Subject(s) - economics , elasticity of substitution , small open economy , openness to experience , elasticity (physics) , open economy , short run , wage , price elasticity of demand , unitary state , exchange rate , microeconomics , monetary economics , production (economics) , labour economics , psychology , social psychology , materials science , law , political science , composite material
We develop a model of a small open economy with optimizing, infinitely lived agents. They have monopoly power over the price of their labour, and wage setting is staggered. We consider the effects of an unanticipated increase in the money supply. In all cases, the exchange rate depreciates immediately to its long‐run value with no overshooting. With unitary elasticity of substitution in preferences between home and foreign goods, output rises instantaneously but gradually returns to its initial value in the long run. Trade remains balanced at all times. With an elasticity of substitution above unity, there is a trade surplus in the short run and a deficit in the long run, as permanently higher net foreign assets are accumulated. Convergence to the steady state is faster, and thus output persistence is smaller. With unitary elasticity the dynamics are the same as in an equivalent closed economy, so, to the extent that an elasticity greater than one is plausible for an open economy, we conclude that openness reduces output persistence.