Working Paper Capital Mobility, Consumption Substitutability, and the Effectiveness of Monetary Policy in Open Economies

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1 econsor Der Open-Access-Publikaionsserver der ZBW Leibniz-Informaionszenrum Wirschaf The Open Access Publicaion Server of he ZBW Leibniz Informaion Cenre for Economics Pierdzioch, Chrisian Working Paper Capial Mobiliy, Consumpion Subsiuabiliy, and he Effeciveness of Moneary Policy in Open Economies Kieler Arbeispapiere, No. 0 Provided in Cooperaion wih: Kiel Insiue for he World Economy (IfW) Suggesed Ciaion: Pierdzioch, Chrisian (2002) : Capial Mobiliy, Consumpion Subsiuabiliy, and he Effeciveness of Moneary Policy in Open Economies, Kieler Arbeispapiere, No. 0 This Version is available a: hp://hdl.handle.ne/049/7777 Nuzungsbedingungen: Die ZBW räum Ihnen als Nuzerin/Nuzer das unengelliche, räumlich unbeschränke und zeilich auf die Dauer des Schuzrechs beschränke einfache Rech ein, das ausgewähle Werk im Rahmen der uner hp:// nachzulesenden vollsändigen Nuzungsbedingungen zu vervielfäligen, mi denen die Nuzerin/der Nuzer sich durch die erse Nuzung einversanden erklär. Terms of use: The ZBW grans you, he user, he non-exclusive righ o use he seleced work free of charge, erriorially unresriced and wihin he ime limi of he erm of he propery righs according o he erms specified a hp:// By he firs use of he seleced work he user agrees and declares o comply wih hese erms of use. zbw Leibniz-Informaionszenrum Wirschaf Leibniz Informaion Cenre for Economics

2 Kiel Insiue for World Economics Duesernbrooker Weg Kiel (Germany) Kiel Working Paper No. 0 Capial Mobiliy, Consumpion Subsiuabiliy, and he Effeciveness of Moneary Policy in Open Economies by Chrisian Pierdzioch May 2002 The responsibiliy for he conens of he working papers ress wih he auhor, no he Insiue. Since working papers are of a preliminary naure, i may be useful o conac he auhor of a paricular working paper abou resuls or caveas before referring o, or quoing, a paper. Any commens on working papers should be sen direcly o he auhor.

3 2 Capial Mobiliy, Consumpion Subsiuabiliy, and he Effeciveness of Moneary Policy in Open Economies * Absrac This paper uses a dynamic general equilibrium wo-counry opimizing model o analyze he consequences of inernaional capial mobiliy for he effeciveness of moneary policy in open economies. The model shows ha he subsiuabiliy of goods produced in differen counries plays a cenral role for he impac of inernaional capial mobiliy on he effeciveness of moneary policy. Paralleling he resuls of he radiional Mundell-Fleming model, a higher degree of inernaional capial mobiliy increases he effeciveness of moneary policy only if he Marshall-Lerner condiion, which is linked o he cross-counry subsiuabiliy of goods, holds. Keywords: Moneary policy; Capial mobiliy JEL classificaion: F32, F36, F4 Dr. Chrisian Pierdzioch Kiel Insiue for World Economics 2400 Kiel, Germany Telephone: Fax: c.pierdzioch@ifw.uni-kiel.de * I hank Chrisophe Kamps for helpful commens. The usual disclaimer applies.

4 . Inroducion Since he publicaion of he classic model of Fleming (962) and Mundell (963) i has been generally acknowledged in he inernaional macro and finance lieraure ha he inernaional mobiliy of capial plays a key role for he effeciveness of moneary policy in open economies. In is basic form, he Mundell-Fleming model implies ha, in a flexible exchange rae sysem and wih capial being mobile inernaionally, a moneary expansion brings abou a depreciaion of he exchange-rae and, hereby, simulaes aggregae demand. Because his effec ends o be sronger he higher is he degree of inernaional capial mobiliy, a key resul of he model is ha he effeciveness of moneary policy, as measured in erms of is shor-run effecs on oupu, is an increasing funcion of he degree of inernaional capial mobiliy. Recenly, Suherland (996) and Senay (2000) have argued ha his key resul of he Mundell-Fleming analysis in principle also holds if one uses a modern micro-founded dynamic moneary general equilibrium macroeconomic model o sudy he oupu effecs of moneary policy in open economies. Using varians of he wo-counry sickyprice 'new-open economy macroeconomics (NOEM) model developed by Obsfeld and Rogoff (995), hey show ha moving from imperfec o perfec capial mobiliy increases he effeciveness of moneary policy. Hence, as in he Mundell-Fleming model, he effeciveness of moneary policy ends o be higher he higher is he degree of inernaional capial mobiliy. When drawing policy conclusions from he Mundell-Fleming model, one has o bring o mind ha he implicaions of his model for he effeciveness of macroeconomic policies under differen degrees of inernaional capial mobiliy hinge upon a number of crucial assumpions. One imporan assumpion is ha he sum of he

5 2 expor and impor elasiciy wih respec o he erms of rade, in absolue value, exceeds uniy (see, e.g. Niehans (975)). If his is he case he Marshall-Lerner condiion holds and he rade balance shows a normal reacion o real exchange rae changes, i.e., a real depreciaion (appreciaion) causes a rade balance surplus (defici). If he Marshall- Lerner condiion did no hold in he Mundell-Fleming model, a moneary policy induced depreciaion of he real exchange rae would give rise o a emporary deerioraion of he rade balance which, in urn, would hamper he shor-run effeciveness of an expansionary domesic moneary policy. In his paper, I show ha a similar resul obains if one uses a modern sochasic NOEM model of he ype developed by Suherland (996) o analyze he implicaions of inernaional capial mobiliy for he effeciveness of moneary policy in open economies. To derive his resul, I draw on he modeling sraegy advanced by Tille (200) and exend Suherland's model by assuming ha he elasiciy of subsiuion beween goods produced in differen counries is differen from he elasiciy of subsiuion beween goods produced in he same counry. Using a varian of he prooype NOEM model developed by Obsfeld and Rogoff (995), Tille has shown ha he elasiciy of subsiuion beween goods produced in differen counries is direcly linked o he Marshall-Lerner condiion and, hus, o he response of he rade balance o macroeconomic policy shocks. He has shown ha a moneary expansion improves he rade balance if he Marshall-Lerner condiion holds and worsens he rade balance if his condiion does no hold. In his paper, I explore he implicaions of his resul for he impac of inernaional capial mobiliy on he effeciveness of moneary policy. I find ha he shor-run effec of a moneary policy shock on he rade balance plays an imporan role for he impac

6 3 of capial mobiliy on he effeciveness of moneary policy in open economies. The reason is ha, in he model analyzed in his paper, he dynamics of he rade balance and, hus, inernaional capial flows exer a direc effec on inernaional relaive asse reurns when he inegraion of inernaional financial markes is incomplee. Inernaional relaive asse reurns, in urn, are a major deerminan of he real exchange rae and, in consequence, of oupu. Upon varying he elasiciy of subsiuion beween goods produced in differen counries, I find ha a higher degree of inernaional capial mobiliy decreases he effeciveness of moneary policy if his elasiciy is so small ha he Marshall-Lerner condiion is no saisfied. In conras, if he elasiciy of subsiuion is large enough so ha he Marshall-Lerner condiion is saisfied, higher capial mobiliy resuls in a higher effeciveness of moneary policy. Thus, as in he radiional Mundell-Fleming model, he Marshall-Lerner condiion plays a cenral role in he NOEM model analyzed in his paper for he implicaions of inernaional capial mobiliy for he effeciveness of moneary policy. The remainder of he paper is organized as follows. In Secion 2, I lay ou he heoreical model I use o derive he resuls repored in his paper. In Secion 3, I use impulse response funcions and numerical simulaions o analyze he effeciveness of moneary policy under alernaive assumpions regarding he degree of inernaional capial mobiliy. Secion 4 concludes. 2. The Model The model I use in his paper is an exension of he NOEM model developed by Suherland (996). I exend Suherland s model by assuming ha he elasiciy of

7 4 subsiuion beween goods produced in differen counries is differen from he elasiciy of subsiuion of goods produced in he same counry. To make Suherland s model more realisic, I furher build ino his model wo feaures which are fairly sandard in he lieraure. Firs, as suggesed by Taylor (997), I assume ha moneary policy arges he shor-erm ineres rae raher han he money supply. Second, I assume ha firms se prices according o a varian of he price seing mechanism advanced by Fuhrer and Moore (995) which assures a reasonable degree of inflaion persisence. The srucure of he model is as follows: The world is made up of wo counries, Home and Foreign. Each counry is inhabied by infiniely-lived idenical households. The households form raional expecaions and maximize heir expeced lifeime uiliy. In addiion, each counry is populaed by a coninuum of firms. Each counries households own he respecive domesic firms. The firms sell differeniaed producs in a monopolisically compeiive goods marke. When changing he price of heir produc, firms incur menu coss, implying ha prices are sicky. The only producion facor used by he firms is labor. Firms hire labor in a perfecly compeiive labor marke. Labor is immobile inernaionally. 2. Households Preferences and Goods Marke Srucure Home and Foreign households have idenical preferences and seek o maximize he presen value of heir expeced lifeime uiliy. The expeced lifeime uiliy of a Home s= s household is defined as U = E β u, wih 0 <β< being he households s

8 5 subjecive discoun facor and E denoing he condiional expecaions operaor. The period-uiliy funcion, u, is of he form: u = ( σ ) /σ ε µ ( σ /( σ ) )( C ) + χ( M / P ) /( ε ) N / µ, () where µ >, σ > 0, ε > 0, and χ > 0. In Eq. (), C denoes a real consumpion index, is he households labor supply, and M / denoes he end-of-period real N money holdings, where is he supply of Home ouside money and is he M aggregae Home price index defined below. Households hold only he money issued by he cenral bank of he counry in which hey reside, i.e., here is no currency subsiuion. P P The aggregae consumpion index, C, is a CES aggregae of an index of Home f consumpion goods, C, and of an index of Foreign consumpion goods, C : h / ρ h ( ρ ) / ρ ( ρ ) / ρ ρ / ( ρ ) C = [ n ( C ) + ( n) ) ], (2) / ρ f ( C where ρ > 0 denoes he elasiciy of subsiuion beween he Home and Foreign h f consumpion index. As in Tille (200), he index C (C ) is defined as a CES aggregae over a coninuum of differeniaed, perishable Home (Foreign) consumpion goods. These goods are sold by Home and Foreign firms in a monopolisically

9 6 compeiive goods marke and are indexed by z wih z [ 0, n) denoing Home and z (n,] denoing Foreign goods. The indices C h f and C can be expressed as: θ /( θ ) θ / ( θ ) n h / θ h ( θ ) / θ f / θ f ( θ ) / θ C = n { c ( z)} dz, C = ( n) { c ( z)} dz, 0 n where c j (z), j = h, f denoes consumpion of good z and θ > denoes he elasiciy of subsiuion beween consumpion goods produced wihin he same counry. The fac ha in general θ ρ implies ha he elasiciy of subsiuion beween goods produced in differen counries is differen from he elasiciy of subsiuion of goods produced in he same counry. Tille (200) proves ha he elasiciy of subsiuion beween goods produced in differen counries, ρ, is equal o he sum of he absolue expor and impor elasiciy wih respec o he erms of rade. This implies ha he Marshall-Lerner condiion holds if ρ > and is violaed if ρ <. The opimal consumpion allocaion is sandard and can be derived as in Tille (200). The resul is: C ( z) = h h h θ h ρ [ p z) / P ] [ P / P ] C (, (3) f f f θ f ρ [ p ( z) / P ] [ P P ] C C ( z) = /. (4)

10 7 Analogous expressions can be derived for he consumpion allocaion of Foreign households. In Eqs. (4) and (5), p h (z) denoes he home currency price of he Home good z [ 0, n) and p f (z) denoes he foreign currency price of he Foreign good h f z (n,]. The price index ( P ) is defined as he minimum expendiure required o h f buy one uni of he index of Home (Foreign) consumpion, C (C ). These price indices are given by: P P h n = n 0 { p h ( z)} θ dz /( θ ) /( θ ) n f f θ, P = ( n) { p ( z)} dz. 0 The aggregae domesic price index is hen of he form: h ρ f ρ /( ρ ) [ n( P ) + ( n)( P ) P = ] (5) Wih idenical preferences a home and abroad and he law-of-one-price holding for each differeniaed good, i immediaely follows ha purchasing power pariy holds: * P = S P, where denoes he aggregae Foreign price index. The Foreign index is * P given by a formula similar o ha given in Eq. (5).

11 8 2.2 The Srucure of Financial Markes When choosing he opimal allocaion of heir wealh, households have o ake ino accoun ha inernaional financial markes are no perfecly inegraed. Whereas Home households have free access o he domesic capial marke, hey incur inermediaion coss when underaking posiions in he inernaional asse marke. Similarly, Foreign households can rade foreign currency denominaed bonds wihou incurring ransacion coss bu incur inermediaion coss when rading in Home currency denominaed bonds. The real inermediaion coss, Z, of underaking posiions in he inernaional asse marke incurred by Home households are given by: Z = ψ ψ, (6) 2 * I [( F F ) / P ] where ψ > 0 and ψ > 0 2 are posiive consans, F denoes he sock of foreign currency denominaed asses held by domesic households, F is he seady sae level of he foreign asse holdings of Home households, and I denoes he level of real funds ransferred by Home households from he Home o he Foreign bond marke and corresponds o he rade balance. Boh Z and I are denominaed in erms of he consumpion aggregaor, C. The firs erm on he righ-hand side of Eq. (6) reflecs convex adjusmen coss and is idenical o he ransacion cos echnology used by Suherland (996). The second

12 9 erm on he righ-hand side of Eq. (6) is inroduced o ensure ha he foreign asse posiion and, hus, he seady sae around which he model is log-linearized is saionary (Schmi-Grohe and Uribe (200)). The saionariy of he seady sae will serve useful in he sochasic simulaions of he model presened in Secion 3. Toal income received by Home households consiss of he yield on heir holdings of Home and Foreign bonds, he profi income for he ownership of Home firms (i.e., dividend income), and he labor income. Given oal income, households deermine heir opimal consumpion, decide on heir preferred Home and Foreign bond holdings, and deermine heir preferred holding of domesic ouside money. In addiion, hey receive ransfers from he governmen and incur he ransacion coss for underaking posiions in he inernaional asse marke. The dynamics of Home households Home bond holdings, herefore, obey he following flow budge consrain: D ( M + w N PC P I PZ + Π + PT, (7) = + R ) D + M where D sands for he quaniy of Home currency denominaed nominal bonds, R denoes he nominal ineres rae on Home bonds beween period and +, T sands for real lump-sum ransfers (denominaed in erms of he consumpion aggregae, C ), w is he nominal wage rae earned in a perfecly compeiive domesic labor marke, and Π denoes he nominal profi income he household receives from domesic firms.

13 0 Assuming for simpliciy ha he producion funcion for good z is of he form y ( z) N ( z), he nominal profi income of firm z is given by = h Π ( z) = p ( z) y ( z) w y ( z). The dynamics of he Home households Foreign bond holdings are given by: F = ( + * R ) * F + P I, (8) where * R denoes he nominal foreign ineres rae paid for holding a nominal Foreign bond beween period and Individual Maximizaion The firs-order condiions for he households ineremporal opimizaion problem are: C /σ = λ P, (9) ε χ( M / P ) ) = λ P, (0) + βp E ( λ+ y z µ ( ) = λ, () w ( + R ) β ( λ ) + = λ, (2) E

14 λ S * * β ( + R ) E ( λ+ S+ ) + ψ λs + ψ 2λS ( F F ) / P = β ( + R ) E ( λ+ S+ I+ ), (3) where λ denoes he Lagrange muliplier. Analogous firs-order condiions can be derived for Foreign households. Eq. (3) shows ha he inermediaion coss for underaking posiions in inernaional financial markes (ψ >, ψ 2 > 0) imply ha he no-arbirage condiion of 0 uncovered ineres rae pariy, ha equaes he rae of reurns on Home and Foreign bonds, includes erms accouning for he coss incurred when ransferring funds beween he Home and he Foreign bond marke. 2.4 Price Seing Each firm has monopoly power on he marke for he differeniaed good i produces. I, herefore, reas he price i charges for is produc as a choice variable. In consequence, one has o specify a price seing mechanism. In his paper, I assume ha firms behave according o a price-seing mechanism similar o he one inroduced by Fuhrer and Moore (995). The advanage of his price-seing mechanism is ha i assures an empirically reasonable degree of ineria in inflaion dynamics. Following McCallum and Nelson (2000), I assume ha firms' price seing decisions can be described as a funcion of he oupu gap, measured as he deviaion of acual

15 2 oupu from is long run flexible price seady sae level, and of he weighed arihmeic average of lagged and expeced inflaion. Leing a variable wih a ha denoe percenage deviaion from he seady sae, he price seing equaion for a Home firm can be expressed as: d h h h pˆ ( z) = 0.5[ dpˆ ( z) EI dpˆ ( z)] yˆ Ψ, (4) where Ψ is a posiive consan. Given he price of he differeniaed good, he quaniy produced by he firm can be derived from he demand funcion for his good: h h θ h ρ [ p ( z) / P ] [ P ( z) P ] Q y ( z) = /, (5) * * where Q = nc + n) C + nz + ( n) Z is he aggregae world-demand funcion. ( 2.5 The Governmen Secor As regards moneary policy, I follow Taylor (993) and assume ha he cenral bank ses he nominal ineres rae in response o deviaions of inflaion and oupu from heir respecive arge levels. I use a sandard specificaion for he Taylor-ype moneary policy rule: ˆ = ˆ ˆ ˆ ˆ +, (6) R µ 0 + ( µ 3)[ dp + µ ( dp π ) + µ 2 y ] + µ 3R ε R,

16 3 where ε R, is a serially uncorrelaed sochasic disurbance erm wih sandard deviaion σ, π denoes he inflaion arge of he cenral bank, and µ and µ 2 are parameers R, ha capure he reacion of he cenral bank o deviaions of he inflaion rae from is arge level and o he oupu gap, defined as he deviaion of acual oupu from is flexible price seady sae oupu. The ineres rae smoohing objecive of cenral banks (Goodfriend (99)) is refleced in he parameer. As regards fiscal policy, I absrac from governmen purchases of consumpion goods, implying ha real ransfers are financed by seignorage. µ Definiion of Equilibrium and Model Soluion In a symmeric monopolisic compeiion equilibrium in he world economy, oupu, consumpion, he exchange rae, prices, ineres raes and wage raes, domesic and foreign bond holdings follow sochasic processes such ha (i) he labor markes in each counry clear, (ii) he opimaliy condiions for consumpion and asse holding are saisfied, (iii) he ineremporal budge consrain for each counry is saisfied, (iv) he markes for domesic and foreign bonds are in equilibrium, and, (v) inflaion dynamics and cenral bank policy saisfy Eqs. (4) and (6), respecively. To solve he model, I follow Obsfeld and Rogoff (995) and Suherland (996) and log-linearize he model around a symmeric flexible-price seady sae in which he Home and Foreign foreign asse posiions are zero. I hen use he algorihm developed by Klein (2000) o numerically simulae he calibraed log-linearized model. The calibraion of he model is given in Table and closely follows Suherland (996).

17 4 Inser Table abou here. When simulaing he model, I assume ha he innovaion erms, ε R,, in he Home and Foreign Taylor rules are perfecly negaively correlaed, i.e., moneary policy shocks are asymmeric. 3. Capial Mobiliy and he Effeciveness of Moneary Policy The impulse response funcions depiced in Figure visualize he impac of a uni moneary policy shock on key Home variables. To compue he impulse responses ploed in Figure, I assume ha he elasiciy of subsiuion beween Home and Foreign goods akes on he value ρ = 5.0, implying ha he Marshall-Lerner condiion is saisfied. This specificaion corresponds o he case analyzed in he radiional Mundell-Fleming model. I also corresponds o he case analyzed by Suherland (996). Inser Figure abou here. The moneary policy shock implies ha he inernaional nominal yield differenial becomes posiive so ha Home bonds become more aracive han Foreign bonds. The ensuing appreciaion of he nominal exchange rae implies ha, as required by he uncovered ineres rae pariy condiion, he posiive inernaional nominal yield differenial corresponds o depreciaion expecaions for he Home currency. Because he prices of he differeniaed goods adjus sluggishly, he nominal appreciaion implies a real appreciaion of he Home currency, where he real exchange rae is defined as

18 5 qˆ sˆ + pˆ f h * pˆ. The real appreciaion of he domesic currency makes Home goods more expensive relaive o Foreign goods. Because he Marshall-Lerner condiion holds, he real appreciaion deerioraes he rade balance and home oupu declines. In consequence, he foreign asse posiion of he Home economy sars o decline. Why does he degree of inernaional financial marke inegraion maer for he dynamics of he model in he afermah of a moneary policy shock? Wih inernaional financial markes being imperfecly inegraed (ψ > 0 ), he impac of he moneary policy shock on he dynamics of he foreign asse posiion is direcly refleced in he condiion of uncovered ineres rae pariy. Neglecing he influence of he second componen of he inermediaion cos funcion, Z, his condiion sipulaes ha, a any poin in ime, he inernaional nominal ineres rae differenial, Rˆ ˆ * R, is proporional o he sum of he expeced rae of change of he Home currency, E ( Sˆ ), and he + expeced rae of change of he cross-border flow of funds, E ( Iˆ ). This direc effec + of he change in he foreign asse posiion on he inernaional nominal yield differenial is absen in a world of high capial mobiliy (ψ = 0 ). I follows from he dynamics of he rade balance depiced in Figure ha he expeced rae of change of he cross-border flow of funds is posiive in he afermah of a moneary policy shock if he Marshall-Lerner condiion holds. To see his, noe ha he rade balance defici realized in he immediae afermah of he moneary policy shock gradually urns ino a surplus as he domesic currency sars o depreciae. From his i immediaely follows ha he expeced rae of change of he cross-border flow of funds is posiive, E ˆ ( I + ) > 0. This, in urn, implies ha, for any given ineres rae differenial, he expeced rae of depreciaion of he domesic currency mus be smaller

19 6 wih segmened inernaional financial markes. As a resul, he iniial appreciaion of he domesic currency will be less pronounced when inernaional financial markes are segmened. I follows ha he oupu effec of he moneary policy shock is larger in he case of high capial mobiliy han in he case of low capial mobiliy. Figure 2 shows impulse responses for a model in which he Marshall-Lerner condiion is no saisfied. To compue he impulse responses depiced in his figure, I change he elasiciy of subsiuion beween Home and Foreign goods from ρ = 5.0 o ρ = 0.5. Because he Marshall-Lerner condiion does no hold, he moneary policyinduced real appreciaion of he Home currency does no lead o normal reacion of he rade balance. The resul is ha Home sars o accumulae foreign asses in he afermah of he moneary policy shock. In he case of imperfecly inegraed financial markes, he resuling asse accumulaion again exers a direc effec on inernaional relaive asse reurns via he condiion of uncovered ineres rae pariy. The resul is ha he moneary policy induced real appreciaion of he Home currency is relaively srong in imperfecly inegraed financial markes. Hence, he oupu effec and, hus, he effeciveness of moneary policy is larger he lower is he degree of inernaional capial mobiliy. Also noe ha he lower is he cross-counry subsiuabiliy of goods he sronger is he real appreciaion of he Home currency required o bring abou goods marke equilibrium. Furher noe ha in he case considered in Figure 2, a moneary conracion resuls in an increase of Home consumpion. Though he rise of he nominal and, because of sicky prices, of he real ineres rae forces households o decrease curren consumpion, he real appreciaion of he Home currency and, hus, he resuling increase in he purchasing power of Home households is so large ha hey sar o

20 7 increase heir consumpion spending. Because Households purchasing power is higher in he shor run han in he long run hey smooh consumpion hrough a rade balance surplus. Inser Figure 2 abou here. Running sochasic simulaions of he model is an alernaive way of illusraing ha he implicaions of capial mobiliy for he effeciveness of moneary policy depend upon he elasiciy of subsiuion beween goods produced in differen counries. Here, I simulae he model using four alernaive specificaions of he moneary policy rule given in Eq. (6). In addiion o he benchmark Taylor rule used in he above analyses, I consider a moneary policy regime of sric inflaion argeing ( µ = ), a moneary policy regime in which he cenral banks reac srongly o he oupu gap ( µ = ), and a moneary policy regime in which he cenral banks respond o real exchange rae flucuaions. In he laer moneary policy regime, I add a erm µ 4 qˆ o he Taylor rule given in Eq. (6), where he coefficien µ assumes he numerical value µ = ( µ 4 = 0. 5) in he Taylor rule describing Home (Foreign) moneary policy. A similar moneary policy rule has been sudied, e.g., by Ball (999). The resuls of he numerical simulaions are given in Table 2. Panel A conains he simulaion resuls for he case ρ = 5.0 and Panel B gives he simulaion resuls for he case ρ = 0.5. Inser Table 2 abou here.

21 8 The message conveyed by he able is ha he main resul derived in his paper does no depend on he specific parameerizaion of he moneary policy rule. In all cases considered in he able, higher capial mobiliy increases he effeciveness of moneary policy if he Marshall-Lerner condiion is saisfied. In conras, higher capial mobiliy diminishes he effeciveness of moneary policy if he elasiciy of subsiuion beween Home and Foreign goods is so small ha he Marshall-Lerner condiion is no saisfied. 4. Conclusions In recen years, resoring o he class of so called NOEM models in he radiion of he model developed by Obsfeld and Rogoff (995) has become a popular way of analyzing he effeciveness of macroeconomic policies in open economies. The approach aken in he NOEM lieraure differs radically from ha of he radiional Mundell-Fleming model in ha i allows policy issues o be analyzed by means of fullfledged micro-founded dynamic general equilibrium models. Despie he differences, NOEM models and he Mundell-Fleming model share some implicaions. The NOEM model analyzed in his paper and he Mundell-Fleming model have in common ha hey predic ha a higher degree of inernaional capial mobiliy enhances he shor-run effeciveness of moneary policy in open economies only if he Marshall-Lerner condiion holds. The key feaure of he NOEM model sudied in his paper is ha he elasiciy of subsiuion beween goods produced in differen counries can be differen from he elasiciy of subsiuion beween goods produced in he same counry. The resuls of numerical simulaions showed ha higher capial mobiliy increases he effeciveness of moneary policy if he elasiciy of subsiuion beween goods produced in differen

22 9 counries exceeds uniy, implying ha he Marshall-Lerner condiion holds. Thus, as in he Mundell-Fleming model, he Marshall-Lerner condiion urned ou o be an imporan deerminan of he implicaions of inernaional financial marke inegraion for he effeciveness of moneary policy in open economies.

23 20 References Ball, L., 999, Policy rules for open economies, in J.B. Taylor (ed.), Moneary policy rules, Universiy of Chicago Press, New Jersey, Fleming, J.M., 962, Domesic financial policies under fixed and under floaing exchange raes, I.M.F. Saff Papers 9, Fuhrer, J. and G. Moore, 995, Inflaion persisence, Quarerly Journal of Economics 0, Goodfriend, M.S., 99, Ineres raes and he conduc of moneary policy, Carnegie- Rocheser Conference Series on Public Policy 34, Klein, P., 2000, Using he generalized Schur form o solve a mulivariae linear raional expecaions model, Journal of Economic Dynamics and Conrol 24, McCallum, B., 200, Should moneary policy respond srongly o oupu gaps? American Economic Review Papers and Proceedings 9, McCallum, B. and E. Nelson, 2000, Moneary policy for an open economy: an alernaive framework wih opimizing agens and sicky prices, Oxford Review of Economic Policy 6, Mundell, R.A., 963, Capial mobiliy and sabilizaion policy under fixed and flexible exchange raes, Canadian Journal of Economics and Poliical Science 29, Niehans, J., 975, Some doubs abou he efficacy of moneary policy under flexible exchange raes, Journal of Inernaional Economics 5, Obsfeld, M. and K. Rogoff, 995, Exchange rae dynamics redux, Journal of Poliical Economy 03, Schmi-Grohe, S. and M. Uribe, 200, Closing small open economy models, manuscrip, Universiy of Pennsylvania, November 200. Senay, Ö., 2000, Moneary policy in an open economy: economic inegraion, disinflaion and sabilizaion, Ph.D. hesis, Universiy of Mancheser, Chaper 3. Briish Thesis Service, Wes Yorkshire, Unied Kingdom. Suherland, A., 996, Financial marke inegraion and macroeconomic volailiy, Scandinavian Journal of Economics 98, Taylor, J.B., 993, Discreion versus policy rules in pracice, Carnegie-Rocheser Conference Series on Public Policy 39, Tille, C., 200, The role of consumpion subsiuabiliy in he inernaional ransmission of moneary shocks, Journal of Inernaional Economics 53,

24 2 Figures and Tables Figure Inernaional capial mobiliy and he dynamic macroeconomic effecs of a uni moneary policy shock ( ρ > ) Noe: Dashed lines obain when seing ψ and solid lines obain when seing ψ. The = 0.0 = 5. 0 elasiciy of subsiuion beween Home and Foreign goods assumes he value ρ = 5.0. Consumpion, oupu and he real exchange rae are measured as percenage deviaions from he seady sae. Bond holdings are measured as percenage deviaions from he seady sae consumpion level. The ineres rae is measured in erms of percenage poin deviaions from he seady sae.