Macroeconomic Adjustment Under an External and Fiscal Constraint : A Fix-Price/Flex-Price Approach

This paper presents a dual economy model of the fix-price/flex-price kind that explicitly allows for the existence of a government budget constraint in a fully open economy. Both the external and fiscal closures resemble very much the contemporary experience of several Latin American countries, where fiscal discipline and fix exchange rate systems have been the norm. Thus, within the public sector, it is assumed that public investment is the adjustment variable, while foreign reserves variation adjusts the external balance. Short-run impacts of policy-induced variables and changes in exogenous external financing are analysed. Relevant trade-offs, especially between output and inflation, follow from an analysis in which the time perspective is rather short. However, in the medium term, some balancing forces in the economy can moderate the trade-offs. We show among a wide range of events and policy options that this is the case of debt relief or a concerted lending strategy