Monetary Disinflation, Fiscal Expansion and the Current Account in an Interdependent World

A two-country, intertemporal, perfect-foresight model with micro foundations, Cobb-Douglas preferences and technologies, floating exchange rates, uncovered interest parity,and nominal wage rigidities is formulated. The transient and steady-state effects of a joint and unilateral monetary disinflation and a fiscal expansion are analysed. The foreign repercussions of monetary and fiscal policy do not affect the home economy, so that the multipliers are the same as for a small open economy. Since Ricardian debt neutrality holds, the nominal interest rate is equal to the rate of time preference plus the discounted average of future, expected monetary growth rates, and is independent of fiscal policy and foreign policies. Also, monetary disinflation does not lead to overshooting of the nominal exchange rate. To give a non-trivial role to wealth effects, current-account dynamics and the nominal exchange rate, and to allow for more interesting international spillover effects, the model is extended to allow for finite lifetimes so that Ricardian debt neutrality no longer holds. The transient effects of tax-financed and debt-financed changes in monetary growth and government spending are discussed.