The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper examines the long-run effects of macroeconomic policy shocks on the behavior of output, inflation, real wages and the real exchange rate in a small open economy. The analysis is based on a two-sector, three-good optimizing model with imperfect capital mobility, nominal wage contracts with backward- or forward-looking price expectations, and endogenous mark-up pricing in the nontraded goods sector. The effects of a cut in government spending on nontraded goods are shown to be independent of the expectational mechanism embedded in wage contracts. A reduction in the nominal devaluation rate lowers steady-state output in the tradable sector under backward-looking contracts, but exerts an expansionary effect under forward-looking contracts.