**S**hocks emanating from domestic policies or from changes in the external economic environment in developing countries invariably set off a dynamic process of adjustment that frequently takes some time to work itself out. Although analysis of the macroeconomic effects of such shocks typically focuses on impact effects or on the eventual steady state at which the economy settles, it is the intermediate run—that is, the “real-time” effect of such shocks—that is often of equal if not even greater concern to policymakers in developing countries. While explicit dynamic solutions to small analytical models can yield valuable insights into particular aspects of the economy’s response to such shocks, general-equilibrium interactions can only be studied in the context of larger models that, unfortunately, do not often prove to be analytically tractable. Thus, numerical simulation experiments with dynamic macroeconomic models become the tool of choice for understanding the real-time effects of policy measures and external shocks in developing countries.

In such macroeconomic models, dynamic behavior may arise from a number of sources. The most familiar are partial adjustment of the endogenous variables and the formation of expectations. Whereas the assumption that agents’ expectations are formed rationally now pervades policy-oriented discussions involving macroeconomic problems in developing countries (see Corden (1989)), medium-sized dynamic macroeconomic models estimated under the rational expectations assumption are not available for such countries. Moreover, research on adjustment paths produced in response to policy and exogenous shocks in developing countries under rational expectations is not much advanced.^{1}

This paper builds on recent research by Haque, Lahiri, and Montiel (1990), in which a fairly small macroeconomic model for developing countries was specified and estimated under the assumption of rational expectations. Our purpose is to explore the model’s implications for the economy’s path of adjustment to the domestic policy shocks and changes in the external environment—on the assumption that expectations are formed rationally. We shall examine the dynamic effects of policy shocks—devaluation, expansionary fiscal policy, and an expansion of domestic credit—as well as of changes in external demand and in foreign interest rates.

The first section of the paper briefly describes the model and some of its more relevant properties. Section II examines the effects of the policy shocks, while the external shocks are analyzed in Section III. The final section summarizes the findings, focusing specifically on the role of expectations in determining the nature of the adjustment paths generated by the shocks.

## I. The Model

The model that we intend to utilize in our simulation exercises represents a small open economy with a Mundell-Fleming production structure, a fixed exchange rate, perfect capital mobility, and continuous full employment. The model is presented in Appendix I, which also contains a definition of the variables. The parameters reported in Appendix I were estimated empirically, using an error-components three-stage least-squares technique, for a pooled cross-sectional time-series sample of 31 developing countries.^{2} Its behavioral equations consist of conventional, widely used specifications, since the model was intended to provide “representative” developing country estimates of parameters that figure prominently in policy discussions. The parameters were estimated using a large pooled cross-sectional time-series sample of countries, a consistent data set, and appropriate empirical techniques. The Mundell-Fleming structure is typically adopted for empirical models of developing countries because of the difficulty of conforming the data to the traded-nontraded distinction required by the analytically preferable “dependent economy” framework. Fixed exchange rate arrangements are common among developing countries, and were even more so during the period of our sample.^{3} The empirical model was designed to test for the degree of effective capital mobility, and proved unable to reject the hypothesis of perfect capital mobility (that is, uncovered interest parity) for the group of countries in the sample. Finally, the full-employment assumption is controversial, but the question of the existence of Keynesian unemployment in developing countries arising from sluggish price adjustment is unsettled, and we have chosen to work with the polar case of complete price flexibility.

The behavioral equations of the model consist of standard empirical specifications, but one feature worth highlighting is the presence of the reserve-import ratio in the import demand function (equation (6) in Appendix I). This is a common specification in the developing country context and is meant to capture, albeit in a crude way, the importance of quantitative import restrictions based on foreign exchange reserves in developing countries (see Khan and Knight (1988)). As will be shown, this feature turns out to affect significantly both the dynamics of adjustment and the steady-state effects of shocks. Rational expectations enter the model in two ways. First, expectations of devaluation of the official nominal exchange rate enter the interest-parity condition (equation (11) in Appendix I), which determines the domestic nominal exchange rate. Second, the real interest rate, which affects both consumption and investment behavior and is given by equation (14)), is assumed to incorporate a rational forecast of the next period’s price level.

To better understand the policy simulations, it is useful to examine the steady-state version of the model, which is given in Appendix II. The model is here presented in recursive blocks, according to its solution algorithm, which works as follows: Since in this paper we work with steady states for which the nominal exchange rate (e) is fixed, we have *E _{t} (e_{t+1}*| OMG

*) =*

_{t}*e*=

_{t+1}*e*, where OMG

_{t}*denotes the set of information available at time*

_{t}*t*and

*E*is the expectations operator. Since the real exchange rate must be constant in the steady state, the domestic price level must be constant also, so that

*E*| OMG

_{t}(P_{t+1}*. With these conditions, equations (13) and (16) of Appendix 1 yield the steady-state values of the domestic nominal (i*

_{t}) =P_{t+1}= P_{t}*) and real*

_{t}*(r*interest rates, both of which equal the foreign nominal interest rate

_{t})*i*. These equations thus appear in block 1 of Appendix II. This solution for

^{*}*r*derived from block 1, together with the use of the steady-state condition

*K*for the capital stock in equation (9) of Appendix I. permits block 2 (consisting of equations (5), (8), and (9) of Appendix I) to be solved for real GDP,

_{t}= K_{t-1}*Y*, the capital stock,

*K*, and investment, I, The solutions will take the form Y =

*Y(i*, and I = I

^{*}), K = K(i^{*})*(i*, with Y

^{*})*,*

^{t}*K*0.

^{t}, I^{t}<The third block contains the monetary equations (10), (11), and (12). The steady-state version of equation (12) (equation (27) in Appendix II) reflects the conditions that *Y _{t}* = Y

_{t-1}=

*Y(i*, with its implication that the money supply (M) is constant—that is,

^{*})*M*. Substituting equations (10) and (11) in this version of equation (27) yields

_{t}= M_{t-1}where *R* is the foreign currency value of international reserves and *DC _{P}* and

*DC*denote central bank credit to the private and public sectors, respectively. Since

_{G}*i and Y*are determined in blocks 1 and 2, respectively, and since

*e, DC*, and

_{P}*DC*are exogenous, this equation contains only two endogenous variables—

_{G}*R*and

*P*. To display the solution of the steady-state model diagrammatically, we can depict the combinations of

*R*and P that satisfy equation (36) as the locus

*MM*in Chart 1. The slope of this locus is

The remainder of the model is grouped into the fourth block, which we have termed the demand block. Using equations (14), (15), and (17)of Appendix I in equation (30) of Appendix II, we can rewrite private disposable income *(Y ^{d})* as

where *P ^{*}* is the level of foreign prices, Z is the volume of imports measured in units of the foreign good, G is real government spending, and

*X*denotes real exports. Substituting this in equation (2) and then using equations (2), (6), (7), and (9) in equation (1), we have

Since *e, G, i ^{*}*, and

*Y*are exogenous, this equation only contains the endogenous variables

^{*}*R*and

*P*. Block 4 therefore also generates a locus in

*(R, P)*space, which is given by equation (37). This locus is denoted by

*DD*in Chart 1. Its slope is negative, that is,

where η* _{x}* and η

_{z}are the relative price elasticities of exports and imports, respectively.

The key endogenous variables in the steady-state version of the model are thus the stock of international reserves *R* and the domestic price level *P*. The solution of the model is depicted by the intersection of the *MM* and *DD* loci at point *A* in Chart 1. The model’s exogenous variables consist of policy variables, namely, the nominal exchange rate, e, the stocks of credit to the private and government sectors, respectively, *DC _{P}* and

*DC*, and government spending on home goods,

_{G}*G*, as well as external variables, consisting of the external interest rate, i

^{*}, foreign demand,

*Y*, and the foreign price,

^{*}*P*. Once the solution values for

^{*}*R*and

*P*are determined as in Chart 1, the values of the remaining endogenous values in block 4 (that is, C,

*X, Z, Y*, and

^{d}, F_{p}, CA*GZ)*can be found.

The stability of the steady-state equilibrium at *A* can be verified by computing the model’s characteristic roots. We computed these roots by using the parameter estimates in Appendix I and linearizing around an artificial steady state generated by values of the exogenous variables intended to capture a “representative” developing country configuration.^{4} We found a single root with modulus above unity. Since our model contains a single “jump” variable (the domestic price level), it thus exhibits saddlepoint stability (see Blanchard and Kahn (1980)).

Having described the nature of the steady state and established the model’s stability, we now examine the adjustment paths. In the next section we examine responses to shocks in the domestic policy variables—the exchange rate, the stock of credit, and government spending on domestic goods. Then Section III looks at the dynamic effects of shocks in the external environment—specifically, changes in world interest rates and foreign demand.

## II. Dynamic Responses to Policy Shocks

Before considering the simulated economy’s response to domestic policy shocks individually, it may be useful to verify the model’s neutrality by examining the effects of a particular combination of nominal shocks—that is, an equiproportional exchange rate devaluation and an increase in both (private and public) domestic credit stocks. Notice that an *x* percent increase in *e, DC _{P}*, and

*DC*would continue to satisfy equation (36) if

_{G}*P*also increased by

*x*percent. The same is true of equation (37), where

*DC*and

_{P}*DC*do not appear. Thus, the model is homogeneous of degree one in

_{G}*e*,

*DC*, and

_{p}*DC*—since all nominal values change in the same proportion, real variables are unaffected, and the model’s neutrality is verified. In terms of Chart 1, both the

_{G}*MM*and

*DD*loci shift to the right by

*x*percent, increasing the equilibrium price level by this amount, but leaving the equilibrium stock of reserves and all other real variables unchanged.

### Devaluation

A neutral shock in this model is one in which the nominal exchange rate and the credit stock are changed in the same proportion. An exchange rate change by itself (a devaluation coupled with unchanged domestic credit targets) is therefore not a neutral shock. For our first exercise we consider a nominal exchange rate devaluation of 10 percent. The steady-state effects of this shock are depicted in Chart 2. Since the stock of domestic credit does not affect equation (37), the *DD* curve shifts horizontally to the right, say to *D’ D’*, in proportion to the devaluation (by 10 percent), as in the case of the neutral shock. Because *DC _{P}* and

*DC*are unchanged, however, the proportional shift in

_{G}*MM*, which can be derived from equation (36), amounts to

since *eR/M < 1. ^{5}* Thus the shift of

*MM*to

*M’ M’*in Chart 2 falls short of the neutral shift. As a result, the steady-state stock of reserves increases (which presumably motivated the devaluation in the first place) and the steady-state real exchange rate depreciates.

The long-run real depreciation comes about through the effect of reserve accumulation on the intensity of import restrictions. This can be verified from equation (37). An increase in the stock of reserves increases imports by reducing the severity of such restrictions, and since this diverts demand from domestic to foreign producers, it has a contractionary impact which must be offset by a lower domestic price level.^{6} This is the intuition behind the negative slope of *DD* in Chart 1, In the absence of this mechanism, the increase in the stock of reserves would not affect demand, and the *DD* curve would be vertical. In this case, as can be verified from Chart 2, the domestic price level would increase fully in proportion to the devaluation, that is, the steady-state real exchange rate would be unchanged. Because of the larger increase in the domestic price level in these circumstances, the steady-state stock of reserves would also be larger.

It may be worth pointing out that the only endogenous variables whose steady-state values are affected by devaluation are those determined in blocks 3 and 4 of Appendix II. Specifically, real output, which emerges from block 2, is not affected. Thus devaluation is neither expansionary nor contractionary in the long run. The reason is that the domestic real interest rate, which determines the capital stock, continues to be determined by the unchanged foreign interest rate. Thus, the output effects of devaluation are temporary, appearing only during the process of adjustment.

We now examine the dynamics of adjustment, considering first the case when the devaluation is unanticipated, and then when it is anticipated.

### Unanticipated Devaluation

On impact, devaluation creates an incipient excess demand for domestic goods through substitution effects. Since output is supply constrained, this implies an increase in the domestic price level in the first period. However, the price level cannot immediately settle at its new steady-state level. If it did, the commodity market would not clear in the first period, because the real depreciation implied by the steady-state price increase leads to increased exports (equation (6)) and reduced imports (equation (9)). Thus, the trade balance improves.^{7} Since the domestic real interest rate would be unchanged (given that the price level would be expected to remain at its steady-state level), output, consumption, and investment would also be unchanged. From equation (1), an improvement in the trade balance with unchanged output and absorption would result in an excess demand for domestic goods.

On impact, therefore, the domestic price level must overshoot its steady-state value (see Chart 3, panel A). This promotes equilibrium in the commodity market in two ways—since the movement in the real exchange rate is dampened, the trade balance improvement is muted. Also, since the price level will now be expected to fall, the domestic real interest rate will rise, as shown in Chart 3, panel D. This chokes off both consumption and investment demand.

The expected reduction in the domestic price level mentioned above materializes in the next period (as it must, under rational expectations) because the economy is then subjected to a deflationary shock in that period. The first-period price increase raises the demand for money, giving rise to a capital inflow and a reserve gain that exceeds the steady-state increase in the stock of reserves (shown in Chart 3, panel C). This first-period reserve gain induces the authorities to permit an easing of import restrictions in the second period, and the resulting increase in imports diverts demand away from domestic goods, causing the price level to fall below its steady-state level (Chart 3, panel A). Since the nominal interest rate continues to be held in place by the interest parity condition, and since no further price decreases are forthcoming, the real interest rate falls sharply—to below its steady-state value—in the second period (Chart 3, panel D).

After the second period, the economy remains close to its steady-state configuration, with the small deviations from that configuration being eliminated very gradually. The price level gradually rises (keeping the real interest rate below its steady-state value), then overshoots its steady-state level, gradually approaching that level from above. In consequence, the real interest rate also moves to its steady-state level from above (Chart 3, panel D).

**Unanticipated Devaluation**

**Unanticipated Devaluation**

**Unanticipated Devaluation**

The behavior of real output during the adjustment period merits particular attention. The first-period increase in real interest rates reduces investment, causing the capital stock to decline. Output therefore falls (Chart 3, panel B)—that is, devaluation has a contractionary effect on output in the short run. This contractionary effect is fundamentally brought about by the price level overshooting and its incorporation into the domestic real interest rate via rational expectations. This result underlines the importance of dynamic analysis and expectational phenomena in assessing the macroeconomic impacts of devaluation (see Lizondo and Montiel (1989)). As the real interest rate falls below its original (and final) level in the second period, investment recovers. However, the capital stock remains below its steady-state level, and so does real output. As the capital stock begins to increase, output recovers (Chart 3, panel B), but before it reaches its steady-state level, the real interest rate overshoots, thus depressing investment and again causing the capital stock to decline. Real output follows the capital stock, which implies that output recovers its steady-state value from below (Chart 3, panel B). In sum, devaluation causes real output to decline in the short and medium terms in this model, primarily because of its short-run impact on domestic real interest rates.^{8}

### Anticipated Devaluation

The anticipation of a future devaluation will itself have macroeconomic effects in this model. To investigate these, we simulated the effects of a devaluation that is expected to—and actually does—take place in the second period of the simulation. The steady-state outcomes are, of course, the same as in an unanticipated devaluation, since they are independent of the initial conditions when the devaluation is implemented. Because of the forward-looking expectations, however, the macro effects of the devaluation begin to be felt when the expectations are formed, rather than when the devaluation actually takes place. These effects are summarized in Chart 4.

**Anticipated Devaluation**

(Second period)

Note: All panels reflect deviations from the steady state.**Anticipated Devaluation**

(Second period)

Note: All panels reflect deviations from the steady state.**Anticipated Devaluation**

(Second period)

Note: All panels reflect deviations from the steady state.Since domestic interest rates are determined by the uncovered interest parity condition, the expectation of a 10 percent devaluation in the next period immediately raises the domestic nominal interest rate in the first period by an equivalent amount. Since the devaluation is also expected to raise the domestic price level when it is implemented, however, domestic real interest rates do not rise by this amount. As shown in the previous section, a nominal devaluation results in a real devaluation both on impact and in the steady state in this model. Thus domestic prices are expected to rise by less than the rate of devaluation, and this expected real depreciation means that the domestic real interest rate will rise (though by substantially less than the nominal rate) in the first period (Chart 4, panel D). As a result, both domestic consumption and investment are discouraged, and the domestic price level falls in the first period (Chart 4, panel A). The reduction in domestic investment causes the capital stock to fall, which reduces output (Chart 4, panel B)—that is, the mere expectation of devaluation is itself contractionary in its effects on real output.

The combination of higher domestic nominal interest rates, lower real output, and lower domestic prices lowers the nominal demand for money, giving rise to a capital outflow and associated reserve loss (Chart 4, panel C). Thus, the expectation of devaluation in the model permits us to simulate an episode of capital flight. When the devaluation takes place, this capital flight is reversed. The nominal interest rate falls, returning to its original level, and domestic prices rise (Chart 4, panel B) for the reasons described in the preceding subsection. Though real output continues to fall, this effect is slight in comparison. Thus the demand for money increases, motivating the reflow of capital, and causing reserves to rise sharply (Chart 3, panel C). From this point on, the dynamics reproduce those of an unanticipated devaluation.

Though it is not obvious from a comparison of the A panels in Charts 3, and 4, the initial price increase in the period when the devaluation is actually implemented is greater when the devaluation was previously anticipated than when it comes as a surprise. The reason is that the loss of reserves brought about by capital flight in anticipation of devaluation implies the presence of tighter import restrictions when the devaluation was anticipated than when it comes as a surprise. Imports are thus lower when devaluation was anticipated, and domestic demand pressures are consequently higher.

### Government Spending Shock

In this subsection we consider the effects of an increase in government spending on domestic goods, financed by an equivalent reduction in government imports. We analyze three cases: an unanticipated permanent increase in spending, an increase in spending that is expected to occur in the future and be permanent, and an unanticipated increase in spending that is transitory in nature.

### Unanticipated Permanent Spending Increase

The steady-state effects of an increase in government spending on home goods are depicted in Chart 5. Since the level of government spending on such goods affects only the demand block (equation (37)) and not the monetary block (equation (36)), only the *DD* curve is affected. Because the change in the spending mix is expansionary, the domestic price level must increase at a given value of R—that is, the *DD* curve must shift to the right, while the *MM* curve is stationary. The new equilibrium will thus be found at a point like *B*, with higher reserves and a higher domestic price level. In other words, the shock will result in a real exchange rate appreciation. Reserves increase because the higher domestic price level increases the demand for money. Since the spending increase on home goods is financed by curtailing government imports and not by domestic credit expansion, the increased demand for money can be satisfied only by a reserve inflow.

This reserve inflow tends to mute the inflationary consequences of the spending shift, because the relaxation of import restrictions that it entails shifts private demand away from domestic products, thus in part offsetting the shift of government demand toward such products. In the absence of this effect the *DD* curve would be vertical in Chart 5, and *D’ D’* would pass through the point D on *MM*. Thus the new steady state would exhibit both higher prices and larger reserves than that at *B*.

It may be worth noting that the spending shift has no effect on domestic interest rates or output in the long run. Again, this is a consequence of the interest parity condition and the determination of output in block 2 (Appendix II), which is unaffected by the composition of government spending.

The dynamics of adjustment are similar in many ways to those of an unanticipated devaluation. The shock increases domestic demand on impact, and therefore results in a price increase (panel A of Chart 6). Although, as shown above, domestic prices also rise in the steady state, the price increase on impact must exceed its steady-state value. The reason is that in the first period import restrictions are unchanged, whereas in the steady state such restrictions are eased owing to the higher steady-state stock of reserves. Since this easing relieves domestic demand pressure, the price increase needed to clear the home commodity market is greater in its absence. The higher domestic price level induces a first-period capital inflow, increasing the stock of foreign exchange reserves (Chart 6, panel C). Prices must fall in the second period, as the higher first-period reserve stock leads to an easing of import restrictions. Because rational agents expect this to happen, the first-period domestic real interest rate rises dramatically (Chart 6, panel D). This crowds out investment and depresses output, so the increase in government spending on home goods is actually contractionary on impact (Chart 6, panel B).

**Steady-State Effects of Increased Government Spending on Domestic Goods**

**Steady-State Effects of Increased Government Spending on Domestic Goods**

**Steady-State Effects of Increased Government Spending on Domestic Goods**

As already mentioned, prices fall in the second period. However, this decrease still leaves the price level above its steady-state level (Chart 6, panel A). This occurs because, owing to slow adjustment of exports and imports, a larger real appreciation is necessary in the short run to clear the home goods market with the increase in government demand than is necessary in the steady state. Because prices remain relatively high in the second period, the real interest rate remains slightly above its steady-state level (Chart 6, panel D), thus continuing to exert a depressing influence on domestic investment. By the third period, the domestic price level has fallen below its steady-state value, which it thereafter approaches from below. Since the price level is gradually rising, therefore, the domestic real interest rate also approaches its steady-state value from below.

**Unanticipated Permanent Fiscal Shock**

(First period)

Note: All panels reflect deviations from the steady state.**Unanticipated Permanent Fiscal Shock**

(First period)

Note: All panels reflect deviations from the steady state.**Unanticipated Permanent Fiscal Shock**

(First period)

Note: All panels reflect deviations from the steady state.The dynamic path of real output is governed by the effects of the real interest rate path described above on investment and thus on the domestic capital stock. After the initial drop in output, recovery sets in as the depleted capital stock stimulates a temporary increase in investment. Though investment remains slightly above its steady-state value for some time after the initial two periods, it takes time to restore the capital stock, so output remains below its equilibrium value, though on a rising trend, in the medium term (Chart 6, panel B). In this model, therefore, the spending shift induces a dynamic response on the part of real output that can be described as contractionary in both the short run and the medium term, but with no change in the long run.

### Anticipated Permanent Spending Increase

The anticipation of a future increase in government spending on domestic goods has macroeconomic consequences before the spending shifts come into play. These are brought about through the implications of such expectations for the domestic real interest rate. As shown above, the shift in spending will increase domestic prices on impact. The expectation of these higher future prices lowers the real interest rate in the first period, since arbitrage holds the nominal interest rate at its initial level (Chart 7, panel D). Lower real interest rates stimulate both consumption and investment demand, thereby causing an immediate increase in the domestic price level (Chart 7, panel A), which is accompanied by a capital inflow and an accumulation of foreign exchange reserves (Chart 7, panel C). The higher level of investment increases the capital stock, raising real output in the first period (Chart 7, panel B). The anticipated spending shift thus has expansionary output effects before the shock itself actually takes place.

When the spending shift occurs (in the second period), prices rise further and the real interest rate increases sharply (Chart 7, panels A and D). These results are the same as observed when the spending shift is unanticipated. However, comparison of panels A in Charts 6 and 7 indicates that the price level effect of the shift at the instant it occurs is greater when it is not anticipated than when it is. The mechanism that produces this result is similar to that described in connection with devaluation—that is, the reserve increase in anticipation of the spending shift causes the latter to take place with less stringent import restrictions. The higher level of imports absorbs some of the demand pressure, muting the effect on prices. After the change in government spending is in place, the dynamics are again qualitatively similar to those that follow an unanticipated spending shift.

**Anticipated Fiscal Shock**

(Second period)

Note: All panels reflect deviations from the steady state.**Anticipated Fiscal Shock**

(Second period)

Note: All panels reflect deviations from the steady state.**Anticipated Fiscal Shock**

(Second period)

Note: All panels reflect deviations from the steady state.### Temporary Government Spending Increase

The dynamics of a temporary shift in government spending toward home goods are given in Chart 8. We have assumed that the shock takes place one period ahead and remains in place for five periods, after which it is completely removed. Notice that in this case the economy must return to its initial steady-state configuration, because the shock is not permanent.

For the period that the shock is announced (or becomes anticipated), and through the first two periods of the shock’s duration, the economy’s dynamic responses are qualitatively very similar to the case of an anticipated permanent fiscal shock, described above. Quantitatively, however, comparison of panels A and D in Chart 8 to panels A and D in Chart 7 reveals that with the transitory shock the initial burden of demand adjustment falls relatively less heavily on the price level and more heavily on the real interest rate—that is, the peak increase in the price level is smaller in the present case than in the case of the permanent shock, and the opposite is true of the real interest rate.

The forward-looking nature of expectations is the reason. When the spending shift is reversed at the end of the sixth period, domestic prices must fall (this corresponds to the lowest point for *P* in Chart 8, panel A). In anticipation of this, the real interest rate must be high in the previous (the fifth) period. But because demand is being restrained by the high real interest rate in that period, the price level can be correspondingly lower. This lower price level, in turn, sustains a high (but not quite as high) real interest rate in the previous (the fourth) period, and so on. Thus, the real interest rate remains above its steady-state level while the shock is in place, and indeed rises toward the end of the shock (Chart 8, panel D), while the price level falls increasingly below its own steady-state level—despite the exogenous increase in demand for domestic goods represented by the spending shift—for the duration of the shock. For the last three periods of the shock, the burden of demand restraint falls increasingly on the real interest rate and decreasingly on the price level. When the shock is removed, the price level and the real interest rate both fall, the latter in anticipation of a price level recovery in the subsequent period, when further demand shocks are anticipated. Reserve dynamics follow the path of prices (Chart 8, panel C), while the behavior of output is governed by the spell of high real interest rates that accompanies the fiscal shock while it is in place (Chart 8, panels D and C).

**Temporary Fiscal Shock**

(Five-period)

Note: All panels reflect deviations from the steady state.**Temporary Fiscal Shock**

(Five-period)

Note: All panels reflect deviations from the steady state.**Temporary Fiscal Shock**

(Five-period)

Note: All panels reflect deviations from the steady state.### Domestic Credit Shock

The final policy shock examined is a permanent increase in the stock of domestic credit to the private sector, announced and implemented simultaneously in the first period. Since this economy is characterized by perfect capital mobility—in the sense that uncovered interest parity holds continuously—the standard “monetary approach to the balance of payments” (MABP) analysis would suggest that the credit expansion would displace an equivalent amount of reserves in the central bank’s balance sheet, leaving all else unaffected. This does not happen in the model under examination, however, because of the role of the reserve stock in determining the severity of import restrictions—that is, because the authorities look at their own gross stock of reserves when setting the degree of import restrictions.^{9} Thus the reserve outflow caused by a credit expansion gives rise to an increase in the severity of import restrictions, which produces long-lasting macroeconomic effects.

This increase is illustrated for the steady-state configuration in Chart 9. Since *DC _{P}* only appears in equation (36), only the locus

*MM*is affected by the credit expansion. Since (36) would continue to hold if

*ed R = -dDC*, the

_{p}*MM*locus shifts downward by the amount of the credit expansion, to a point like

*C*at the original domestic price level P

_{0}. The consequent loss of reserves at C, amounting to

*(R*in Chart 9, is what would be observed under the MABP, since without the feedback from reserves to imports the locus

_{0}- R_{2})*DD*would be vertical, passing through both

*A*and C and resulting in a new steady-state equilibrium at C. In this model, however, the loss of reserves triggers a tightening of import restrictions. This shifts demand toward the domestic good, raising the domestic price level and thereby containing the loss of reserves. This mechanism results in a new steady-state equilibrium at B, rather than C, with both reserves and output higher than would be observed under the MABP, but nevertheless with lower reserves and higher prices than without credit expansion.

**Steady-State Effects of Domestic Credit Expansion**

**Steady-State Effects of Domestic Credit Expansion**

**Steady-State Effects of Domestic Credit Expansion**

The dynamics of adjustment to the new steady state at *B* are rather simple, and are depicted in Chart 10. The initial credit expansion generates a capital outflow that results in a loss of reserves (panel C). Since this loss will induce a tightening of import restrictions in the next period, domestic prices will rise at that time, in anticipation of which the first-period real interest rate falls (panel D). But this decline in the real interest rate stimulates domestic consumption and investment, which means that domestic prices must also rise on impact (panel A). Because investment has risen, the capital stock increases, and output rises (panel B). Thus the credit increase works through a reduction in the real interest rate to exert expansionary effects on both domestic prices and output on impact.

**Credit Shock**

**Credit Shock**

**Credit Shock**

As the import restrictions take hold in the second period, domestic prices rise as expected (panel A). Reserves consequently recover somewhat (panel C). The price level must overshoot its steady-state value in the second period, because short-run trade elasticities are smaller than long-run elasticities, requiring a larger real appreciation to clear the domestic goods market. Since the price level will be expected to fall from this point, the real interest rate exceeds its steady-state value in the second period (panel D). This recovery in the real interest rate depresses investment and halts the output expansion (panel B). From this point, the price level and the real interest rate begin to fall toward their steady-state values, with international reserves following domestic prices owing to the impact of the latter on money demand.

## III. Dynamic Responses to External Shocks

The economy modeled in Appendix I is affected by changes in both foreign interest rates and incomes. Because the country is small and uncovered interest parity holds continuously, the fixed nominal exchange rate implies that the domestic nominal interest rate must adjust to the nominal interest rate that prevails externally. Also, since domestic output is an imperfect substitute for the output of the rest of the world, foreign incomes affect the foreign demand for domestic output.^{10} In this section we examine the effects of unanticipated permanent shocks in both of these variables, forgoing the analysis of anticipated or transitory shocks to avoid taxonomy.

### Permanent Increase in External Interest Rate

Unlike the previous shocks, an increase in the external interest rate affects both of the steady-state loci described above, because the foreign interest rate enters both equations (36) and (37). An increase in *i ^{*}* reduces the real demand for money, requiring an increase in the price level to clear the money market, thus causing

*MM*to shift to the right, to a position such as

*M’ M’*in Chart 11. At the same time, the increase in i

^{*}has contractionary effects on the demand for domestic output, so

*DD*shifts to the left, to a position such as

*D’ D’*in Chart 11. The steady-state effect on international reserves is theoretically unambiguous—they must fall, as depicted in Chart 11. On the other hand, while the effect on domestic prices is ambiguous in theory, our estimated parameters and reference data imply that the domestic price level must fall—that is, the equilibrium real exchange rate depreciates, because the downward shift in the

*DD*curve exceeds that in the

*MM*curve. Incidentally, notice that this is the result that would in any case emerge if

*DD*were vertical—in other words, if the effect of reserves on import restrictions were absent from the model.

**Steady-State Effects of an Increase in External Interest Rate**

**Steady-State Effects of an Increase in External Interest Rate**

**Steady-State Effects of an Increase in External Interest Rate**

It is worth noting as well that in this case, unlike all the others analyzed in this paper, the long-run level of output is affected. The increase in the steady-state interest rate depresses investment, which in turn implies a reduction in the size of the capital stock that can be maintained in the long run, and consequently in the level of output produced.

The dynamics of adjustment to the new steady-state equilibrium are again rather simple. Since no devaluation is anticipated, the domestic nominal interest rate adjusts immediately to the new level of the external rate. Because of lags in the response of domestic absorption to a change in the real interest rate, however, the price level cannot adjust immediately to its new lower steady-state value. If it did so, a state of excess demand would exist in the domestic commodity market, since domestic absorption would remain in excess of its steady-state level. Thus, the price level must fall in the first period, but not all the way to its steady-state value. Since reserves fall in the first period, following domestic prices (Chart 12, panel C), import restrictions are tightened in the second period, causing a slight increase in the price level. Because this increase is anticipated in the first period, the increase in the first-period domestic real interest rate falls short of its steady-state value. On impact, therefore, both prices and the real interest rate move partially toward their steady-state value.

Since domestic prices resume their downward adjustment after the second period, the real interest rate must overshoot its steady-state value from the second period onward (Chart 12, panel D). Adjustment in both prices and the real interest rate is monotonic and quite prolonged. As in previous cases, the behavior of real output follows that of the real interest rate. Output falls sharply on impact and in the second period. It continues to fall gradually to its lower steady-state value, as the prolonged duration of high real interest rates depresses investment and gradually depletes the capital stock. This shock is contractionary on impact, during the transition, and in the long run.

### An Increase in External Demand

An increase in external demand (Y^{*} in Appendices I and II) affects the demand block (block 4) in the steady-state model, but not the monetary block (block 3). An increase in export demand is expansionary, requiring an increase in domestic prices at a given value of *R* to restore equilibrium in the domestic commodity market. Thus the *DD* curve shifts to the right. Qualitatively, the situation is similar to that arising from a permanent shift in government spending toward home goods depicted in Chart 2 international reserves rise and the real exchange rate appreciates in steady state.

The dynamics of adjustment take on a now familiar form. Prices rise on impact, reflecting the expansionary demand stimulus from abroad (Chart 13, panel A). The real interest rate shows a small initial increase, reflecting an anticipated reduction in the price level in the second period owing to an easing of import restrictions induced by a first-period reserve gain (Chart 13, panel C). Owing to partial adjustment in the export function, the demand stimulus arising from the increase in foreign income builds gradually over time to its steady-state level. Since this source of demand pressure thus rises overtime, domestic prices must follow a rising trend after the second period. This means that the real interest rate must lie below its steady-state value during this time (Chart 13, panel D). The requirement that the domestic price level rise to its steady-state value explains why the second-period level of prices must be below that value (panel A). Finally, even after the adjustment of exports to the (once and for all) foreign demand shock is effectively complete, adjustment lags in the export and import functions imply that the trade balance will not have fully adjusted to past price changes. Thus the domestic price (and consequently the real interest rate as well) must slightly overshoot its steady-state level, approaching that level from above.

**Foreign Interest Rate Shock**

**Foreign Interest Rate Shock**

**Foreign Interest Rate Shock**

The dynamics of reserves and real output follow those of prices and the real interest rate, respectively. Reserves rise on impact and decrease slightly (following the price level) in the second period, recovering gradually thereafter in close similarity to the path of the domestic price level (panel C). Output falls in the short run, owing to the effect of the higher domestic real interest rate on the capital stock. As the real interest rate falls below its steady-state level and remains there for a prolonged period, however, investment and the capital stock recover, pushing output toward its steady-state level (Chart 13, panel B). The overshooting of the real interest rate causes investment to once again fall below its steady-state value, bringing the expansion of output to a halt. Investment and output gradually recover their steady-state levels from below.

## IV. Summary and Conclusions

In each of the simulations described above, the dynamic response of the economy to a shock emerges from the interaction of several important features of the model employed. These features include price flexibility, rational expectations, perfect capital mobility, and endogenous import restrictions. The qualitative properties of the adjustment paths generated by the shocks we have studied depend on these properties, and are not very sensitive to parameter values (such as response speeds in the behavioral equations) that leave these features unchanged. At the most general level, therefore, we offer the following conclusion. Properties of developing country economies about which no consensus currently exists among knowledgeable observers (that is, the degree of wage-price flexibility, the extent of capital mobility, etc.) are crucially important for determining the “real-time” response of such economies to both policy and exogenous shocks.^{11} While a convergence of views may emerge about certain steady-state properties of developing country models—for example, that expectations should be correct, prices flexible, and capital mobility perfect—they tell little about the process of adjustment.

**External Demand Shock**

**External Demand Shock**

**External Demand Shock**

This conclusion has important implications for both policy and research on developing country macroeconomics. Regarding policy, the implication is that the state of our knowledge of most developing countries suggests that real-time macroeconomic “fine-tuning” is likely to be very difficult, because the dynamic responses of the system to the policies one might choose to administer will in most cases be highly uncertain. Regarding research, the obvious suggestion is that much needs to be learned about the empirical relevance in particular developing economies of structural features such as those listed above that proved to be critical in determining the nature of adjustment paths in our model. The empirical approach adopted in Haque, Lahiri, and Montiel (1990) yields evidence about the degree of capital mobility, while maintaining the hypotheses of price flexibility and rational expectations. More research is needed on both of the latter. However, given data limitations in developing countries, progress is likely to be slow.

In the meantime, the relevance of the particular substantive results derived in our simulations depends, of course, on one’s readiness to accept these maintained hypotheses. Conditional on their validity, some of our salient findings are as follows:

• The speed of adjustment, even to permanent shocks that are perceived as such, can differ markedly across shocks. In the case of devaluation and a permanent shift in government spending, for example, after three years the economy is essentially in the vicinity of its steady state. By contrast, adjustment to an external interest rate shock is quite protracted.

• As is familiar in rational expectations models, the macroeconomic effects of shocks depend on whether they are anticipated or not. In this model, an important difference between anticipated and unanticipated shocks is that, in the context of endogenous import restrictions, the degree of severity of the restrictions in place when the shock actually occurs depends on whether the shock had previously been anticipated.

• As is also familiar from such models, shocks begin to exert macroeconomic effects when they first become anticipated, rather than when they actually occur. This is particularly evident with devaluation, where the anticipation of an impending change in the exchange rate gives rise to capital flight, which in turn causes a tightening of import restrictions that later increase the price level effects of devaluation.

• Output dynamics suggest that it is meaningless to ask whether particular shocks are contractionary unless the time frame is specified. With devaluation, for example, we found a contractionary effect in the short run, but no effect in the long run.

• Finally, endogenous import restrictions were found to have important effects, not only on the dynamics, but also in the steady state. Because of such restrictions, a nominal devaluation results in a long-run real depreciation in our model, and changes in the stock of domestic credit have real effects, even with perfect capital mobility.

These conclusions, while conditional on the specified model and the form of the simulation experiments, may not appear particularly controversial. Nonetheless, without a model at hand of the type we have employed, they would be difficult to verify. Certainly understanding the time paths taken by the key macroeconomic variables after a shock would be out of the question. The next stage in the exercise could be the derivation of the paths of the policy variables, taken either individually or in a combination, to achieve the desired impact, transition, and steady-state values of the target variables—output, balance of payments, prices, real exchange rate, etc. The model we have developed and analyzed can be readily used toward such an end.

## APPENDIX I Structure of the Dynamic Model

**Definition of Variables**

**Definition of Variables**

Y | Real GDP |

C | Real private consumption expenditures |

I | Total real investment expenditures |

G | Government expenditure on domestic goods |

X | Real exports |

e | Nominal exchange rate (price of foreign currency in domestic currency terms) |

P^{*} | Foreign currency price of imports |

P | Domestic currency price of domestic goods |

Z | Real imports in terms of foreign goods |

r | Real rate of interest |

Y^{d} | Real disposable income |

F_{p} | Stock of foreign assets held by the private sector (measured in foreign currency terms) |

DC_{P} | Stock of domestic bank credit held by the private sector |

i | Nominal interest rate |

T | Real taxes |

M | Money supply (nominal) |

K | Aggregate capital stock |

Y^{*} | Real foreign income |

R | Reserves |

DC | Total domestic credit |

DC_{G} | Domestic credit to the public sector |

CA | Current account of the balance of payments |

F_{G} | Foreign assets held by nonfinancial public sector |

L_{t} | Population |

**Definition of Variables**

Y | Real GDP |

C | Real private consumption expenditures |

I | Total real investment expenditures |

G | Government expenditure on domestic goods |

X | Real exports |

e | Nominal exchange rate (price of foreign currency in domestic currency terms) |

P^{*} | Foreign currency price of imports |

P | Domestic currency price of domestic goods |

Z | Real imports in terms of foreign goods |

r | Real rate of interest |

Y^{d} | Real disposable income |

F_{p} | Stock of foreign assets held by the private sector (measured in foreign currency terms) |

DC_{P} | Stock of domestic bank credit held by the private sector |

i | Nominal interest rate |

T | Real taxes |

M | Money supply (nominal) |

K | Aggregate capital stock |

Y^{*} | Real foreign income |

R | Reserves |

DC | Total domestic credit |

DC_{G} | Domestic credit to the public sector |

CA | Current account of the balance of payments |

F_{G} | Foreign assets held by nonfinancial public sector |

L_{t} | Population |

## APPENDIX II Structure of the Steady-State Model

1. | Interest Rates | |

$\begin{array}{cc}{i}_{t}={i}_{t}^{*}& \left(20\right)\end{array}$ | ||

$\begin{array}{cc}{r}_{t}={i}_{t}& \left(21\right)\end{array}$ | ||

2. | Output-Capital Block | |

$\begin{array}{cc}\mathrm{log}I={k}_{0}-0.207r+0.199\mathrm{log}Y+0.815\mathrm{log}K& \left(22\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}Y={q}_{0}+0.162\mathrm{log}K+0.838\mathrm{log}L& \left(23\right)\end{array}$ | ||

$\begin{array}{cc}I=0.05K& \left(24\right)\end{array}$ | ||

3. | Monetary Block | |

$\begin{array}{cc}M=eR+DC& \left(25\right)\end{array}$ | ||

$\begin{array}{cc}DC=D{C}_{p}+D{C}_{G}& \left(26\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}(M/P)={\overline{\beta}}_{0}-0.27i+\mathrm{log}Y& \left(27\right)\end{array}$ | ||

4. | Demand Block | |

$\begin{array}{cc}Y=C+I+G+X-e{P}^{*}Z/P& \left(28\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}C={\alpha}_{0}+12r+\mathrm{log}{Y}^{d}& \left(29\right)\end{array}$ | ||

$\begin{array}{cc}{Y}^{d}=Y+\frac{{i}^{*}e{F}_{p}}{P}-i\frac{DCP}{P}-T& \left(30\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}X={\overline{\tau}}_{0}+0.74\mathrm{log}(e{P}^{*}/P)+1.45\mathrm{log}{Y}^{*}& \left(31\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}Z={\overline{\delta}}_{0}+0.84\mathrm{log}(e{P}^{*}/P)+0.882\mathrm{log}Y+0.399\mathrm{log}(R/{P}^{*}Z)& \left(32\right)\end{array}$ | ||

$\begin{array}{cc}CA=PX-e{P}^{*}(Z+GZ)+{i}^{*}e({F}_{p}+{F}_{G}+R)& \left(33\right)\end{array}$ | ||

$\begin{array}{cc}CA=0& \left(34\right)\end{array}$ | ||

$\begin{array}{cc}e{P}^{*}GZ=P(T-G)+{i}^{*}e({F}_{G}+R)+iD{C}_{p}& \left(35\right)\end{array}$ |

1. | Interest Rates | |

$\begin{array}{cc}{i}_{t}={i}_{t}^{*}& \left(20\right)\end{array}$ | ||

$\begin{array}{cc}{r}_{t}={i}_{t}& \left(21\right)\end{array}$ | ||

2. | Output-Capital Block | |

$\begin{array}{cc}\mathrm{log}I={k}_{0}-0.207r+0.199\mathrm{log}Y+0.815\mathrm{log}K& \left(22\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}Y={q}_{0}+0.162\mathrm{log}K+0.838\mathrm{log}L& \left(23\right)\end{array}$ | ||

$\begin{array}{cc}I=0.05K& \left(24\right)\end{array}$ | ||

3. | Monetary Block | |

$\begin{array}{cc}M=eR+DC& \left(25\right)\end{array}$ | ||

$\begin{array}{cc}DC=D{C}_{p}+D{C}_{G}& \left(26\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}(M/P)={\overline{\beta}}_{0}-0.27i+\mathrm{log}Y& \left(27\right)\end{array}$ | ||

4. | Demand Block | |

$\begin{array}{cc}Y=C+I+G+X-e{P}^{*}Z/P& \left(28\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}C={\alpha}_{0}+12r+\mathrm{log}{Y}^{d}& \left(29\right)\end{array}$ | ||

$\begin{array}{cc}{Y}^{d}=Y+\frac{{i}^{*}e{F}_{p}}{P}-i\frac{DCP}{P}-T& \left(30\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}X={\overline{\tau}}_{0}+0.74\mathrm{log}(e{P}^{*}/P)+1.45\mathrm{log}{Y}^{*}& \left(31\right)\end{array}$ | ||

$\begin{array}{cc}\mathrm{log}Z={\overline{\delta}}_{0}+0.84\mathrm{log}(e{P}^{*}/P)+0.882\mathrm{log}Y+0.399\mathrm{log}(R/{P}^{*}Z)& \left(32\right)\end{array}$ | ||

$\begin{array}{cc}CA=PX-e{P}^{*}(Z+GZ)+{i}^{*}e({F}_{p}+{F}_{G}+R)& \left(33\right)\end{array}$ | ||

$\begin{array}{cc}CA=0& \left(34\right)\end{array}$ | ||

$\begin{array}{cc}e{P}^{*}GZ=P(T-G)+{i}^{*}e({F}_{G}+R)+iD{C}_{p}& \left(35\right)\end{array}$ |

## References

Agenor, Pierre-Richard, “Stabilization Policies in Developing Countries with a Parallel Market for Foreign Exchange: A Formal Framework,”

, International Monetary Fund, Vol. 37 (September 1990), pp. 560–92,*Staff Papers**reprinted in this volume as Chap. 8*.Blanchard, O., and C. Kahn, “The Solution of Linear Difference Models Under Rational Expectations,”

, Vol. 48 (July 1980), pp. 1305–311.*Econometrica*Corden, W, Max, “Macroeconomic Adjustment in Developing Countries,”

, Vol. 4 (January 1989) pp. 51–64.*World Bank Research Observer*Haque, Nadeem U., and Peter Montiel, “Is Devaluation Contractionary? The Roles of Wage Flexibility and Capital Mobility” (unpublished; International Monetary Fund, March 1990).

Haque, Nadeem U., Kajal Lahiri, and Peter J. Montiel, “A Macroeconomic Model for Developing Countries,”

, International Monetary Fund, Vol. 37 (September 1990), pp. 537–59,*Staff Papers**reprinted in this volume as Chap. 9*.Haque, Nadeem U., Peter Montiel, and Steven Symansky, “A Forward-Looking Macroeconomic Simulation Model for a Developing Country,”

*IMF Working Paper,*WP/89/53 (June 1989),*reprinted in this volume as Chap. 11*.International Monetary Fund,

, Vol. 18(July 15, 1989).*IMF Survey*Khan, Mohsin S., and Malcolm D. Knight, “Stabilization Programs in Developing Countries: A Formal Framework,”

, International Monetary Fund, Vol, 28 (March 1981), pp. 1–53,*Staff Papers**reprinted in this volume as Chap. 3.*Khan, Mohsin S., and Malcolm D. Knight, “Import Compression and Export Performance in Developing Countries,”

, Vol. 70 (May 1988), pp. 315–21.*Review of Economics and Statistics*Lizondo, J. Saul, and Peter J. Montiel, “Contractionary Devaluation in Developing Countries: An Analytical Overview,”

, International Monetary Fund, Vol. 36 (March 1989), pp. 182–227.*Staff Papers*Ocampo, Jose Antonio, “The Macroeconomic Effect of Import Controls: A Keynesian Analysis”

, Vol. 27 (October 1987), pp. 285–305.*Journal of Development Economics*

^{}*

The authors are grateful to Mohsin Khan for helpful comments, and to Ravina Malkani for excellent research assistance. The views expressed are the authors’ and do not necessarily represent those of the IMF.

^{}1

The best-known macroeconomic simulation model for developing countries is by Khan and Knight (1981). That model is estimated and simulated with adaptive expectations. Haque, Montiel, and Symansky (1989) construct a developing country simulation model and use it to examine the dynamic effects of several policy and external shocks with forward-looking expectations. Agénor (1990) estimates and simulates a small rational expectations model for developing countries.

^{}2

Details of the estimation, including diagnostic statistics, are provided in Haque, Lahiri, and Montiel (1990), Since that paper also contains a detailed equation-by-equation description of the model, the exposition in this section will be brief.

^{}3

As of June 30, 1989, 84 developing country members of the International Monetary Fund defended an exchange parity for their currencies; see International Monetary Fund (1989).

^{}6

For an analysis of the aggregate demand effects of import restrictions in developing countries, see Ocampo (1987).

^{}7

The Marshall-Lerner condition is satisfied by the model of Appendix I. Notice that the perfect capital mobility assumption implies that the higher domestic price level results in a capital inflow and a substantial reserve gain. While this operates to ease import restrictions and increase the trade deficit, this effect appears with a one-period lag.

^{}8

This result is sensitive to the assumptions of perfect wage-price flexibility and perfect capital mobility. For an analysis directed specifically to these issues, see Haque and Montiel (1990).

^{}9

Under perfect capital mobility, one might question why they should do so, since a reserve target could readily be attained by altering the stock of domestic credit, thereby inducing private capital flows that would permit achievement of a reserve target. Implicitly, it is assumed that the authorities face constraints—perhaps in the form of imperfect control over the supply of domestic credit—that do not permit credit policy to be flexibly adjusted to this end. An alternative specification—in which import restrictions depend on the sum of the foreign exchange held by the central bank and the private sector (which might be more reasonable when capital mobility is high)—is explored in a separate paper (see Haque and Montiel (1990)),

^{}10

A third link to the rest of the world, through foreign prices, is also present in the model. However, we will not describe the effect of shocks to this variable.

^{}11

This is confirmed in Haque and Montiel (1990), where the dynamic effects of devaluation are shown to be highly sensitive to features of this type.