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The author would like to thank Dale Henderson, Mohsin Khan, Saul Lizondo and Geoffrey Woglom for useful comments and conversations on the topic. Special thanks are due to Jagdeep Bhandari, who contributed substantially to the paper.
Allowing for investment would make the model much more complicated and preclude an analytical solution. This is an important limitation of the model, because the level of investment is itself an important target for policy. However, as long as the speed of adjustment of the capital stock to its desired value via investment/disinvestment is slow relative to the rate at which markets for financial assets adjust, the analysis of the short-run behavior of aggregate demand presented below will remain valid.
Alternatively, fp could be taken to be the stock of land. In essence, fp is an asset with a flexible, market-determined domestic currency price which is traded in organized markets by well-informed agents. It is intended to represent “inflation hedges”, which figure so prominently in developing-country policy discussions and might best be considered a composite of highly substitutable assets, such as land and foreign exchange.
Real output, which tends to shift asset composition among money and all other assets in response to transactions motives, is excluded from the asset demand functions because our assumptions of slow capital-stock adjustment and full employment render the level of real output constant over the time frame of the analysis.
Since the real interest rate already appears with a negative sign in (6), including the present value of factor incomes among the arguments of the function c( ) would not qualitatively affect the analysis. Notice that this specification rules out direct McKinnon-Shaw effects of the controlled interest rate iM on private consumption via intertemporal substitution. The effects of this omission are discussed below.
This is actually an approximation to the true present value of the subsidy, which depends on the entire stream of future interest rates and credit. The approximation is adopted for tractibility.
This assumes, of course, that foreign exchange reserves do not pay interest.
Sales at the official rate may be inadvertent. For example, the case of “leakages” from the official to the parallel market arising from export underinvoicing or import overinvoicing can be treated as a sale of foreign exchange to the parallel market at the official rate. A dual-market model incorporating such leakages is presented in Bhandari and Vegh (1990).
Notice that, if the direct McKinnon-Shaw effect of iM on consumption were present, this would contribute to a negative interest-rate effect on demand, making the ambiguous case more likely. However, as the next section will show, the presence of iM in the consumption function will not alter the qualitative nature of the general-equilibrium effects of changes in iM.
The case e6 < 0 is of greater interest both because it is likely to be empirically dominant and because the magnitude of the fiscal effects are tied to essentially arbitrary assumptions about the initial size of b and the composition of induced government spending.