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Appendix A: Equilibrium Conditions
Appendix B: Internalization of Learning-by-Doing
Mr. Lama is an Economist in the Western Hemisphere Division of the IMF Institute. Mr. Medina is from the Central Bank of Chile. We thank José Dorich, Alok Johri, Michel Juillard, Leonardo Martinez, Diego Restuccia, Jorge Roldós, Carlos Urrutia, Rodrigo Valdes and seminar participants at the 2009 Society of Computational Economics Conference. All remaining errors are ours.
For instance, if an economy faces a demand shock such as a discovery of natural resources or a supply shock such as higher productivity relative to the main trade partners, then the real exchange rate will appreciate.
The term “Dutch Disease” was introduced to describe the situation experienced in the Netherlands in 1960s after the discovery of gas deposits in the North Sea. The discovery of natural resources was followed by an appreciation of the real exchange rate and a crowding out of the manufacturing exports. More recently, the term is also used to describe the negative effects on exports induced by foreign aid, remittances, capital inflows or an improvement in the terms of trade.
For a reference on commodity currencies see Chen and Rogoff (2003).
If we assume that prices in some sectors of the economy are sticky and the nominal exchange rate is stabilized, then the real exchange rate adjustment is going to come partially from an increase in domestic inflation. Either if we assume a pricing behavior as in Rotemberg (1982) or Calvo (1983), the higher inflation induced in the sticky sectors due to the exchange rate stabilization will generate a loss of resources in those sectors, and hence a misallocation of resources.
Central banks typically can stabilize the exchange rate through intervention in the foreign exchange market or through domestic open-market operations that affect the short- term interest rate. In this paper we adopt the assumption of perfect asset substitutability which makes these two options equivalent.
This premium is a function of the net foreign asset positions relative to GDP,
We follow Christiano et al. (2005) and specify an investment adjustment cost that satisfies the following conditions: S(1) = 1, S′(1) = 0, S′′ (1) = –μS < 0. This assumption generates an inertia in investment that is consistent with a time-to-build specification.
We assume an exogenous process for commodity exports to simplify the model. Considering a more realistic setup in which the commodity sector hires physical capital and labor would not change the qualitative results of the model. For instance, in Canada the commodity sector (mining, gas, and oil) only hires about 2 percent of the labor force. Taking into account this feature of the data does not affect the main policy implications of the model.
For the elasticity of the investment adjustment cost we chose the value μS = 2.5 taken from Christiano et al. (2005).
In the impulse response function we show the trade balance excluding the commodity exports, to better assess the effects of higher commodity prices.
An additional friction we consider in the model is monopolistic competition which generates a misallocation of resources at the steady state. Goodfriend and King (2001) showed that monetary policy is not effective to remove the markup of monopolistic competition at the steady state. If we additionally consider a subsidy on employment, then it is possible to achieve the first-best allocation with the combination of fiscal and monetary policy.
If we evaluate a variable such as a production, a deviation with respect to the benchmark model is consistent with the definition of output gap in a standard New Keynesian model.
In Schmitt-Grohé and Uribe (2007) it is shown that an optimized rule of this form generate dynamics that approximate the Ramsey policy. In the model the parameters of the optimized Taylor-type rule are given by ψπ = 2.23, ψi = 0.56, ψy = –0.76, and ψs = –0.25.
Notice that since investment responds sluggishly owing to the investment adjustment costs, most of the variation of production in the short-run is generated by fluctuations in the labor supply.
This is the ratio of λ for a rule with exchange rate intervention such as equation (13) compared with the λ with no exchange rate intervention. For ψs= 0 this ratio is equal to 1.