## Abstract

The dynamics of the real exchange rate and the price of equity for a small open economy are analyzed using an optimizing model in which the process of capital accumulation entails adjustment costs. The analysis demonstrates how changes in fiscal policies or world interest rates can generate sustained movements in real exchange rates and equity prices simply because investment requires scarce resources. Interpreting such movements as evidence of market inefficiencies would be incorrect since adjustment is driven entirely by equilibrium in asset and goods markets. The results, however, do indicate that a stable and consistent set of fiscal policies can help reduce unnecessary volatility in real exchange rates and equity prices.

The 1980s have witnessed large swings in both real exchange rates and equity prices in many countries. These movements have been described as excessively volatile and have been interpreted by some analysts as evidence that exchange rates and equity prices have diverged from market fundamentals.^{1} This interpretation has generated proposals for a system of explicit target zones for exchange rates and for new regulations in securities markets in order to limit the degree of apparent volatility.^{2} The present paper takes another view and interprets such movements as reflecting the outcome of optimal economic decisions by households and firms in response to changes in fiscal policies or world interest rates. According to this view, it is by adjusting underlying policies rather than interfering with market mechanisms that policymakers are best able to ensure stability in foreign exchange and equity markets.^{3}

The paper develops an optimizing model of an open economy to analyze the dynamics of the real exchange rate, the price of equity, and investment. The analysis demonstrates how changes in fiscal policies or world interest rates can generate sustained movements in real exchange rates and equity prices simply because investment requires scarce resources. Interpreting such movements as evidence of market inefficiencies would be incorrect since adjustment in the model is driven entirely by equilibrium in asset and goods markets. The results, however, do indicate that a stable and consistent set of fiscal policies can play an important role in reducing unnecessary volatility in real exchange rates and equity prices.

The connection between the exchange rate and the price of equity has been explored in a recent paper by Gavin (1986). which extends the sticky price framework of Dornbusch (1976). The analysis presented here differs from Gavin’s in allowing a role for capital accumulation, leaving aside monetary questions, and using an explicit optimizing model. Much recent work in open economy macroeconomics has employed optimizing models to highlight the important role that real exchange rates play in the capital accumulation process. For example, Bruno (1982), Marion (1984), Razin (1984), and Murphy (1986) use two-period models to study the interaction of the real exchange rate and investment for small open economies. Dooley and Isard (1988) develop an infinite horizon, multicountry model that emphasizes how differences in capital accumulation across countries affect real exchange rates. In all of these papers, the capital stocks adjust to their optimal levels within one period following economic shocks.

In a recent paper. Brock (1988) investigates the dynamics of the real exchange rate and the current account in an infinite horizon optimizing model of a small open economy in which the capital stock adjusts gradually over time. He illustrates the important differences between temporary, permanent, and future changes in fiscal policies for macroeconomie adjustment. His formal analysis, however, employs a specification of the investment process that requires that the market value of capital always equal its replacement cost. This prevents the real exchange rate from changing relative to the price of equity in response to changes in tax and government spending policies.^{4}.In contrast, the model presented in this paper allows the price of equity and the real exchange rate to move independently of each other following economic and policy shocks. This permits a richer treatment of adjustment dynamics.^{5}

To carry out the analysis, we employ an intertemporal version of the dependent economy framework originated by Salter (1959) and Swan (1960). This adaptation features the role of optimizing consumers and firms in determining the paths of investment, the real exchange rate, and the price of equity for a small open economy that can borrow and lend on world markets.^{6}.By distinguishing between traded and non-traded goods, the dependent economy setting provides a measure of realism and allows market clearing in the nontraded goods sector to be identified with internal macroeconomic balance. The assumption that consumers and firms are forward looking in choosing their optimal plans permits careful consideration of how the timing of anticipated changes in policy can influence economic behavior.

One general feature of the analysis emerges from a comparison of the effects of temporary changes in fiscal policies with the effects of permanent changes in these policies. While a temporary policy change is in place, the real exchange rate, defined as the relative price of nontraded goods, and the price of equity move together. Alternatively, changes in policy expected to be permanent will lead to opposing movements in these variables as the economy adjusts toward long-run equilibrium. This feature is consistent with the U.S. experience of a sharp real appreciation of the dollar accompanied by a booming equity market from mid-1982 through early 1985, an episode during which the large budget deficits of the Reagan administration’s fiscal expansion generated the popular expectation of future fiscal tightening, some of which was subsequently realized.

The analysis also suggests important qualitative differences in adjustment for a given change in the government’s budget deficit depending on the manner in which the change is carried out. For example, a reduction in the deficit brought about through a cut in government spending will have quite different effects on the real exchange rate, the price of equity, and investment than will an equivalent reduction accomplished by an increase in the tax rate. In addition, a given change in government spending itself will have qualitatively different effects depending on the composition of spending between traded and nontraded goods.^{7}

Section I develops the basic model and provides a graphical solution. Section II presents the results of how the economy responds to changes in government fiscal policies and changes in the world interest rate. Section III concludes the paper with a brief summary of findings and suggestions for future research.

### I. The Model

We assume a small open economy producing traded and nontraded goods. The traded good, which can be consumed or used to produce capital goods, has its price determined in world markets. Since the economy is small relative to the rest of the world, residents take the price of the traded good as given. The nontraded good is assumed to be used exclusively in the production of capital goods and has its price determined domestically by market clearing.^{8} Unlimited borrowing and lending, subject to the usual intertemporal budget constraint, is available to residents of the economy.

#### Production

Traded and nontraded goods are produced using the services of labor and installed capital with constant-returns-to-scale technologies. We assume that the traded sector is capital intensive relative to the non-traded sector and that factor intensity reversals and specialization in production never occur^{9}. Labor is supplied inelastically in amount *L* and the capital stock is fixed at each point in time but changes over time as a result of investment. Both labor and capital are mobile across production sectors.^{10}. Under the assumptions of perfect competition, profit maximization, and factor market clearing, the following supply functions can be derived:

where *P* is the relative price of the nontraded good in terms of the traded good (which we refer to as the real exchange rate) ^{11}, *K* is the economy-wide capital stock, and subscripts denote partial derivatives of the functions. For convenience, the fixed supply of labor and time subscripts are suppressed here and throughout the paper when possible. In equations (1) and (2), an increase in *K* at a constant real exchange rate will raise output in the relatively capital-intensive traded sector and lower output in the relatively labor-intensive nontraded sector according to the Rybczynski effect. An increase in the real exchange rate, *P*, will raise output in the nontraded sector and lower output in the traded sector as resources are shifted between sectors.

The assumption that all factors of production are mobile between sectors also implies that the returns to factors are solely functions of the real exchange rate. Accordingly, the rental rate on installed capital can be expressed as

where an increase in the real exchange rate will lower the rental rate on capital since the nontraded sector is relatively labor-intensive.^{12}

#### Asset Markets and Investment

Residents of the home country allocate their wealth over two real assets that are assumed to be perfect substitutes for each other. The two assets are an internationally traded bond paying the fixed world interest rate *(r)* and a domestically traded equity claim on firms in the capital supply industry. Arbitrage in domestic asset markets equates the expected yields on claims to installed capital with the interest rate on bonds:

The expected yield on an equity claim to installed capital, given by the left-hand side of equation (4), is composed of the expected capital gain on equity (*(D/V)*. Residents of the economy are assumed to have perfect foresight so that the expected capital gain equals the actual capital gain.^{13}

Investment is carried out by firms in the capital supply industry and follows the adjustment cost specification of Hayashi (1982). Firms in the production sectors are assumed to rent capital services from firms in the capital supply industry. To increase the capital stock by *J* units, firms in the capital supply industry must initially purchase *J* units of traded output. This traded output is then irreversibly transformed into capital at an installation cost that uses nontraded output. If we assume that this installation cost is an increasing function of the amount of capital formation relative to the existing capital stock, then total investment expenditure is given by

where *I*^{T} *= J* is the amount of traded output used and *I*^{N} = *Jh(J/K)* is the amount of nontraded output used to produce *J* units of capital. The assumption that the marginal cost of installation is nondecreasing in *J/K* ensures determinancy of the capital stock despite constant-returns-to-scale technologies and perfect competition.^{14}

The representative firm in the capital supply industry is assumed to choose investment so as to maximize its market value. By assuming that all investment expenditure is financed out of retained earnings and that firms have issued no previous debt, the number of equity claims outstanding will be constant and the market value of an individual firm will be proportional to the value of an equity claim.^{15} As a result, integration of equation (4), ruling out speculative bubbles by assumption, gives the firm’s market value:

where the number of equity shares has been normalized to unity for convenience. Equation (6) defines the market value of a firm in the capital supply industry as equal to the present discounted value of its dividend stream. Dividends are equal to the difference between the firm’s after-tax revenue from capital rentals less its expenditures on investment:

where *r*^{k} is the rental rate for installed capital measured in units of traded goods and τ is the tax rate applied to rental income.^{16}

The representative firm maximizes equation (6) subject to the following accumulation constraint for the capital stock:

where ξ is a constant rate of depreciation. We assume that gross capital formation is always positive, so that the non-negativity condition on gross capital formation *(J)* need not be explicitly imposed. First-order conditions for this problem, as shown in the Appendix, yield the following set of relationships:

Equation (9) sets the marginal value of installed capital equal to its marginal cost and implicitly defines the rate of capital formation *(J/K)* as an increasing function of the marginal value of capital relative to its installation cost:

where *Q = (q -* 1) is the adjusted marginal value of capital.^{17} Equation (10) describes the evolution of the marginal value of installed capital over time.

As discussed in Hayashi (1982) and Summers (1981), our assumptions about production technologies and installation costs imply that the marginal value of installed capital for this economy will be equal to the average value of installed capital. In other words, the market value of an equity claim on a unit of installed capital will equal the marginal value of an additional unit of installed capital *(q)*. Accordingly, we can identify the variable *q* as the price of equity measured in terms of traded goods.

By using equation (11) to substitute for the rate of capital formation in equations (5), (8). and (10). we obtain relationships describing the demand for investment goods, the dynamics of the price of equity, and the dynamics of the capital stock as functions of *q, P*, and *K*:

where the partial derivatives of the functions are given as

The two derivatives with ambiguous signs (φ_{1} and φ_{2}) will both be determinate at the steady-state equilibrium for the model where the rate of capital accumulation equals the rate of depreciation *(x =* Δ). For a given path of the real exchange rate and exogenous variables, these equations determine how investment, the capital stock, and the price of equity evolve through time.

#### Consumption

The infinitely lived representative household chooses consumption so as to maximize the discounted sum of instantaneous utility:

where instantaneous utility is a function of consumption of the traded good (c) and γ is the constant rate of time preference.^{18} Equation (16) is maximized subject to an accumulation constraint that sets the change in household bond holdings *(B*^{h}*)* equal to the excess of income over consumption expenditure:

where income consists of interest earnings on bond holdings *(rB*^{h}*)*. dividend payments on equity holdings *(D)*, after-tax labor income [(1-τ)wL], and lump-sum transfers payments *(R)*.^{19} As shown in the Appendix, the first-order conditions for the household’s problem are

where λ is the marginal utility of consumption. Note that with a constant world interest rate and a constant rate of time preference we must impose the condition *r* = λ to ensure the existence of a steady state with a nonzero but finite level of consumption. It follows, therefore, from equations (18) and (19) that residents will smooth consumption perfectly over time yielding a constant level of consumption for any given path of lifetime income.

#### The Government

The government is assumed to finance transfer payments and its purchases of traded and nontraded goods through a tax on incomes from labor and capital and by borrowing on international markets. We assume that the government obeys its intertemporal budget constraint so that the present value of future receipts minus the present value of future expenditures exactly offsets the initial stock of government debt. The accumulation constraint for government debt is given as

where *B*^{g} is the stock of government debt. Government purchases of goods are assumed to have no direct effect on the utility of residents in the economy.^{20}

#### Equilibrium

Equilibrium in the economy occurs when the market for the non-traded good clears. This condition must hold at each point in time and determines the equilibrium path for the real exchange rate:

Equation (21) determines the equilibrium real exchange rate for given values of the capital stock, price of equity, and the level of government spending on the nontraded good. Solving for the real exchange rate yields

where the signs of the partial derivatives follow from equations (1), (11), and (13). An increase in *q* raises investment, thereby bidding up the price of the nontraded good. A rise in the capital stock will both raise the level of investment and tower the output of the labor-intensive nontraded sector, thus requiring an increase in the price of the nontraded good to clear the market. Finally, an increase in government purchases of the nontraded good will yield an increase in the price of the nontraded good.

#### Solution of the Model

By using equation (22) to substitute for the real exchange rate in equations (14) and (15), we obtain two relationships describing the evolution of the capital stock and price of equity as functions of *q, K*. G^{N}, τ, and *r*.

To solve the model, these equations are linearized around the point where

where the derivatives, evaluated at the steady-state values of *q* and *K*, are given as

and the changes *(dz) ate* expressed as deviations from steady-state values. The determinant of this differential equation system is equal to *(H _{1}F_{2} - H_{2}F_{1})*, which is negative thereby ensuring that the equilibrium where

*q*and

*K*along the stable adjustment path is given in general form as

where *Z* is an arbitrary constant determined by the initial value of K, μ. is the stable (negative) eigenvalue of the transition matrix, and the ω^{i}, are the elements of the eigenvector associated with μ By using equations (26) and (27), the relationship between *q* and *K* along the stable path can be expressed as

where (ω_{1}/ω_{2}) = *H _{2}*/(

*H*) < 0. As a result, the price of equity and the capital stock will move in opposite directions along the stable path.

_{1}- μTo calculate how the real exchange rate evolves over time, we first linearize equation (22) around the steady state and then substitute for *dq* using equation (28) to obtain

By using the definition of *ω*_{2} / *ω*_{2}, the term in brackets can be rewritten as

This term is always positive since υ_{1}, υ_{2}, φ_{2}, and *r* are positive while μ, is negative, implying that the real exchange rate and the capital stock will move in the same direction along a stable adjustment path. Hence, the model predicts real appreciation accompanying capital accumulation as the economy adjusts toward long-run equilibrium along the stable path, in contrast to Brock (1988) where real depreciation is associated with capital accumulation along the stable path. The reason for this difference is that the present analysis models adjustment costs as an increasing rather than a linear function of the rate of capital formation, thereby permitting the value of installed capital (the price of equity) to diverge from the installation cost of capital (the real exchange rate).

A graphical solution of the model is presented in Figure 1 where the steady-state values of *q* and *K* are given by the intersection of the *K* (accounting for general equilibrium effects on the real exchange rate) lowers the return to capital (and thus dividends), thereby requiring a fall in the price of equity so that the yield on equity with zero expected capital gains equals the world real interest rate. The *K* induces a real appreciation (through general equilibrium effects on the nontraded goods market), which raises the cost of investment and requires an increase in *q* to keep investment from falling. As shown in Figure 1 the stable adjustment path (55), described by equation (28), is downward sloping and follows from the pattern of adjustment for points off of the ^{21}

### II. Adjustment to Economic and Policy Shocks

This section considers how the real exchange rate, the price of equity, and the capital stock adjust in response to changes in fiscal policies and the world real interest rate. Both temporary and permanent changes are examined.

### A Reduction in the Income Tax Rate

A permanent reduction in the income tax rate (τ) that is financed by government borrowing will initially raise the after-tax return to equity and thereby increase the demand for equity claims.^{22} This increased demand for equities leads to an immediate rise in the price of equity in order to restore equilibrium in the equity market. As noted earlier, the assumed specification of adjustment costs in the model imply that the average and marginal values of installed capital are equivalent. Accordingly, an increase in the price of equity also represents an increase in the marginal value of installed capital. Given the initial real exchange rate (which represents the installation cost of capital), the higher price of equity therefore induces an increase in the rate of investment by firms in the capital supply industry.

As illustrated in Figure 2, a permanent tax cut shifts the ^{23} The higher rate of investment then drives the dynamics as capital accumulates and the price of equity declines along the stable path. Both the capital stock and price of equity increase in the new long-run equilibrium, although in the short run the price of equity overshoots its long-run value.

The rise in investment produces an initial appreciation of the real exchange rate that shifts resources into production of nontraded goods. This appreciation, however, is proportionately less than the rise in the adjusted price of equity *(Q = q*—1) since, according to equation (21), a proportionate increase in the real exchange rate would produce an excess supply of nontraded output. As shown by equation (29), real appreciation must accompany capital accumulation along the stable path. As a result, the short-run effect is an undershooting of the long-run real exchange rate.

A temporary reduction in the income tax rate is illustrated in Figure 3. As in the case of a permanent reduction, the initial effect is an upward jump in the price of equity that is accompanied by a real appreciation. The jump in the price of equity and the extent of real appreciation will be greater the longer is the period of time during which the tax cut is in effect. In all cases, though, the jump in the price of equity must be smaller than for a permanent tax change so as to yield dynamics that place the economy on the original stable path *(SS)* at the time the tax cut is rescinded. The price of equity declines during the period preceding the tax increase while the capital stock at first rises and then declines. After the increase in the tax rate, the economy adjusts along the original stable path, with the price of equity rising and the capital stock falling.

The bottom panel of Figure 3 shows the adjustment pattern of *Q* and *P*. The real exchange rate appreciates on impact by proportionately less than the rise in the adjusted price of equity *(Q)*. Since capital accumulates for a period of time, it is possible for the real exchange rate to continue to appreciate.^{24} Eventually, the falling price of equity will dominate, lowering investment demand and inducing real depreciation. The rate of real depreciation rises until the tax rate increases at time t,, after which the rate of real depreciation gradually declines. In terms of Figure 3, the capital stock begins to decline at some time prior to the actual increase in the tax rate, when the ratio *Q/P* momentarily equals its steady-state value. Unlike the case of a permanent tax cut, a temporary tax cut thus yields an episode during which the real exchange rate and the price of equity adjust over time in the same direction.

### An Increase in Government Spending

An increase in government spending financed through borrowing will have very different effects on the economy depending upon whether the government purchases traded or nontraded output. The major difference between these two types of expenditure is that purchases of non-traded output will directly affect conditions in the nontraded goods market, thereby requiring adjustment of the real exchange rate and the price of equity as private investment is crowded out. In contrast, spending on traded goods will have no direct impact on conditions in the markets for nontraded output or equity.

An increase in government spending on traded output will have no effect on the price of equity, the capital stock, or the real exchange rate. The only effect will come as households react to the increase in spending by smoothing the drop in lifetime income represented by the future lump-sum tax burden. ^{25} On the other hand, an increase in government spending on nontraded goods will alter equilibrium in the market for nontraded goods, thereby inducing adjustment of the real exchange rate, the price of equity, and the capital stock.

As shown in Figure 4 a permanent increase in government spending on nontraded output will shift the

The immediate effect of a permanent increase in spending on non-traded output is a real appreciation, which raises installation costs in the capital supply industry and lowers the return to installed capital. The equity market reacts to the decline in the return to capital by immediately bidding down the price of equity so as to re-establish equilibrium.

**Permanent Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

**Permanent Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

**Permanent Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

With the price of equity now lower and the installation cost of capital higher, the ratio *Q/P* has clearly fallen so that the rate of investment spending drops below the rate of depreciation. Along the adjustment path the capital stock declines as the price of equity rises and the real exchange rate depreciates.

A temporary increase in government spending on nontraded output is illustrated in Figure 5. The initial effects on the price of equity and the real exchange rate are similar to the case of a permanent increase: the ratio *Q/P* falls, the rate of investment falls, and the capital stock begins to decline. The drop in the price of equity is less than for a permanent increase, since the resulting dynamics must move the economy back to the stable path *SS* associated with the initial equilibrium. This implies from equation (22) that for a given increase in government spending, a temporary increase will produce a greater initial real appreciation.

**Temporary Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

**Temporary Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

**Temporary Increase in Government Purchases of Nontraded Goods**

Citation: IMF Staff Papers 1989, 001; 10.5089/9781451956825.024.A004

Along the adjustment path, the price of equity will rise at an increasing rate until the level of government spending is reduced. As shown in the bottom panel of Figure 5 the real exchange rate may decline for a while, but will eventually begin to rise as the increasing price of equity dominates the declining capital stock in determining the real exchange rate (equation (22)). When the level of spending is finally reduced, the real exchange rate immediately depreciates, thereby lowering the installation cost of capital relative to the price of equity so that investment rises.^{26} The final phase of adjustment is characterized by a gradually declining price of equity, a rising capital stock, and an appreciating real exchange rate. As in the case of a temporary change in the tax rate, a temporary change in government spending on nontraded goods will be characterized by a period of time during which the real exchange rate and the price of equity move in the same direction prior to the final phase of adjustment along the stable path.

### An Application: The Reagan Tax Cut

The real appreciation of the U.S. dollar from mid-1982 through early 1985 was accompanied by a stock market boom. This experience is consistent with the model’s prediction for a policy scenario of a permanent tax cut associated with an expected future reduction in government spending on nontraded goods.

A permanent tax cut would itself produce an initial real appreciation and a rise in the price of equity but would be followed by additional real appreciation and a declining price of equity (as demonstrated in Figure 2). If, however, the tax cut produced a budget deficit that generated the expectation of a future reduction in spending on nontraded goods, then adjustment during the time period prior to the reduction in spending would be characterized by real appreciation accompanied by a rising price of equity. This can be seen by considering the example of a temporary increase in government spending illustrated in Figure 5. Spending is temporarily high and is expected to be lower in the future, generating real appreciation and a rising price of equity.

The large budget deficits that emerged in the wake of the tax cuts of 1981 generated the popular expectation of future fiscal tightening. To the extent that President Reagan’s pledge never to raise taxes was believed, then the tightening would be expected to come in spending cuts. This provides one possible explanation for the episode of real appreciation accompanied by rising equity prices in the United States during the 1982-85 period.

### A Reduction in the World Interest Rate

To consider a permanent reduction in the world interest rate (r), it is necessary to assume that the rate of household time preference (γ) also falls in order to ensure a determinate steady state with r = *γ* Under this assumption, a reduction in *r* will shift the *(Q)* for reasons analagous to the case of a tax cut described above. Adjustment proceeds with capital accumulation accompanied by a falling price of equity and real appreciation in a manner equivalent to the case of a permanent reduction in the tax rate.

The only important difference from the case of a tax cut concerns the level of consumption. Depending on whether the economy has a positive or negative initial net asset position, the decline in the world interest rate will either lower or raise the level of lifetime income and thus consumption. A temporary reduction in the world interest rate can be analyzed in the same way as a temporary cut in the tax rate. Again, the only important difference concerns the effect on lifetime income and consumption resulting from the initial net asset position of the economy.

A fundamental feature of the model presented in this paper is that a common worldwide shock, such as a change in the world interest rate, will induce similar movements in equity prices across a group of small economies. For example, a reduction in the world interest rate will lead to an initial rise in equity prices and then a gradual decline as yields on equities in each country, measured in terms of a common numeraire, are arbitraged with the world interest rate. Recent evidence on the international pattern of equity returns, however, finds comovements in equity prices across countries when measured in terms of own-currency numeraires, with differences in equity yields arising primarily from changes in real exchange rates. To investigate this phenomenon, the present analysis would need to be modified in two important ways. First, risk would need to be incorporated into the analysis in order to allow for differences in real yields across assets. Second, the model would need to be expanded to a two-country version in which the world interest rate is endogenous. These modifications are beyond the scope of the present analysis and represent paths for future extensions.

## III. Conclusions

The paper has considered how the price of equity, the real exchange rate, and the capital stock for a small open economy adjust following changes in government fiscal policies and changes in the world interest rate. The results suggest important qualitative differences in adjustment to a given change in the government’s budgetary stance depending on how the change is brought about. For example, an expansion in the government’s budget deficit will have quite different effects on the price of equity, the real exchange rate, and the capital stock depending on whether the expansion is achieved through cutting taxes or raising government spending. Furthermore, a given change in government spending will have different effects depending on the breakdown of spending between traded and nontraded output. This serves to reinforce the point made by Frenkel and Razin (1986): that the composition of a change in budgetary policy is critical in understanding its likely impacts on the economy.

The analysis also demonstrates how an optimizing perfect foresight framework in which all markets clear can generate significant movements in the equilibrium levels of the real exchange rate and the price of equity in response to economic and policy shocks simply because investment requires scarce resources. To interpret such movements as evidence of market inefficiencies or as deviations from fundamental equilibrium values would not be correct since adjustment in this framework is driven entirely by equilibrium in asset and goods markets. The results, however, do suggest that a stable set of underlying fiscal policies can play an important role in reducing the volatility of real exchange rates and equity prices. Such volatility can generate important externalities in the actual economy where individuals are likely to be risk averse.

A general feature of the analysis emerges in comparing the effects of temporary changes in fiscal policies with the effects of permanent changes in these policies. During episodes when a temporary policy change is in place, the real exchange rate and the price of equity will move in the same direction. On the other hand, changes in policy that are expected to be permanent will lead to opposite movements in the real exchange rate and the price of equity as the economy adjusts toward long-run equilibrium. For example, following the initial impact effects, a temporary increase in government spending on nontraded goods will yield a rising price of equity accompanied by real appreciation during the period of time that the increased spending is in effect, whereas a permanent increase in spending on nontraded goods is followed by a rising price of equity and real depreciation. This suggests that historical episodes of real appreciation accompanied by surging equity markets may be associated with fiscal policies that are expected to be short-lived.

As with any simple framework, this paper has chosen to emphasize certain aspects of adjustment in the open economy while leaving aside or ignoring additional important issues. The purpose here was to provide an illustrative framework for considering a possible mechanism centered on the investment process through which economic and policy shocks may be transmitted to the reai exchange rate, the price of equity, and the current account. Although this emphasis provides some insight into the issues addressed, it cannot answer many important questions. For example, it would be useful to incorporate money into the analysis in order to study the nominal exchange rate and monetary policies. In addition, the framework could be extended to consider the effects of changes in the terms of trade. Finally, the present model could be easily adapted to analyze how productivity shocks in different sectors affect the real exchange rate and the price of equity.

### APPENDIX: Derivations and Extensions

This Appendix provides details of the derivation of expressions presented in the text and extends the analysis to consider adjustment of the current account balance.

#### Firms

The maximization problem facing a representative firm in the capital installation industry is solved by setting up a present-value Hamiltonian:

and deriving the following first-order conditions:

where *q* is the multiplier on the firm’s capital accumulation constraint. The firm is assumed to take *P* and *r*^{k} as given since it is small relative to the market. Equations (9) and (10) of the text are obtained bv rearranging equations (32) and (33).

#### Households

The maximization problem facing the representative household is solved by setting up the following present-value Hamiltonian:

and taking first-order conditions:

where λ is the multiplier on the household’s accumulation constraint. Equations (18) and (19) of the text follow from equations (35) and (36).

#### The Current Account

A relationship for the current account surplus can be derived by subtracting the accumulation equation (20) for government debt from the accumulation equation (17) for household bond holdings to yield

where *I = I ^{T} + PI*

^{N}. Since total income must equal the value of output, this equation can be rewritten as

where the market-clearing condition for the nontraded good has been used. As mentioned above, residents of this economy smooth consumption perfectly. This implies that consumption can be written as the annuity value of lifetime income:

In addition, residents in this economy fully anticipate that the government budget will balance intertemporally:

where the government is assumed to adjust transfers (R) whenever a change in spending or tax revenue occurs so as to ensure that equation (40) holds. By substituting for transfer payments in equation (39) using equation (40). consumption can be rewritten as

where again the nontraded goods market-clearing condition and the equality between total incomes and the value of output have been used to simplify the expression. By employing equation (41) to substitute for consumption in equation (38), the current account surplus can be expressed as

This equation simply states that the current account will be in surplus or deficit, respectively, depending on whether the quantity *(y ^{T} - I^{T} - G^{T})* is falling or rising through time.

Along the stable adjustment path, traded output net of investment, *(y ^{T} - I^{T})*, may either rise or fall as capital accumulates, depending upon parameter values. Although capital accumulation at a constant real exchange rate will expand the relatively capital-intensive traded sector (via the Rybczynski effect), the accompanying real appreciation draws resources out of the traded sector and into the nontraded sector. If this latter relative-price effect dominates the Rybczynski effect, then the traded sector will contract and total investment expenditure will rise as capital accumulates along the stable path. In this case, capital accumulation would be accompanied by a current account surplus.

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^{}*

Mr. Murphy is Assistant Professor of Economics at Boston College. This paper was written while he was a Visiting Scholar at the Research Department. The author thanks participants in seminars at the Fund, the University of Pennsylvania, and Boston College and three anonymous referees for helpful comments on an earlier draft of this paper.

^{}1

See Williamson (1985) for a discussion of real exchange rate misalignment. Borensztein (1987) presents evidence that the appreciation of the U.S. dollar over the period 1980-84 is consistent with the hypothesis of a speculative bubble, although he is also unable to reject alternative explanations, Shiller (1984) describes stock prices as being determined in part by “fads.”

^{}2

See Williamson (1985) for an analysis of a possible system of target zones for the exchange rates of industrial countries.

^{}3

Frenkel and Razin (1986) and Edwards (1987) present related views.

^{}4

In Brock’s model, government subsidies to investment activity will drive a wedge between the market value of capital and the real exchange rate. This, though, is a one-time effect with subsequent changes in the market value of capital exactly equal to changes in the real exchange rate.

^{}5

(1988) also uses an adjustment-cost framework to study capital accumulation in the open economy. His analysis, however, emphasizes the dynamics of the terms of trade rather than the adjustment of the real exchange rate.

^{}6

See McKenzie (1982) for a similar adaptation of the dependent economy framework. McKenzie assumes that the traded good is the investment good and focuses on the roles of factor intensity and intertemporal substitution in determining the dynamics of the real exchange rate. The present paper follows Brock (1988) in assuming that investment requires inputs of the nontraded good and in focusing on adjustment in response to changes in fiscal policies.

^{}7

See Khan and Lizondo (1987) for a related discussion of how the mix of fiscal policies accompanying a nominal devaluation is critical in determining the extent of real depreciation.

^{}8

By assuming that only the traded good is consumed, the analysis leaves aside important issues concerning how the time profile of consumption is related to the domestic real interest rate. Incorporating nontraded consumption greatly complicates the analysis and obscures the role of investment in determining the real exchange rate. See Dornbusch (1983) for a model of optimal borrowing in which both traded and nontraded goods are consumed but in which there is no investment activity.

^{}9

This assumption about factor intensities is sufficient to ensure that the steady-state equilibrium of the model is a unique saddlepoint. Previous work on capital accumulation in the open economy has employed nonoptimizing models in which global stability of the model required the traded sector to be relatively capital intensive (see, for example, Dornbusch (1980) and Obstfeld and Stockman (1985)). The optimizing model presented in this paper will always be “saddlepath stable” when the traded sector is capital intensive but will be globally unstable when the traded sector is labor intensive.

^{}10

To highlight the role of aggregate (as opposed to sectoral) capital accumulation in determining the dynamics of the real exchange rate and the price of equity, the analysis assumes that capital and labor are costlessly reallocated across production sectors in order to equalize their respective rental rates. An alternative production setup could assume that the factors of production are sector-specific, as in Murphy (1988), or that the factors of production are reallocated gradually across production sectors, as in Mussa (1978). In the presence of aggregate capital accumulation, however, both of these alternatives become analytically intractable and would require numerical simulation for various parameter values in order to characterize the economy’s dynamics; see, for example. Murphy (1988).

^{}11

An increase in *P* thus represents a real appreciation. The model presented in this paper focuses exclusively on the real side of the economy in order to study the interaction of relative prices and capital accumulation. To determine nominal prices and the nominal exchange rate it would be necessary to add a monetary sector to the economy. This would then raise the important issue of how to model money demand in an optimizing framework; an issue that remains controversial and that is beyond the scope of the present analysis.

^{}12

As discussed in Section II. equation (3) implies that the long-run real exchange rale will be determined exclusively by the supply side of the economy. If instead capita) were sector-specific rather than mobile between sectors, then rental rates in each sector would depend on the real exchange rate *and* the sectoral distribution of the capital stock. As noted in Murphy (1988), though, the long-run real exchange rate would continue to be determined exclusively by the supply side provided the two sectors have the same rates of depreciation and adjustment cost functions. The reason is that in the long run rental rates will be equalized across sectors even when capital is sector specific.

^{}13

The assumption that residents of the economy have perfect foresight means that they understand the structure of the economy and fully account for the effects of current and future policies on the economy in forming their expectations. While this assumption about expectations is obviously critical in determining the adjustment path for the economy, its forward-looking nature is more appealing than alternative backward-looking schemes when considering equilibrium in financial markets.

^{}14

Note that the installation cost applies to the aggregate capital stock regardless of the allocation of the stock between the two sectors. Accordingly, “capital” is best viewed here as machines that can be readily shifted across production sectors and the installation cost is simply the cost of turning raw traded goods into machines.

^{}15

The firm is assumed to borrow from residents at the world interest rate when its retained earnings fall short of its investment expenditures. Note that since bonds and equities are perfect substitutes in investor portfolios, the mix of external finance has no effect on the market value of the firm.

^{}16

Note that if the firm were allowed to fully deduct its investment expenditures in calculating its taxable income, then changes in the tax rate would have no effect on investment incentives. Although equation (7) assumes zero deductibility, the results of this paper will continue to hold provided investment expenditures are less than fully deductible.

^{}17

In the steady state, the rate of capital formation equals the rate of depreciation *(x* = 5) so that the capital stock is constant. Since the analysis considers adjustment in the neighborhood of the steady state, it follows that the rate of investment is always positive, implying that *Q* always exceeds zero.

^{}18

The assumption that only the traded good is consumed leaves aside important issues concerning how changes in the real exchange rate induce intertemporal substitution effects on consumption. Allowing nontraded consumption, though, would greatly complicate the analysis and obscure the specific mechanisms highlighted here. See Dornbusch (1983) for a model of optimal borrowing in which both traded and nontraded goods are consumed but in which there is no investment activity.

^{}19

The household also receives income in the form of capital gains on equity. Since the number of outstanding equity claims is assumed to be constant (recall that firms finance investment expenditure out of retained earnings or by borrowing), the capital gain exactly equals the increase in the value of equity holdings. As a result, identical capital gain terms would show up on both sides of the accumulation equation for household wealth and would therefore cancel, yielding equation (17).

^{}20

The results of this paper would continue to hold if government purchases were incorporated as a separable term in the representative household’s utility function.

^{}21

Since the main focus of the next section is on the dynamics of the real exchange rate and the price of equity, the adjustment of the current account is discussed in the Appendix.

^{}22

The future level of lump-sum transfers to households is assumed to be the revenue variable that the government adjusts in order to ensure that the government’s budget is balanced intertemporally. Because households fully anticipate this future adjustment and because transfers are nondistortionary, the exact timing of the adjustment in transfers is irrelevant for the impact of the policy change on the economy. If instead the government adjusts a distortionary tax to ensure that its budget constraint is satisfied, then the timing of the adjustment would be critical in determining the effect of the initial tax cut on the economy.

^{}23

If the increase in the price of equity is either less than or greater than the amount needed to place the economy on the stable path, then the economy will never reach the steady-state equilibrium given by the intersection of the

^{}24

Continued real appreciation is more likely the longer is the time during which the tax cut is in effect. What is needed is for the capita) stock to be rising at a sufficient rate relative to the rate at which the price of equity is falling so that the change in the real exchange rate, as given by equation (29), is positive.

^{}25

A change in government spending on traded goods, however, would have an effect on the price of equity, the real exchange rate, and investment if consumption included nontraded goods. The channel here would be through the change in nontraded consumption induced by the change in the future tax burden associated with the change in government spending. An increase in spending would, in this case, lower the consumption demand for nontraded goods, resulting in a real depreciation, rise in the price of equity, and capital accumulation.

^{}26

In Figure 5 it is possible that the adjustment trajectory crosses into the region where the capital stock begins to rise prior to the actual reduction in spending. This will occur if the price of equity increases sufficiently relative to the real exchange rate so as to actually raise the ratio *Q/P* above its steady-state value. In this situation, the capital stock will begin to rise before the reduction in spending occurs.