For simplicity we assume only two periods, t = 0,1, and focus on the effect of shocks only at the start of period 0.
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Luis Felipe Céspedes is an Economist in the European I Department of the International Monetary Fund. Roberto Chang is Associate Professor of Economics at Rutgers University. Andrés Velasco is Sumitomo Professor of International Finance and Development at the Kennedy School of Government, Harvard University. We are grateful to the Research Department of the IMF for their hospitality while working on this paper. We are also indebted to Michael Devereux, Michael Kumhof, and seminar participants at the Third Annual Research Conference of the IMF. Banco de Mexico, Harvard University, the Middle Eastern Technical Institute (Ankara), and Universidad Torcuato di Telia (Buenos Aires) for useful comments and suggestions. Chang and Velasco thank the National Science Foundation and the Harvard Center for International Development for financial support. The title is inspired by Taylor (1981).
With Cobb-Douglas shares γ and 1 – γ.
Except for the world interest rate and the risk premium, which are just deviations (not percentage deviations) from the steady state.
If this elasticity is smaller than one, then p, is positive, and vice versa. Mil is exactly one, then Pf = 0.
We consider only the case in which the slope of the IS is larger than the slope of the BP. The opposite case is empirically odd, since it implies that an increase in the world interest rate or a fall in exports leads the economy to a boom in production and investment.
Remember that these are percentage deviations from the no-shock steady state, holding prices and wages constant. Without nominal stickiness, output is exogenous (pinned down by the inherited capital stock and by equilibrium labor supply l = 0), the IS and BP pin down the equilibrium real exchange rate for a given output level, and the LM only determines the price level.
The same is true of export shocks.
Notice that the presence of financial imperfections has ambiguous effects on the size of the expan-sion. On the one hand, having μ > 0 and large δe reduces the size of the vertical hand, a large μ increases the slope of the BP, which magnifies the equilibrium impact of any depreciation.