(IMF Staff Papers) The Impact of Monetary and Fiscal Policy Under Flexible Exchange Rates and Alternative Expectations Structures

The Impact of Monetary and Fiscal
Policy Under Flexible Exchange

Rates and Alternative
Expectations Structures
DONALD J. MATHIESON*
D URING THE 1960s, a number of notable economists including Fried-

man (1953), Sohmen (1961), Machlup (1972), and Johnson (1973)
argued that the speculative crises and sharp exchange rate changes of the
Bretton Woods system could be avoided by a switch to a system of floating
exchange rates. They suggested that such a change would yield a gradual
adjustment process that would help to insulate economies from external
disturbances. The actual experience with flexible rates has not, however,
been as favorable as anticipated. For instance, McKinnon (1976, p. 100)
has asserted that the current system of floating exchange rates has been
characterized by: 1
(1) movements in the spot exchange rate of up to 20 per cent on a
quarter-to-quarter basis, or 5 per cent on a week-to-week basis, that
are not secular trends but are movements that generally reverse
themselves;
(2) a significant widening of the bid-ask spreads in the spot markets
over those of the 1960s;
(3) an even larger increase in the bid-ask spreads in the forward markets;
(4) forward rates that have been poor predictors of spot rates; and
(5) official intervention that has continued at as high a level as, or
higher than, under the old fixed rate system.
* Mr. Mathieson, economist in the Financial Studies Division of the Research

Department, holds degrees from the University of Illinois and Stanford Univer-
sity. He has taught at Columbia University.
This paper has benefited from comments by colleagues in the Fund, who are
naturally
1
not responsible for any remaining errors.
For a detailed discussion of recent exchange rate movements, see the Inter-
national Monetary Fund's Annual Report, 1976.
535
©International Monetary Fund. Not for Redistribution

536 INTERNATIONAL MONETARY FUND STAFF PAPERS
While it is still unclear whether these exchange rate movements reflect

the influence of endogenous shocks, such as the oil crisis, the lack of
speculative capital (as suggested by McKinnon (1976, p. 101)), or the
influence of government intervention in the foreign exchange market, it
is nevertheless clear that the adjustment process has not been as smooth
as anticipated and that flexible rates have not succeeded in insulating
economies from external disturbances.
Recently, a number of economists have argued that, in order to under-
stand exchange rate movements, one must examine the process by which
exchange rate expectations are formulated. One is immediately confronted
with the fact, however, that there are a variety of potential hypotheses
that can be used to describe the formation of exchange rate expectations.
A traditional hypothesis derived from inflation theory is that the formation
of expectations can be described by an adaptive process. Under this
expectations structure, the expected exchange rate adjusts gradually to
changes in the actual exchange rate. As pointed out by a number of
economists, however, the adaptive expectations hypothesis creates the
prospects of unrealized profits in the forward markets. Kouri (1975) and
Dornbusch (1976) have therefore argued that one should assume that
exchange rate forecasts are "efficient" or "rational"—that foreign
exchange market participants use all available information to forecast
future exchange rate movements. While "efficient" forecasts do not mean
that the forward rate will always be an accurate estimate of the actual
future exchange rate in stochastic models, rational expectations are
equivalent to perfect foresight in deterministic models.2 Feige and Pearce
(1976) and Knight (1976) have argued, however, that rational expectations
are economically inefficient. They claim that it would be efficient for market
participants to gather complete information about the determinants of
market prices only if the marginal cost of acquiring such information is
zero—something they regard as unlikely. These authors have therefore
proposed two alternative expectations structures. Feige and Pearce sug-
gest that "economically" rational expectations can be formed by apply-
ing the Box-Jenkins (1976) forecasting technique.3 Their empirical
2
The presence of stochastic variables means that the forward rate could differ
from the actual future exchange rate whenever there are "surprise," or unantici-
pated,
3
occurrences between time / and / + 1.
The Box and Jenkins time series methodology assumes that the current value
of any variable (e.g., the rate of inflation—Pi) can be represented as a function
of past values of the variable and a stochastic term. One could thus write the
current rate of inflation as
P, = iri P,_i + ir2Pi-2 + . . . + at
or as ir(B) P, = at

IMPACT OF MONETARY AND FISCAL POLICY 537
analysis of inflationary expectations in the United States indicates that

economically rational expectations will in general differ from both adap-
tive and rational expectations and will be independent of innovations in
monetary and fiscal policy. In contrast, Knight argued that while indi-
viduals might have some understanding of the long-run effects of a change
in a policy parameter or an external shock, they will be uncertain about
the exact path the economy will follow to the new long-run equilibrium.
He therefore suggested that the formation of exchange rate expectations
could be described by a "semirational" structure. This involves combining
an initial change in expectations that reflects the private sector's best
estimate of the long-run effects of a change in a policy parameter or
external shock with a learning (or adaptive) component that reflects the
uncertainties about the actual path.
This paper attempts to compare the economy's response to monetary
and fiscal policy under the adaptive, rational, and semirational expectations
structures. In examining the economy's response to policy changes, we
are especially interested in considering whether each expectations struc-
ture implies a unique response to a policy change. To compare the adjust-
ment process generated under different expectations structures, the rest of
our paper is divided into four sections. In Section I, the basic model of a
small, open economy with a flexible exchange rate is developed. This model
is based on Dornbusch's (1976) rational expectations model but is modified
to allow for a more general definition of the aggregate price level, the use
of real rather than nominal interest rates in the expenditure function, and
the possibility of either rational, adaptive, or semirational expectations.
Then, in Section II, this model is used to contrast the exchange rate,
interest rate, and price level movements generated by an increase in the
money supply under the alternative expectations structures. It is shown
that, in the context of this model, one can distinguish between the adjust-
ment processes under the alternative expectations structures only by
examining the behavior of the domestic interest rates relative to the world
interest rates during the period immediately following the increase in the
money supply. Section III examines the adjustment process generated by
where Pt = inflation rate at time /

ir(B) = polynomial in the lag operation B (i.e., B'X, = Xt_i)
a, = random error with E(a,) = 0, E(at • a,_,) = <r2/
Note that in such a series, the current rate of inflation is independent of policy
variables. To identify and estimate the underlying process, Box and Jenkins first
express each time series as a mixed autoregressive moving average process. The
resulting time series models are referred to as autoregressive integrated moving
average (ARIMA) models. Box and Jenkins have derived techniques for esti-
mating these ARIMA models.

an increase in government spending. In general, the economy's response

to an increase in government spending cannot be used to differentiate
between the different expectations structures. It is shown that the adjust-
ment processes produced by an increase in government spending under
rational and semirational expectations not only are almost identical but
also differ only slightly from the process under adaptive expectations.
Section IV presents the limitations of the model and conclusions.
I. The Basic Model
To facilitate a comparison between our results and those derived in the

literature, the model is similar to that developed by Dornbusch (1976).
Consider a small economy that exists in a world of perfect capital mobility.
Capital mobility will ensure that the domestic interest rate will differ from
the exogenous world interest rate only by the expected rate of depreciation
of the exchange rate. If we let r(r*) be the domestic (world) interest rate
and ee be the expected rate of change of the exchange rate, then capital
mobility implies that 4
(1)
In the model, it is assumed that asset markets clear much more quickly
than do goods markets. In the asset markets, continuous portfolio equi-
librium is maintained by interest rate and exchange rate movements that
will immediately offset any asset market disturbances. In contrast, goods
market prices will adjust much more slowly to any excess demand or
supply. In the goods market, one must also distinguish between the be-
havior of the prices of the imported and domestic (or exported) goods.
The imported good can be purchased at fixed world prices, but this good
is viewed as an imperfect substitute for the domestic good. These assump-
tions mean not only that domestic demand and supply considerations
will determine the absolute and relative prices of the domestic good but
also that the price of this good will respond only gradually to any dis-
turbances in the goods market.
THE MONEY MARKET
The demand for real balances is taken as a function of the level of real
income (y) and the domestic nominal interest rate (r). In log-linear form,
4
See Appendix I for a summary of notation. The symbols are generally the
same as those used by Dornbusch (1976). The exchange rate is defined as
domestic currency/foreign currency.

the money market is in equilibrium when the supply of real money

equals the demand for real balances
(2)
where m, p, p*, e, and y denote, respectively, the logs of the nominal
quantity of money, the price of the domestic good, the price of the
imported good, the exchange rate, and real income.5 The supply of real
balances equals the level of nominal money divided by the "price" level.
Since there is a domestic good and an imported good, the price level that
is relevant for portfolio owners must reflect the effects of changes in the
prices of both goods. For simplicity, it has been assumed that the true
price level can be represented by a log-linear, fixed-weights index that
depends on the price of the domestic good and the domestic equivalent
of the price of the imported good (which will equal the exchange rate
multiplied by the price of the imported good). The price index is thus
given by ap + (1 — «)e + (1 — a)p* where a represents the weight that
the price of the domestic good receives in the general price index.
THE GOODS MARKET
The demand for the domestic good (D) is taken as a function of the
relative price of the domestic good, the level of real income, and the real
interest rate. Thus,
(3)
e
where p is the expected rate of change in the price of the domestic good.
The real interest rate has been defined to equal the nominal interest rate
less the expected rate of inflation as measured by our price index. Since
the foreign price of the imported good is fixed, the expected rate of price
change depends only on the expected rates of change in the price of the
domestic good and the exchange rate.
The rate of increase in the price of the domestic good (p) is assumed to
depend on the excess demand for the domestic good. Thus,
(4)
EXPECTATIONS
To examine the influence of expectations on the adjustment process,
5
It is assumed that real income is fixed at the full employment level.

it is assumed that there are three possible expectations structures—rational,

adaptive, or semirational. In a deterministic system, rational expectations
are equivalent to perfect foresight, which means that the expected rate of
change of either the price of the domestic good (pe) or the exchange rate
(«e) will equal the actual rate of change. In contrast, with adaptive expecta-
tions, market participants are assumed to adjust their expectations grad-
ually. Actual and expected price or exchange rate movements can there-
fore diverge for extended periods of time. Under this expectations struc-
ture, it is assumed that a partial adjustment mechanism can be used to
describe the manner in which the private sector relates actual and ex-
pected price and exchange rate movements. Thus,
(5)
(6)
The semirational expectations structure is based on the hypothesis
that market participants may have some estimate of the long-run effects
of a change in a policy instrument but are uncertain about the exact path
that the economy will follow to the long-run equilibrium. In this situa-
tion, one must differentiate between the initial and medium-term changes
in expectations. To illustrate the nature of this difference, let X' be the
expected value of any price X. Given a change in a policy instrument, the
initial movement in X" will reflect (1) whether or not the private sector
regards this change in the policy instrument as permanent or transitory,
and (2), to the degree that the policy change is regarded as permanent,
the private sector's best estimate of the long-run effect of this policy
change onX. If it is assumed for the moment that the levels of government
spending (g) and the money supply (tri) are the only policy parameters,
then the private sector's best estimate of the long-run value of X will
naturally be defined as some function (j(g, m)) of the policy instruments.
Under semirational expectations, the long-run expected change in the
value of AT will thus equal
We refer to dEX as the extrapolative component of semirational expecta-

tions.
Once this initial change in expectations has taken place, however, the
subsequent behavior of the expected value of X will be dominated by the
belief that X will ultimately move toward the new value of EX. The
expected change in X during this period will be some positive function
of the gap between the long-run value (EX) and the actual value. Thus,

We refer to this as the "learning" component of the semirational expecta-

tions structure.
The relationship between the actual and expected values of p and e
under semirational expectations will thus be given by
(7)
(long-run expected change in p" owing to change in m or g)
(8)
(9)
(medium-term relationship between p" and p)
(10)
(long-run expected change in «" owing to change in m or g)
with
(ID
(12)
(medium-term relationship between ee and «)
The adjustment processes generated under these different expectations
structures can be compared if we first consider an increase in the money
supply.
II. An Increase in the Nominal Money Supply

Given an increase in the nominal money supply, a stable economy will
eventually achieve a new steady state equilibrium with a higher price for
6
Footnotes 8 and 23 explain why the price of the domestic good rises with
an increase in the money supply and falls with an increase in government
spending.
7
Footnotes 8 and 23 explain why the exchange rate rises with an increase in
the money supply and falls with an increase in government spending.

the domestic good and a depreciated exchange rate.5 But let us examine
how the economy will move from the initial equilibrium to its new long-
run equilibrium by first considering rational expectations.
RATIONAL EXPECTATIONS
Under rational expectations, equations (l)-(4) can describe the adjust-

ment process if we substitute p and e for pe and ee. These relationships can
then be reduced to two differential equations in the exchange rate (e) and
the price of the domestic good (p), which are given by 9
(13)
(14)
The adjustment process implicit in the preceding relationships can be
described with the aid of Figure 1. The p = 0 curve represents the combina-
tions of p and t that will yield a stable price for the domestic good. Any
point to the right (left) of this line will yield a rising (falling) price of the
domestic good. The k = 0 curve portrays the combinations of p and e
that will generate a stable exchange rate. Any point to the right (left) of
8
In the long run, the conditions for steady equilibrium are given by
The equilibrium t and p will thus equal
Thus,
These results also explain wh> (in equation (8)) and (in equation (11)).
9
In Appendix II, it is shown that the adjustment process described by equations (13)
and (14) will be stable only if 1 — ainr>0. This condition is required to ensure that the
goods market is stable. Any disturbance in the goods market that generates an increase
in the price of the domestic good (p>0) will also reduce the real interest rate (by — ap).
A decline in the real interest rate, however, will stimulate spending on goods and will
lead to a further increase in the price of the domestic good (by arairp). If the price level
is ultimately to converge to a stable steady state value (i.e., the goods market is to be
stable), then the induced change in p must be smaller than the initial change, which
means that 1 —trour must be greater than zero.
It is also assumed that dp/de=Tr[5\—(1 — a)<ra]/(l — oW)>0. This essentially requires
that the relative price effect generated by a change in the exchange rate outweigh the
real interest rate effect. One could reverse the sign of this expression and still derive the
same qualitative conclusions as described in the text.

FIGURE 1. ADJUSTMENT PROCESS UNDER RATIONAL EXPECTATIONS
this curve will produce a depreciation (appreciation) of the exchange rate.10

As illustrated by the arrows in Figure 1, not all exchange rate and price
level movements will drive the economy back toward the steady state
equilibrium (point A) following any disturbance. In fact, as shown in
Appendix II, there is a unique saddle point path (illustrated by the dotted
line in Figure 1) that the economy must follow if (a) perfect foresight is to
be maintained and if (b) the economy is to return to the steady state equi-
librium. Along this saddle point path, the money market will be in con-
tinuous equilibrium, and the goods market will follow the path described
by equation (4).
10
The slopes of the two curves are given by
The arrows in Figure 1 describe the movement of p and e when they are off the p—0 and
i=0 curves.

The presence of this saddle point path implies a Harrod-Domar "knife-

edged" adjustment process. The basic problem is that any point that is
not on the saddle point path will generate portfolio and price adjustments
that will lead to a continuous movement away from any stable steady state.
At a point such as B in Figure 1, for example, asset and goods market
adjustments will interact to produce a steady, continuous increase in both
the exchange rate and the price of the domestic good. Since random shocks
could frequently produce departures from the saddle point path, it appears
that a perfect foresight economy would find it difficult to achieve a stable
steady state equilibrium. To deal with this problem of instability, the
advocates of the perfect foresight hypothesis implicitly assume that
market participants will always formulate their plans so that the economy
will be inherently stable. This means that the adjustment path generated
by the private sector's behavior will always be identical with the saddle
point path. What is left unspecified, however, is exactly what incentives
or mechanisms exist to ensure that the saddle point path will be selected.
In our analysis of the perfect foresight case, we nonetheless accept this
assumption of stability. To understand the implications of this structure,
let us consider how the economy will respond to an increase in the money
supply.
A permanent increase in the nominal money supply will create an initial
excess supply of real money that portfolio owners will seek to eliminate
by buying bonds. These bond purchases will result in not only a decline in
the domestic interest rate but also a capital outflow that will lead to an
initial discrete depreciation of the exchange rate. In terms of the analysis
developed in Figure 1, an increase in m will shift the e = 0 curve to the
right but will leave the p = 0 curve unchanged. (See Figure 2.) The shift
in the e - 0 curve reflects the fact that a higher m will create an excess
supply of money that will have to be offset by a higher e for each given
value of p. The initial increase in « that is required to maintain money
market equilibrium is given by the move from A to D in Figure 2. It must
be remembered, however, that the domestic interest rate can fall below
the world interest rate only if there is the expectation that the exchange
rate will appreciate over time. (See equation (1).) n This means that the
initial depreciation of the exchange rate must be large enough to create
the anticipation of a future appreciation. However, an appreciation will
be expected only if the exchange rate initially depreciates by more than
the increase in the money supply. The initial depreciation of the exchange
11
This reflects the assumption that there is perfect capital mobility, which
implies that the yields on all bonds will be equalized across countries (after
allowance is made for expected exchange rate movements).

FIGURE 2. IMPACT OF AN INCREASE IN THE MONEY SUPPLY

UNDER RATIONAL EXPECTATIONS
rate thus restores instantaneous equilibrium to the money market not

only by reducing the real money supply (via a higher price for the imported
good) but also by creating the conditions that will allow the domestic
interest rate to decline below the world rate, thereby stimulating the
demand for money. And, while these exchange rate and interest rate
movements will restore money market equilibrium, they will also create
an excess demand for the domestic good. The final movement to the new
equilibrium (at point E) must therefore involve a gradual increase in the
price of the domestic good and a gradual appreciation of the exchange rate.
Thus, the adjustment process under rational expectations will be char-
acterized by an initial depreciation of the exchange rate coupled with no
change in the price of the domestic good, and then an appreciation of the
exchange rate associated with a rising price of the domestic good. Purchas-
ing power parity relationships will therefore not be maintained during
most of the adjustment process.
ADAPTIVE EXPECTATIONS
To describe the impact of an increase in the money supply under adap-

tive expectations, one must allow for the fact that actual and expected
movements in the exchange rate and the price of the domestic good may

diverge for extended periods of time. To draw a comparison with the

adjustment process under rational expectations, we can once again dis-
tinguish between the initial and medium-term effects of a change in m.
However, there is a subtle but important distinction between the nature
of the initial period under rational expectations and that under adaptive
expectations. Under both expectations structures, the initial effects will be
those that occur during the period in which the price of the domestic good
does not respond to any excess demand or supply. Under rational expecta-
tions, price and exchange rate expectations are nonetheless free to vary
during this period. Under adaptive expectations, however, both the ex-
pected price of the domestic good and the expected exchange rate will be
fixed during the initial period. This reflects the assumption that expecta-
tions respond only slowly to actual price movements. The analysis of the
medium-term effects naturally relaxes this assumption and allows for the
feedback between changes in the actual and expected levels of the exchange
rate and the price of the domestic good.
To illustrate the initial effects generated by an increase in the money
supply under adaptive expectations, we can use Figure 3. Although this
figure looks similar to Figure 1, there are a number of important differ-
ences.12 The p = 0 curve now represents the combinations of p and e
that will yield goods market equilibrium given the expected exchange rate
and the expected price of the domestic good. The slope of the p = 0 curve
is unity, which reflects the fact that if pe and e" are held constant, there must
be equal changes in e and p in order to keep the goods market in equilib-
12
When combined with the adaptive expectations mechanisms described in equa-
tions (5) and (6), the adjustment processes in the money and goods markets are
given by
m-ap-(l-a)(-(l-a)p*=-\r+<t,y=-\(r*+6e')+^y (15)
and
P=v[t>(i+p*-p}-<,(r-ap<-(\-a}i'}+(y-\}y]
or, using r*+'te=r,
i>=*[!>(t+P*-p-)-v(r*+at°-ap°-)+(y-V)y} (16)
These four relationships describe the adjustment process for the actual and expected
price of the domestic good (p andp') and the actual and expected exchange rate (e and «•)•
As shown in Appendix III, this set of relationships can be reduced to a system of three
differential equations in p, pe, and <?. A necessary condition for this system to be stable
is that 1— a—|3X>0. This is equivalent to the condition that a depreciation of the ex-
change rate will work to reduce any excess supply of real money. An increase in e will
reduce the real money supply by —(1 — a)de (where 1 —a is the weight that the price of
the imported good receives in the overall price index). At the same time, however, an
increase in e will raise the expected rate of depreciation of the exchange rate by dt°=0d<-
(equation (6)), which will thereby increase the domestic interest rate by an equivalent
amount. As the domestic interest rate rises, however, the demand for money will de-
cline by —Xrfe e = — X(3rfe. Thus, a depreciation of the exchange rate will reduce any initial
supply of real balances as long as 1— <*>/3X or 1— a—/3X>0.

FIGURE 3. ADJUSTMENT PROCESS UNDER ADAPTIVE EXPECTATIONS
p=0
rium (p = O).13 The EE line in Figure 3 represents the combinations of

e and p that will yield money market equilibrium given a fixed expected
exchange rate.14
An increase in m will again create an initial excess supply of money.
To eliminate this portfolio imbalance, the private sector will buy bonds
and generate capital outflow. In contrast to the rational expectations case,
however, these initial portfolio adjustments cannot lead to a change in
the domestic interest rate. As long as the expected exchange rate remains
fixed, asset market arbitrage will tie the domestic interest rate to the world
interest rate. The private sector can therefore initially purchase bonds in
the world market at a fixed nominal interest rate. This capital outflow will
nonetheless lead to a discrete depreciation of the spot exchange rate by an
amount that exceeds the increment in the money supply. A depreciation of
this size is required to restore equilibrium to the money market with an
unchanged real money supply. Since the level of real income is fixed and
13
This reflects the fact that the behavior of the price of the domestic good is given by
14
If i'=Q initially, then continuous equilibrium in the money market will be main-
tained if «=[Xr*—<t>y—ap]/(l— a). The EE curve thus has a negative slope equal to
-(!-«)/«.

the domestic interest rate is initially tied to the world interest rate, the
demand for real money will not be affected by the increase in the money
supply. Money market equilibrium can therefore be maintained only if
exchange rate movements increase the general price level sufficiently to
offset the increase in the nominal money supply and to leave the real
money supply unchanged. Since the price of the imported good carries
the weight 1 — a in the aggregate price index, the exchange rate must
depreciate by de — dm/(\ — a) > dm.
In terms of the analysis developed in Figure 3, the increase in the money
supply will initially shift the EE curve to the right but will leave the p = 0
curve unchanged. (See Figure 4.) The initial increase in e that is required to
maintain money market equilibrium is given by the move from A to B in
Figure 4. Thus, just as under rational expectations, the initial exchange rate
response to an increase in the money supply will involve an overshooting
of the ultimate exchange rate level.
While the initial overshooting of the exchange rate will therefore occur
under both adaptive and rational expectations, the amount by which the
exchange rate overshoots its long-run value will be different under the
two alternative expectations structures. As has been shown, the overshoot-
ing of the exchange rate is part of the process by which instantaneous
FIGURE 4. INITIAL IMPACT OF AN INCREASE IN THE MONEY
SUPPLY UNDER ADAPTIVE EXPECTATIONS
E'

equilibrium is restored to the money market following an increase in the

money supply. The size of this initial depreciation will be determined by
whether this exchange rate movement is required to offset just the increase
in the money supply (as under adaptive expectations) or the increase in
the money supply and the effects of an initial interest rate movement
(as under rational expectations). Since the depreciation of the exchange
rates helps to restore money market equilibrium by raising the prices of the
imported good and thereby reducing the real supply of money, less over-
shooting will occur under rational expectations than under adaptive ex-
pectations. This reflects the fact that, under rational expectations, part of
the initial portfolio disequilibrium will be eliminated by the increase in
the demand for money that is generated by the decline in the domestic
interest rate. Thus, while the largest initial interest rate movements will
occur under rational expectations, the largest initial exchange rate move-
ments will take place under adaptive expectations.
The medium-term effects of an increase in the money supply under
adaptive expectations are somewhat more complex to analyze. The initial
depreciation of the exchange rate will lead the private sector to increase
its estimate of the expected exchange rate (ee > 0). As the expected ex-
change rate increases, however, asset market arbitrage will force the
domestic interest rate above the world interest rate.15 The initial deprecia-
tion of the exchange rate will also create an excess demand for the domestic
good that will drive up the price of that good. Thus, for at least some
period, we will see a rising price level and a rising domestic interest rate.
The interaction between changes in actual and expected exchange rate
and price level movements means that the economy can follow either a
cyclical or direct path to its new long-run equilibrium involving a higher
p and e.16 If the approach to the long-run equilibrium is cyclical, then the
exchange rate may overshoot its long-run value not only at the beginning
but also during the later stages of the adjustment process. Figure 5 con-
trasts the adjustment processes for the exchange rate, the price of the
domestic good, and the domestic interest rate under rational and adaptive
15
One would usually expect an increase in the money supply to drive down
the domestic interest rate initially. This cannot happen in our model as long as
we maintain the assumption of perfect capital mobility. In this situation, the
domestic interest rate can differ from the world rate only by the expected rate
of depreciation. If one were to assume that there was less than perfect capital
mobility, then it is possible that one could see both a rise in the expected rate
of 16depreciation and a fall in the domestic interest rate.
In the long run, the percentage increases in the exchange rate and the price
of the domestic good will exactly equal the percentage increase in m. The cycli-
cal nature of the adjustment paths will be determined by the characteristic roots
of the three differential equations that describe the behavior of the economy under
adaptive expectations. (See Appendix III.)

expectations. In Figure 5, panel A portrays the adjustment process under

rational expectations; panel B illustrates a direct approach to equilibrium
under adaptive expectations; and panel C describes one potential cyclical
FIGURE 5. ADJUSTMENT PROCESSES GENERATED BY AN INCREASE IN THE

MONEY SUPPLY UNDER RATIONAL EXPECTATIONS, ADAPTIVE EXPECTATIONS
(DIRECT APPROACH), AND ADAPTIVE EXPECTATIONS (CYCLICAL APPROACH)
A. RATIONAL EXPECTATIONS
B. ADAPTIVE EXPECTATIONS DIRECT APPROACH
C. ADAPTIVE EXPECTATIONSùCYCLICAL APPROACH

path under adaptive expectations. Under rational expectations, an increase

in the money supply will produce an initial decline in the domestic interest
rate and a depreciation of the exchange rate. This will be followed by a
gradual decline of the exchange rate to its long-run level, a gradual rise in
the price of the domestic good to its new steady state value, and a gradual
increase of the domestic interest rate to equality with the world interest
rate.
Under adaptive expectations, a direct approach to the new equilibrium
(panel B) will generate paths for the exchange rate and the price of the
domestic good that are quite similar to those under rational expectations.
However, under adaptive expectations, the domestic interest rate will
temporarily rise above rather than fall below the world interest rate.
If there is a cyclical approach to equilibrium under adaptive expecta-
tions, then the behavior of r, /?, and e will be quite different from the
rational expectations case. (See panel C.) In this situation, the exchange
rate and the price of the domestic good may overshoot and undershoot
their long-run equilibrium values a number of times. Thus, under adaptive
expectations, it is much more likely that the adjustment process will show
much greater price, exchange rate, and interest rate fluctuations than under
rational expectations. But the key to whether adaptive or rational expecta-
tions best characterize the expectations structure of the economy will be
the behavior of nominal interest rates following an increase in the nominal
money supply. Under rational expectations, the initial decline in the interest
rate will be followed by a gradual return to equality with the world interest
rate. In contrast, under adaptive expectations, the domestic interest rate
will gradually rise above the world interest rate before returning to an
equality.
SEMIRATIONAL EXPECTATIONS
Under semirational expectations, market participants will have some

understanding of the long-run effects of a change in monetary or fiscal
policy, but they will be uncertain about the exact path that the economy
will follow from the initial equilibrium to the long-run equilibrium.
In this situation, an increase in the nominal money supply will create not
only an excess supply of money but also the expectation of a long-run
depreciation of the exchange rate and a long-run increase in the price of
the domestic good. This initial change in expectations represents the in-
fluence of the extrapolative component of the semirational structure.17
Since market participants will anticipate a long-run depreciation of the
17
The learning component of the semirational structure will initially be fixed.

FIGURE 6. IMPACT OF AN INCREASE IN THE MONEY SUPPLY

UNDER SEMIRATIONAL EXPECTATIONS
exchange rate, the domestic interest rate will rise above the world interest
rate by the amount of the anticipated depreciation. This is represented by
the movement of the interest rate from A to B in Figure 6.18 This initial
increase in the domestic interest rate will reduce the demand for money
(by —Arfee), which will work to further increase the initial excess supply
of money. To restore equilibrium in the money market, the exchange rate
must therefore initially undergo a discrete depreciation (which will raise
the price level and reduce the supply of real money) by an amount that is
larger than the initial depreciations under either adaptive or rational ex-
pectations. The initial depreciation must be larger under semirational
expectations because it must offset the excess supply of money created by
both the increase in the nominal money supply and the decline in the
demand for money induced by the rise in the domestic interest rate. In
contrast, the initial depreciation (under adaptive expectations) has to
offset only the increase in the nominal money supply, since the domestic
interest rate will initially be tied to the world interest rate. And under
rational expectations, the realization that the exchange rate will initially
overshoot its long-run value creates the anticipation of a long-run apprecia-
tion of the exchange rate that drives down the domestic interest rate. Since
a lower interest rate will increase the demand for money, however, a smaller
initial depreciation is required to restore money market equilibrium.19
18
Figure 6 portrays both the initial and the medium-term movements in r, e,
and19 p. Appendix IV examines the stability of the actual adjustment path.
Using equations (10)-(12), it can be seen that the initial response of semi-
rational expectations to an increase in m equals

To calculate the medium-term effects of the increase in the money

supply, one must allow for the feedback effects associated with the learn-
ing component of the semirational structure. It has been shown that the
increase in the money supply interacted with the extrapolative component
of the semirational structure to initially create the expectation of a long-
run depreciation of the exchange rate. This expectation not only pushed the
domestic interest rate above the world rate but also forced the exchange
rate to overshoot its long-run value (to point D in Figure 6). It must be
recognized, however, that this extrapolative effect has only a once-and-for-
all impact that occurs at the instant in time when the money supply is
increased. During the rest of the adjustment process, the behavior of ex-
pectations will be determined by the learning component of the semi-
rational structure.20 This means that, once the initial changes in r and e
have taken place, the private sector will find itself faced with a situation
where the exchange rate lies above its long-run value but the price of the
domestic good is below its long-run value. It will thus be expected that the
price of the domestic good will rise over time, whereas the exchange rate
will appreciate. This expectation will influence the adjustment process in
both the goods and asset markets.
In the goods market, both the depreciation of the exchange rate and
the realization that the price of the domestic good must rise over time will
work to create an excess demand for the domestic good. This excess
demand will drive up the price of the nontraded good.
In the asset market, the realization that the exchange rate must appre-
ciate to reach its long-run equilibrium will lead to a sharp decline in the
domestic interest rate, to a level that is below the world interest rate. In
Figure 6, this interest rate change is reflected by the move from B to C.
This decline in the domestic interest rate will raise the demand for real
money balances. At the same time, however, the rising price of the domestic
good will be reducing the real supply of money. Thus, to maintain con-
tinuous money market equilibrium, the exchange rate must appreciate to
lower the price of the imported good and to increase the real money supply.
It should be emphasized, however, that the sharp initial changes in the
This increase in the expected exchange rate will raise the domestic interest rate by an
equivalent amount. In the money market, equilibrium will be maintained if the exchange
rate depreciates (de > 0) by
20
This analysis is based on the assumption that expectations are formulated
at the beginning of the trading "day" and are revised only at the beginning of
the next "day," once market participants have observed the trading prices that
have prevailed during the current "day."

interest rate reflect the assumption that asset markets clear instantaneously.
If asset markets adjusted more gradually, then one would see a gradual
upswing of the interest rate followed by a gradual decline, instead of the
discrete changes described in this paper.
As shown in Figure 6, these price, exchange rate, and interest rate
movements will interact to produce a smooth asymptotic path to the long-
run equilibrium. (See Appendix IV for an analysis of this path.) During
this part of the adjustment process, the interest rate will gradually rise to
equality with the world interest rate, the price of the domestic good will
increase to its long-run value, and the exchange rate will appreciate to
its new steady value.
What then are the basic differences and similarities between the adjust-
ment processes under the three different expectations structures following
an increase in the money supply? The major difference between the various
adjustment processes lies in the behavior of the domestic interest rate.
Under rational expectations, a sharp initial decline is followed by a gradual
return to equality with the world interest rate. Under adaptive expecta-
tions, in contrast, the interest rate may gradually rise above the world
level and then return to its initial level, or there may be a series of cycles
with a rising and falling interest rate. And under semirational expecta-
tions, the interest rate will undergo a sharp rise, then a sharp decline, and
finally a gradual recovery to the initial value. A second difference between
the adjustment processes is that only the adaptive expectations structure
can possibly involve a cyclical adjustment process. Under either rational
or semirational expectations, the initial discrete adjustments will be fol-
lowed by an asymptotic movement to the long-run equilibrium. However,
one element that is shared by all three adjustment processes is an initial
exchange rate depreciation that is larger than the increase in the money
supply. This discrete depreciation is required to restore money market
equilibrium, and the existence (but not the size) of this overshooting is
independent of the expectations structure.
III. An Increase in Government Spending
To incorporate fiscal policy into this analysis, we must allow for the
impact of government spending and taxation on asset and goods market
behavior. To simplify the analysis, it is assumed (1) that government
spending can be expressed as a proportion (g) of private spending (/)),
(2) that government tax revenues are raised via a lump-sum tax and a tax
on income, and (3) that all government deficits or surpluses are financed

by issuing or retiring bonds. The government budget constraint can there-

fore be written as 21
where B° = the stock of government bonds

to = lump-sum taxes
ti = income tax rate
The presence of taxes means that the demand for goods and for assets
will depend on disposable rather than gross income. Nominal disposable
income (YD) equals factor income (PY) plus earnings on private holdings
of domestic (rBD) and foreign (rBF) bonds, and less any taxes (f0 + t\PY).
Thus,
In the asset markets, the impact of fiscal policy will be generated via the
issuance of bonds and the effects of changes in taxes on disposable income
and thereby on asset demands, whereas the effects of fiscal policy on the
goods market will be produced by changes in government spending and
the impact of changes in taxes on disposable income and thereby on
consumption demands. The conditions for money market equilibrium
will be identical with those described in equation (2). We are thus assum-
ing that the level of output (rather than disposable income) is still the best
indicator of the transactions demand for money. Since it has been assumed
that government spending (G) can be expressed as a proportion of private
spending on the domestic good, the total demand for the domestic good
will be G + D = gD + D = (1 + g)D. Equation (4) must therefore be
rewritten as
or, using r = r*+ee

(17)
Given these changes, consider the effects of an increase in the level of
government spending (via an increase in g) under the assumption of either
rational, adaptive, or semirational expectations.22
21
It has been assumed implicitly that all government spending is on the
domestic
22
good.
To simplify the analysis, assume that the government always changes the
income tax rate so as to offset any changes in interest earnings on private hold-
ings of bonds. This assumption will allow one to abstract from the effects of
changes in interest income on asset and goods demands and will fix the level of
disposable income.

Before we consider the actual adjustment paths generated under the

alternative expectations structures, it must be emphasized that there are
two general characteristics of the model that strongly influence the nature
of the adjustment process. First, since the goods market is assumed to
adjust slowly, the initial impact of an increase in government spending
must be generated via its impact on expectations. If a higher level of
government spending is going to have an immediate impact on the domes-
tic interest rate, for example, then it must be able to affect the expected
rate of depreciation of the exchange rate, or asset market arbitrage will
tie the domestic interest rate to the fixed world interest rate. As will be
shown, this characteristic often means that fiscal policy will have only a
very limited initial impact on the domestic economy. Second, the impact
of fiscal policy is further restricted by the assumptions of perfect capital
mobility and a given world interest rate. The nature of these restrictions
can best be illustrated if we consider why the capital mobility assumption
will interact with the conditions for money market equilibrium to ensure
that an increase in government spending financed by the issuance of bonds
will ultimately lead to a higher price of the domestic good and an appre-
ciation of the exchange rate.23
An appreciation of the exchange rate must be combined with a higher
price of the domestic good because this is the only combination of price
and exchange rate movements that will ensure long-run money market
equilibrium following an increase in government spending. In the long
run, the real demand for money (which depends on the level of real income
and the nominal interest rate) will be independent of the level of govern-
ment spending. This independence reflects the fact that the level of real
income will be fixed at the full employment level, and the nominal in-
terest rate will be tied to the international interest rate. With a given real
demand for money, however, long-run money market equilibrium can
be attained only with a fixed real supply of money. And if the higher level
of government spending is financed solely by issuing bonds, then the
nominal money supply will not be affected by this expansionary policy.
A fixed real money supply can therefore be achieved only if price and
exchange rate movements combine to leave the overall price level un-
23
The long-run effects of an increase in government spending can be shown
to equal
In a recent survey of models of exchange rate movements, Isard (1977) noted

that both Shafer's (1976) simulation model and Daniel's (1976) theoretical
model also yield the result that an increase in government spending financed by
debt insurance will lead to an appreciation of the exchange rate.

change^. Since an increase in government spending on the domestic good

will drive up its price, a stable overall price level will require a fall in the
price of the imported good. Given the fixed international prices of the
imported good, the prices of imported goods can decline only if the ex-
change rate appreciates. These constraints on the long-run effects of
expansionary fiscal policy will naturally have an important impact on the
short-run adjustment process.
RATIONAL EXPECTATIONS
To illustrate the adjustment path produced by an increase in govern-

ment spending, let us first consider rational expectations. To finance its
purchases of the domestic good, the government must increase its is-
suance of bonds. Since a significant proportion of these bonds will be
sold on the world bond market, the resulting capital inflows will create
the expectation of an appreciation of the exchange rate. This expectation
will generate portfolio adjustments that will initially drive the domestic
interest rate below the world interest rate, thereby stimulating the demand
for money. With a fixed nominal money supply, however, this excess
demand for money can be satisfied only if the general price level declines
in order to increase the real money supply. Since the price of the domestic
good will not respond immediately to a change in demand, the general
price level will decline only if there is a discrete appreciation of the ex-
change rate. In the goods market, the initial rigidity of the price of the
domestic good means that the higher level of government spending will
merely be added to the backlog of excess demands. The initial impact of
an increase in government spending is therefore generated through ex-
pectations in the sense that the initial exchange rate and interest rate
movements reflect changes in expectations regarding future exchange rate
movements.
The initial impact of an increase in g can be illustrated using the graph-
ical analysis developed in Figures 1 and 2. As shown in Figure 7, an
increase in g will raise the p = 0 curve but will leave the e = 0 curve
unchanged. This shift reflects the fact that a higher level of government
spending will create an excess demand for goods that can be eliminated
only by a higher value of p for each value of e. The initial appreciation of
the exchange rate is given by the movement from A to B in Figure 7.
While the initial appreciation of the exchange rate will reduce private
spending on the domestic good, the higher level of government spending
will still be sufficient to create an excess demand for the domestic good
that will eventually force up its price.24 As this price rises, it will work to
24
This is the movement from B to C in Figure 7.

FIGURE 7. IMPACT OF AN INCREASE IN GOVERNMENT SPENDING

UNDER RATIONAL EXPECTATIONS
continuously reduce the real supply of money. During this period, money
market equilibrium can therefore be maintained only if the exchange rate
appreciates and thereby reduces the price of the imported good. This con-
tinuous exchange rate appreciation will keep the domestic interest rate
below the world rate during the move to the long-run equilibrium.
Figure 8 portrays the movements of e, p, and r during the adjustment
FIGURE 8. ADJUSTMENT PROCESS GENERATED BY AN INCREASE IN
GOVERNMENT SPENDING UNDER RATIONAL EXPECTATIONS

process. It is interesting to note that, following the initial discrete decline

in the interest rate and the appreciation of the exchange rate, the adjust-
ment process will involve increases in both the price of the domestic good
and the domestic interest rate at the same time that the exchange rate is
appreciating. As we shall see, this is fairly similar to the behavior under
adaptive expectations.
ADAPTIVE EXPECTATIONS
Under adaptive expectations, one must again distinguish between the

initial and medium-term effects of an increase in government spending.
Three factors play a crucial role in determining the initial impact of an
increase in government spending under adaptive expectations. First, since
the price of the domestic good cannot immediately respond to changes in
aggregate demand, the exchange rate and the domestic interest rate are the
only variables capable of adjusting in the short run. Second, domestic
interest rate adjustments are limited by the fact that the interest rate can
deviate from the world interest rate only if the exchange rate is expected
to change. And, finally, as has just been shown under rational expecta-
tions, the initial effects of an increase in government spending must be
generated via a change in expectations. Under adaptive expectations,
however, the expected exchange rate and the expected price level will
initially be fixed and independent of any actual exchange rate or price level
movements. Thus, other than to create an excess demand for goods, the
announcement of an increase in the level of government spending will have
no initial impact on the level of the exchange rate, the price of the domestic
good, or the domestic interest rate.
To illustrate why this is true, one can use the graphical analysis described
in Figures 3 and 4. It must be remembered that in these figures the EE
curve represents the combinations of e and p that will yield money market
equilibrium given the expected exchange rate, the price of the domestic
good, and the stock of money. As shown in Figure 9, an increase in g
will push the p = 0 curve up to the left but will leave the EE curve un-
changed. Since the goods market adjusts slowly, the price of the domestic
good will not respond instantaneously to the new excess demand. The
demand for and supply of money will also not be affected by any increase
in government spending financed by issuing bonds, because the domestic
interest rate will initially be tied to the world interest rate. Thus, if any
initial appreciation of the exchange rate did take place, it would create an
excess supply of real balances by lowering the price of the imported good.
The effects of an increase in government spending will therefore neces-
sarily be felt somewhat more gradually under adaptive than under rational
expectations.
The medium-term effects of an increase in government spending reflect

FIGURE 9. INITIAL IMPACT OF AN INCREASE IN GOVERNMENT

SPENDING UNDER ADAPTIVE EXPECTATIONS
the feedback between changes in the actual and expected levels of both the
exchange rate and the price of the domestic good. The initial excess demand
for the domestic good will drive up the price of that good and will thereby
reduce the real supply of money. To maintain money market equilibrium,
the exchange rate must therefore begin to appreciate to lower the domestic
price of the imported good. This appreciation of the exchange rate will
also lower the expected value of the exchange rate and will lead to a de-
cline of the domestic interest rate below the world interest rate. From this
point on, however, exactly what path the domestic variables will follow
to the new steady state will depend on whether the adjustment path is
direct or cyclical. In Figure 10, we have illustrated the paths that will be
followed by e, /?, and r if there is a direct approach to equilibrium. A com-
parison with the rational expectations paths (Figure 8) indicates that the
economy's response to an increase in government spending will be quite
similar under both adaptive and rational expectations.25 The initial
changes in r and e provide the only differences between the two adjust-
ment processes. The behavior of the domestic interest rate following an
increase in government spending may once again provide the best evidence
of whether expectations are rational or adaptive. Under rational expecta-
25
This assumes that there is a direct rather than a cyclical adjustment process
under adaptive expectations.


GOVERNMENT SPENDING UNDER ADAPTIVE EXPECTATIONS
tions, one will see a sharp initial decline in the interest rate followed by a
gradual recovery to equality with the world interest rate, whereas under
adaptive expectations, one will see a gradual decline and a gradual re-
covery of the domestic interest rate.
SEMIRATIONAL EXPECTATIONS
Under semirational expectations, the initial effects of an increase in

government spending are again generated via a change in expectations.
Market participants will recognize that in the long run an increase in
government spending will lead to an increase in the price of the domestic
good and an appreciation of the exchange rate. The domestic interest rate
will therefore initially drop below the world rate to reflect the expected
appreciation of the domestic currency. Since this decline in the domestic
interest rate will create an excess demand for real balances, portfolio
adjustments will force an exchange rate appreciation to lower the price of
the imported good and to increase the real supply of money.
Unless the demand for money is highly sensitive to interest rate changes,
however, the initial appreciation of the exchange rate will be less than the
long-run expected appreciation.26 Since market participants will thus
26
The relationship between the initial appreciation of the exchange rate and
the long-run expected appreciation can be described as follows. The long-run
expected appreciation is given by
(Confd on p. 562.)


GOVERNMENT SPENDING UNDER SEMIRATIONAL EXPECTATIONS
anticipate an additional appreciation of the exchange rate, the domestic

interest rate will gradually increase but will remain below the world in-
terest rate until the new equilibrium is reached. As shown in Figure 11,
the initial discrete changes in the exchange rate and interest rates will be
followed by a gradual rise in the price of the domestic good, and a gradual
recovery of the domestic interest rate to equality with the world interest
rate.
Thus, in contrast to the situation following an increase in the money
supply, the adjustment paths generated by an increase in government
spending are quite similar under rational and semirational expectations
and only slightly different under adaptive expectations. All paths will
involve (1) an initial discrete appreciation (except under adaptive expecta-
tions) followed by a further gradual appreciation to the new steady state
value for the exchange rate, (2) a gradual increase in the price of the do-
mestic good, and (3) a temporary decline of the domestic interest rate
To maintain money market equilibrium, we must have
After this appreciation, Ee < e if X < 1 — a.

below the world interest rate. The only really distinguishing difference
between the various adjustment paths is that the domestic interest rate
will not undergo an initial discrete decline under adaptive expectations.
IV. Limitations of the Model and Conclusions
It is clear that our model of the effects of monetary and fiscal policy
under floating exchange rates is based on a number of assumptions that
not only simplify the analysis but also limit its generality. The most
important restrictions are imposed by the assumptions of a small country
and perfect capital mobility. The small-country assumption implies that
the economy faces a fixed world price for the imported good and a given
international interest rate. And the perfect capital mobility assumption
means that the domestic interest rate can differ from the world interest
rate only by the expected rate of depreciation of the exchange rate. Thus,
apart from exchange risks, domestic bonds are viewed as perfect sub-
stitutes for international bonds. As has been shown, these assumptions
are especially important for analyzing the effects of expansionary fiscal
policy, for they imply that the authorities can issue any quantity of bonds
that they desire without affecting the international interest rate. A more
complete analysis would make the international interest rate sensitive to
the quantity of bonds issued. In this situation, a higher level of debt-
financed government spending would raise the international interest rate
applied to domestic bonds. This means that one would see a smaller
appreciation than in the small-country case, or possibly even a deprecia-
tion of the exchange rate. The incorporation of these effects will be an
important part of future work.
It is usually argued that the manner in which the private sector formu-
lates the expectations will play a crucial role in determining the economy's
response to monetary and fiscal policy. Table 1 summarizes the nature of
the adjustment processes generated by either an increase in the nominal
money supply or an increase in government spending for a small, open
economy with a floating exchange rate. What is surprising about Table 1,
however, is the rather similar qualitative nature of the adjustment processes
under the different expectations structures. Perhaps the only way to estab-
lish which expectations structure best describes the economy's actual
expectations structure is to examine the behavior of nominal interest
rates following an increase in the money supply. An increase in the nominal
money supply will initially force the interest rate to decline if expectations
are rational, and to first rise sharply and then decline sharply if expecta-
tions are semirational; it will have only a gradual impact on the interest

TABLE 1. SMALL, OPEN ECONOMY WITH FLOATING EXCHANGE RATE: ADJUSTMENT

PATHS GENERATED BY INCREASE IN NOMINAL MONEY SUPPLY
AND IN GOVERNMENT SPENDING
Expectations Structure
Rational Adaptive 1 Semirational
Effects of increase in
money supply
Initial impact
Price of domestic good None None None
Interest rate Decline None Sharp rise fol-
lowed by
sharp decline
Exchange rate Depreciation Depreciation Depreciation
Medium-term impact
Price of domestic good Gradual rise Gradual rise Gradual rise
Interest rate Gradual rise Gradual rise Gradual rise
and then
decline
Exchange rate Gradual ap- Gradual ap- Gradual appre-
preciation preciation ciation
Effects of increase in
government spending
Initial impact
Price of domestic good None None None
Interest rate Decline None Decline
Exchange rate Appreciation None Appreciation
Medium-term impact
Price of domestic good Gradual rise Gradual rise Gradual rise
Interest rate Gradual rise Gradual de- Gradual rise
cline fol-
lowed by
gradual
rise
Exchange rate Gradual ap- Gradual ap- Gradual appre-
preciation preciation ciation
1
If direct approach to equilibrium.
rate if expectations are adaptive. Unfortunately, even these criteria cannot

be used to distinguish between the different expectations structures if one
is concerned with the economy's response to an increase in government
spending. Only under adaptive expectations is the behavior of the interest
rate qualitatively different from that under either rational or semirational
expectations.
There are, however, some important quantitative differences between
the behavior of exchange rates and interest rates under the alternative
expectations structures. Following an increase in the money supply, the
largest initial interest rate changes will occur under semirational expecta-
tions, and the smallest under adaptive expectations. The initial deprecia-

tion of the exchange rate produced by an increase in the money supply

will be larger under adaptive expectations than under rational expectations.
APPENDICES
I. Notation
Unless otherwise noted, each variable represents the log of the original variable
(a capital letter denoting the nonlog value):
m = nominal money supply
p = price of domestic good
p* = international price of imported good
c = exchange rate (domestic currency/foreign currency)
y = real output
r = domestic interest rate (not as log)
r* — world interest rate (not as log)
pe = expected price of domestic good
ee — expected exchange rate
E€ = long-run expected exchange rate (under semirational expectations)
BG = stock of outstanding government bonds (not as log)
to = lump-sum taxes (not as log)
h = income tax rate (not as log)
YD = nominal disposable income (not as log)
g = government spending as proportion of private spending on the domestic good
(not as log)
D
B - private holdings of domestic government bonds (not as log)
D = domestic demand for the domestic good (not as log)
II. Rational Expectations
Under rational expectations, the adjustment process will be described by

(18)
(19)
(20)
These three relationships can be reduced to two differential equations in e and p of

the form
with A = — X(l— <nra)

For this system to have a stable saddle point path, one must have
(21)
(22)
This condition will be satisfied only if A>0 or 1 — aira > 0.

The slopes of the c=0 and />=0 curves given in Figure 1 will therefore equal
The saddle point path that will allow the economy to return to a stable equilibrium
and still maintain perfect foresight will be given by
Since both the numerator and denominator go to zero as the steady state equi-
librium is approached, one can evaluate the slope of the preceding expression by using
L'Hopital's rule. Thus,
The solutions for ire given by
then this system Jias two roots—one positive and one negative. One can show
that the positive root implies a path that has a slope greater than the p = 0 curve—an
unstable path. The negative root is thus the stable path.

III. Adaptive Expectations
Under adaptive expectations, the adjustment process will be described by

(23)
(24)
(25)
(26)
(27)
e
These five relationships can be reduced to three differential equations in /?, e , and pe.
Thus,
with
Sufficient conditions for this system to be stable are
(28)
(29)
Condition (29) will be satisfied only if
IV. Semirational Expectations
Since the extrapolative component of semirational expectations affects the adjust-

ment path only at the initial instant of time when the policy change is announced, the
stability of the adjustment process is determined by the behavior of the economy under
the learning component. Using the condition for money market equilibrium (equa-
tion (2)), the definition of the learning component of semirational expectations (equa-
tions (7)-(12)), and the conditions for goods market equilibrium (equation (14)), one can
show that the adjustment paths for all the endogenous variables can be derived from
the path for p. The differential equation describing the path for p will be given by

This system will be stable if
which will be true if
BIBLIOGRAPHY
Box, George E. P., and Gwilym M. Jenkins, Time Series Analysis: Forecasting
and Control (San Francisco, 1976).
Daniel, Betty C., "Analysis of Stabilization Policies in Open Economies under
Conditions of Inflation and Inflationary Expectations" (unpublished doctoral
dissertation, University of North Carolina, 1976).
Dornbusch, Rudiger, "Expectations and Exchange Rate Dynamics," Journal of
Political Economy, Vol. 84 (December 1976), pp. 1161-76.
Feige, Edgar L., and Douglas K. Pearce, "Economically Rational Expectations:
Are Innovations in the Rate of Inflation Independent of Innovations in
Measures of Monetary and Fiscal Policy?" Journal of Political Economy,
Vol. 84 (June 1976), pp. 499-522.
Friedman, Milton, "The Case for Flexible Exchange Rates," in his Essays in
Positive Economics (University of Chicago Press, 1953), pp. 157-203.
Isard, Peter, "The Process of Exchange-Rate Determination: A Survey of Impor-
tant Models and Major Issues," Board of Governors of the Federal Reserve
System, International Finance Discussion Paper No. 101 (January 1977).
Johnson, Harry G., "The Case for Flexible Exchange Rates, 1969," in his Further
Essays in Monetary Economics (Harvard University Press, 1973), pp. 198-228.
Knight, Malcolm, "Output, Prices, and the Floating Exchange Rate in Canada:
A Monetary Approach" (unpublished, International Monetary Fund,
December 30, 1976).
Kouri, Pentti J. K., "The Exchange Rate and the Balance of Payments in the
Short Run and in the Long Run: A Monetary Approach" (unpublished,
International Monetary Fund, December 17, 1975).
Machlup, Fritz, The Alignment of Foreign Exchange Rates: The First Horowitz
Lectures (New York, 1972).
Mathieson, Donald J., "Monetary Interdependence Under Flexible Exchange
Rates" (unpublished, International Monetary Fund, March 2, 1976).
McKinnon, Ronald L, review of Fritz Machlup, The Alignment of Foreign Ex-
change Rates: The First Horowitz Lectures, in Journal of International Eco-
nomics, Vol. 5 (February 1975), pp. 99-101.
Shafer, Jeffrey Richard, "The Macroeconomic Behavior of a Large Open Econ-
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Yale University, 1976).
Sohmen, Egon, Flexible Exchange Rates: Theory and Controversy (University
of Chicago Press, 1961).

(IMF Staff Papers) The Impact of Monetary and Fiscal Policy Under Flexible Exchange Rates and Alternative Expectations Structures

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(IMF Staff Papers) The Impact of Monetary and Fiscal Policy Under Flexible Exchange Rates and Alternative Expectations Structures

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The Impact of Monetary and Fiscal

Policy Under Flexible Exchange

D URING THE 1960s, a number of notable economists including Fried-

* Mr. Mathieson, economist in the Financial Studies Division of the Research

©International Monetary Fund. Not for Redistribution

While it is still unclear whether these exchange rate movements reflect

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analysis of inflationary expectations in the United States indicates that

where Pt = inflation rate at time /

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an increase in government spending. In general, the economy's response

I. The Basic Model

To facilitate a comparison between our results and those derived in the

THE MONEY MARKET

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the money market is in equilibrium when the supply of real money

THE GOODS MARKET

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it is assumed that there are three possible expectations structures—rational,

We refer to dEX as the extrapolative component of semirational expecta-

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We refer to this as the "learning" component of the semirational expecta-

II. An Increase in the Nominal Money Supply

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Under rational expectations, equations (l)-(4) can describe the adjust-

The equilibrium t and p will thus equal

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FIGURE 1. ADJUSTMENT PROCESS UNDER RATIONAL EXPECTATIONS

this curve will produce a depreciation (appreciation) of the exchange rate.10

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The presence of this saddle point path implies a Harrod-Domar "knife-

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FIGURE 2. IMPACT OF AN INCREASE IN THE MONEY SUPPLY

rate thus restores instantaneous equilibrium to the money market not

To describe the impact of an increase in the money supply under adap-

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diverge for extended periods of time. To draw a comparison with the

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FIGURE 3. ADJUSTMENT PROCESS UNDER ADAPTIVE EXPECTATIONS

rium (p = O).13 The EE line in Figure 3 represents the combinations of

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equilibrium is restored to the money market following an increase in the

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expectations. In Figure 5, panel A portrays the adjustment process under

FIGURE 5. ADJUSTMENT PROCESSES GENERATED BY AN INCREASE IN THE

B. ADAPTIVE EXPECTATIONS DIRECT APPROACH

C. ADAPTIVE EXPECTATIONSùCYCLICAL APPROACH

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path under adaptive expectations. Under rational expectations, an increase

Under semirational expectations, market participants will have some

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FIGURE 6. IMPACT OF AN INCREASE IN THE MONEY SUPPLY

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To calculate the medium-term effects of the increase in the money

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III. An Increase in Government Spending

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by issuing or retiring bonds. The government budget constraint can there-

where B° = the stock of government bonds

or, using r = r*+ee

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Before we consider the actual adjustment paths generated under the