Exchange Rate, Output and Macroeconomic Policy: A Structuralist Approach

Moumita Basu, Ranjanendra Narayan Nag, Bhaskar Goswami


Current account imbalance and concomitant macroeconomic
instability in emerging market economies have been major issues of
recent macroeconomic modelling. This paper addresses these issues by
asking how international interdependence has impinged on key
macroeconomic variables and policy options. There are three assets:
domestic bonds, foreign bonds and money. Domestic bonds and foreign
bonds are imperfect substitutes due to presence of risk premium. The
striking features of the model include endogenous risk premium and
balance sheet effect on investment demand due to exchange rate
depreciation. We use a simple open economy structuralist macro model
that explains the interaction between current account adjustment and
exchange rate dynamics. The balance sheet effect and the risk premium
together explain how fiscal expansion or monetary expansion may have
both short run and long run contractionary effect on the output level
with worsening current account balance in the short run. JEL
Classifications: F41, F32, E52, E62 Keywords: Current Account, Exchange
Rate, Risk Premium, Balance Sheet Effect

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