Dynamic stability conditions might differ for

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dynamic stability conditions might differ for alternative policy assignments and could therefore be used to assess the appropriateness of the policy mix. Related work by Mundell (1960) investigated the relative efficacy of fixed and flexible exchange rates in helping countries adjust to economic shocks. Mundell showed that the answer depended on government policy rules, the speed of domestic price-level adjustment in the face of excess or deficient demand, and the degree of capital mobility. Mundell’s emphasis on the role of differential sector adjustment speeds in determining an economy’s dynamic behavior proved influ- ential in other contexts—for example, in Dornbusch’s (1976) Mundellian model of exchange-rate overshooting. In one of his most celebrated contributions, Mundell (1963) took the speed of capital market adjustment to an extreme. With perfect capital mobility, he showed, only fiscal policy affects output under fixed exchange rates; monetary policy serves only to alter the level of international reserves. In contrast, fiscal policy might be dramatically weakened under floating rates. One implication of this anal- ysis, which was not seen right away, was that the balance of payments might be a misleading indicator of external balance in a world where central banks could in principle borrow reserves in world capital markets. A more relevant concept of external balance would have to focus on the long-run solvency of the private and public sectors, taking into account vulnerabilities that might expose a country to a liquidity crisis. The Mundellian idea of the policy mix was a major conceptual advance and seemingly offered an elegant way to avoid unpleasant tradeoffs. But the approach had at least two theoretical drawbacks. First, Mundell’s theoretical specification of the capital account as a flow function of interest rate levels (a formulation used by Maurice Obstfeld 6
Fleming (1962) as well) was theoretically ad hoc. It implied, implausibly, that capital would flow at a uniform speed forever even in the face of a constant domestic-foreign interest differential. The second problem, already mentioned, was the definition of external balance in terms of official reserve flows, rather than in terms of attaining some satisfactory sustainable paths for domestic consumption and investment. As a medium-term proposition, it would be unattractive, perhaps even infeasible, to maintain balance of payments equilibrium through a permanently higher interest rate. The results of such a policy—crowding out of domestic invest- ment and an ongoing buildup of external debt—would eventually call for a sharp drop in consumption. 6 While Mundell’s framework was perhaps useful for thinking about very short-run issues (such as the need to maintain adequate national liquidity), it failed completely to bridge the gap from the short run to the longer term.

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