Real Adjustment and Exchange Rate Dynamics.pdf

# In figure 95 the new long run equilibrium at z

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In figure 9.5 the new long-run equilibrium at Z depicts what we consider to be the more plausible case—that the resource boom causes a long-run real appreciation. Note that the condition for IT to fall (b 2 < 0) is identical to the condition that k fall in equation (15). n If the manufactur- ing sector is small in its use of capital so that the expulsion of labor to the services sector is small, real appreciation will ensue. Manufacturing output also falls unambiguously in model 2. The capital stock in that sector falls, but there is the possibility, associated with real depreciation, that labor input per unit of capital rises. That rise, however, 12. It also is easily shown that if b 2 is negative so that the long-run effect is a fall in the real exchange rate, that fall is less than the short-run effect given by (8).

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298 J. Peter Neary/Douglas D. Purvis K' K Fig. 9.5 Equilibrium effects of a resource boom. cannot be large enough to lead to a net increase in manufacturing output. Using the labor demand condition (5) and the labor market equilibrium condition (8), the logarithm of manufacturing output can be written as: Using the definition of e, the coefficient of k M is seen to be positive. Hence the level of manufacturing output falls by more the greater the outflow of capital into the benzine sector: the direct output-reducing effect of this outflow is more than sufficient to offset any reduction in costs brought about by a real depreciation. 9.2.4 Short-Run Dynamics Using the long-run solutions (19), the dynamic adjustment equation (17) can be rewritten as (17') k M The dynamics can now be illustrated in figure 9.5 where on impact, with k M fixed, the economy moves from the initial equilibrium E o to E x .
299 Real Adjustment Since the labor market clears continually, and by (17') k M declines steadily to k M * , the economy follows the path E X Z' marked by the arrows along L'L'. In the short run the real exchange rate overshoots its long- run value. 13 This overshooting is the result of Marshallian dynamics: it is worth repeating that it is overshooting the real exchange rate, in response to real shocks, and caused by real inertia. 9.3 Real Shocks and the Nominal Exchange Rate In this section we combine the real model of resource allocation and output of the previous sections with a simple monetary model of nominal exchange rate determination in order to examine the effect of a resource boom on the nominal exchange rate. The nominal money stock is treated as exogenously determined; we continue to assume that relative prices adjust instantaneously to clear markets so that there is no role for monetary policy. As before, the dynamics of the model arise from the adjustment of sectoral capital stocks in response to perceived changes in returns. International financial markets are treated as being closely integrated.

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