world. This line can naturally vary over time. For our analysis we will
assume that it is fixed in the short run.
The model I will use is the standard Keynesian model with the as-
sumptions about the aggregate supply: the supply curve is sloped up-
ward and static. There are no real shocks. The shift in the aggregate
demand curve will cause an increase in the GDP with an adjustment
to the price level. That is the money can influence real variables, but
there will be some increase in prices as well. The Hick’s assumption
of liquidity trap is strongly rejected. Furthemore all liquidity con-
straints are eliminated, because the country can borrow money from
the rest of the world, thus the government deficit, government budget
and capital spending by the government would be exogenous. The
economy can undergo strong inflation due to devaluation of the cur-
rency on the foreign open market or due to an increase in the mone-
tary base.
Further assumptions are that there are clearances in the markets and
that the unemployment rate is involuntary. There is some level of un-
employment were everybody in the economy can find a job if they are
looking for it. The assumption about the unemployment comes di-
rectly from Keynes.
Here is the model. The basic function is that GDP has four separate
functions: public consumption, investment, government spending (as
usual here are only real spending and not government transfers) and
the current account, which is composed of the import and export
functions.
Y = C + I + G + (IM - EX)
Y - Gross domestic product
C - Consumption function
G - Government spending
IM - imports
EX - exports
2.1 THE CONSUMPTION FUNCTION
C(Y, r, ð, W/P, E/P)
Consumption is the function of the following variables:
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r – real interest rate
ð - inflation rate
W/P - real wage and P is the price level
E/P - real exchange rate
The consumption has a positive relationship with the real wage. The
reasons for this is simple; as the economy is producing more goods
the consumption will go up. An increase in nominal wage will stimu-
late consumption in the short run through the inflation, while increas-
ing the real wage will affect the variable part of consumption. The
variable consumption function has an inverse proportional relation-
ship with the real and nominal exchange rate, as well as the interest
rate. This is only a small part of consumption, but nominal and real
appreciation will decrease the demand for the foreign goods.
The consumption function can be written in the following format:
C= c°(-r,y) + A + c(y, -r, -E/P, W/P)
Where A is
A = z + (y, E/P)
c° is the autonomous consumption give as a function of c°(-r,y). “A”
is the demand for imports, which is the function of the autonomous
demand for imports z and the variable part which is a function of real
GDP and real exchange rate.
Here I am making an assumption there will be always demand for
some imports because we are dealing with a small open economy that
is not self-sufficient.
The only time the autonomous demand for imports can change is if
the economy becomes self-sufficient or there is a long-term constant
depreciation of the real exchange rate. This will cause cause the
agents to adjust their long term demand for imports.
2.2 INVESTMENT FUNCTION
I (E/P, A*, CM)
A* - foreign demand for the domestic (Croatian) goods
I= i(-r)° + i(CM) – iA*(CM,E/P)
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The investment function is composed of the autonomous investments
i(-r)°. Autonomous investment depends inversely on the medium
term movements in the real interest rate. The second part of the in-
vestment function is the foreign investments. These investments will
depend only on the capital mobility curve or the current level of real
interest rate that is imposed on the country by the world. The third
part of the investment function is the investments made abroad. These
investments can be in the form of exports or actual contracts between
the Croatian firms and the firms from other countries. The investment
from Croatia to the rest of the world will depend on the temporary dis-
equilibrium between IS-LM-CM and the long run trend in the real ex-
change rate. (note: long run changes in the real exchange rate will not
be analyzed)
The main part I have to stress here is that we assume that there is a
strong existence of the Feldstein-Horioka paradox. That is I?S. The
country can run a deficit on its current account, without running a sur-
plus on the capital account and vice versa. This is a necessary side ef-
fect of perfect capital mobility. Due to this effect, we have perfect
capital mobility.
2.3 THE GOVERNMENT SPENDING
Like in most Keynesian models, this model assumes that the govern-
ment spending is an exogenous variable. Although I will assume that,
the government can determine its spending and run an unlimited
amount of deficit through the foreign debt; Croatian reality is much
more different and I will address the Croatian foreign debt and fiscal
deficit as a separate issue because it is not just a long term, but a
short-term problem.
The main assumption behind the government spending being exoge-
nous is the fact that government collects taxes and all of the budget
deficit can be financed through either domestic or foreign borrowing.
Ricardian equivalence is ignored here and assumed to be undone like
proposed in the (Barsky, Mankiew, Zeldes 1986).
2.4 IMPORT FUNCTION
Import as a function is dependent on the following variables:
IM (E, E/P, Y, CM)
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NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
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