Exchange Rate Dynamics,Endogenous Risk Premium and the Balance Sheet Effect: An Effective Demand Model

Abstract

This article describes a macroeconomic framework for analysing the interaction between output, domestic interest rate and exchange rate in the presence of the endogenous risk premium and balance sheet effect of exchange rate depreciation on investment demand. Output is demand determined. There are three assets: money, domestic bonds and foreign bonds. Domestic bonds and foreign bonds are not perfect substitutes due to the presence of risk premium. The endogenous risk premium depends on certain macroeconomic fundamentals, namely budget deficit and current account balance. Using this framework, we will examine implications of monetary policy, fiscal policy, tariff liberalization and global interest rate hike for exchange rate dynamics and output. The balance sheet effect and the risk premium together explain how an expansionary fiscal policy may generate recession, while tariff liberalization may produce favourable macroeconomic outcomes. Moreover, the model shows that an increase in world interest rate may have contractionary effect on the domestic output level due to the presence of the balance sheet effect of exchange rate depreciation.

JEL Classification: E27, E63, F13, F32

Keywords

Risk premium exchange rate dynamics balance sheet effect effective demand output

Introduction

The role of risk premium in determining macroeconomic outcomes of an emerging market economy has been a central topic in recent macroeconomic modelling. The reason why risk premium arises is that investors expect to be properly compensated for the amount of risk they undertake in the form of a risk premium, or additional returns above the rate of return on a risk-free investment. The fact that capital flow, exchange rate movement and risk premium are interconnected is well recognized in the literature, but the usual accounts miss some essential aspects of an emerging market economy, namely macroeconomic imbalance and the associated increase in risk premium acting as a trigger of macroeconomic crisis. The immediate implication of macroeconomic crisis is substantial output and employment loss. The motivation for writing this article is to fill this gap in the literature.

Different episodes of financial crisis have indicated sudden stop in capital flow and an increase in risk premium. The question is how rise in risk premium may act as a trigger of financial crisis. One plausible explanation is gradual weakening of macroeconomic fundamentals attributable to fiscal profligacy. It has been observed that expansionary policies representing macroeconomic populism¹ lead to initial expansion of output and employment in the presence of substantial excess capacity. Overtime, such populist policies lead to unmanageable fiscal imbalances coupled with current account deficit and increase in debt to the GDP ratio. As a result, risk premium begins to rise and capital outflow is inevitable. This is combined with the adverse balance sheet effect of exchange rate depreciation. The explanation is simple. Post globalization, external commercial borrowing has emerged as a significant component of capital inflows. However, this is associated with currency mismatches. While debt is denominated in foreign currencies, revenue is earned in domestic currencies, as is often the case in emerging market economies. Exchange rate depreciation causes rise in debt service charges and adversely affects balance sheet of a firm. Since net worth declines, firms fail to undertake new investment projects and thus private investment is adversely affected. The net effect of depreciation may prove to be contractionary if the negative balance sheet effects on private investment dominate the positive pro-competitive effects on net exports.² Thus rise in risk premium and consequent exchange rate depreciation may act as a trigger leading to sharp capital outflows and outright economic collapse. In this article, we construct an effective demand model to explain how the expansionary policies may have contractionary implications due to rise in risk premium, exchange rate depreciation and fall in investment.

Some recent works on the issue of risk premium and its associated macroeconomic implications are worth mentioning (see, e.g., Engel, 2016). Wu (2015) has found that the negative-risk premium in the interest rate plays a pivotal role in influencing the magnitude of sterilization and in inducing endogenous change in the exchange rate. What we have attempted is to address macroeconomic crisis that may be triggered of by endogenous adjustment in risk premium. In its orientation, this article is closer to the works of Dornbusch (1983), Krugman (1999, 2003), Blanchard, Giavazzi, and Sa (2005) and Sikdar (2014). Dornbusch (1983) introduced the endogenous risk premium which is related to relative asset supplies and to the distribution of wealth. In his model, the domestic outside debt and domestic wealth play a crucial role in determining risk premium. Krugman (1999, 2003) emphasized the role of firm’s balance sheets in explaining financial crisis in South-East Asian countries. Blanchard et al. (2005) investigated current account imbalance and exchange rate dynamics using a model of the portfolio balance approach. However, what is left out in such works is adjustment in the real sector since these models of exchange rate dynamics are essentially full employment models. A notable exception is the paper by Sikdar (2014). The paper considered macroeconomic implications of endogenous risk premium in an effective demand model. The article discussed how different macroeconomic policies influence output level through adjustment in the risk premium. However, Sikdar (2014) left out the role of balance sheet effect of exchange rate depreciation on investment.

This article constructs a dynamic open economy macroeconomic model in which output is demand determined. Aggregate demand of the economy consists of consumption expenditure, investment expenditure, government expenditure and net exports (NX). Government imposes an ad valorem tariff rate on importable. The tariff revenue is redistributed to the public and hence, tariff revenue plays an important role in determining both consumption expenditure and import demand as well. Investment expenditure is expressed as an inverse function of both the real interest rate and real exchange rate which captures the balance sheet effect of exchange rate depreciation. The asset structure of the economy includes money, domestic bonds and foreign bonds. Domestic bonds and foreign bonds are considered to be imperfect substitutes in the presence of risk premium which is positively related to budget deficit (BD) and negatively related to NX. An abrupt increase in risk premium raises serious doubts about overall macroeconomic stability of an economy. And this may be compounded by down grading of credit worthiness of an economy by global credit rating agencies and International Monetary Fund as well. This article looks into this aspect by introducing an endogenous risk premium. The model captures exchange rate dynamics which is subject to interest rate differential and risk premium under rational expectation. On the other hand, output dynamics depends on disequilibrium in the commodity market. It is instructive to note that the study of any adjustment process in the wake of any shock needs an analysis of transitional dynamics as the system moves from one steady state to new one. The analysis of details of transitional dynamics is couched in terms of the hypothesis of overshooting or undershooting of exchange rate.³

The remainder of the article is organized as follows. The second section describes the model. The comparative static exercises are examined in the third section. The final section summarizes the main results and offers some concluding remarks.

The Model

The salient features of the model are as follows. Aggregate output of the economy is demand determined. The economy has an investment demand which is inversely related to the real exchange rate and interest rate. There are three assets: money, domestic bonds and foreign bonds. Domestic bonds and foreign bonds are not perfect substitutes due to the presence of risk premium. The endogenous risk premium depends on BD and on NX. The government imposes a tariff on importable. Here, we assume that the tariff revenue is redistributed by the government and hence, disposable income includes tariff revenue. The exchange rate dynamics is subject to interest rate differential and risk premium under rational expectation. On the other hand, excess demand in the commodity market drives output adjustment overtime.

Aggregate Demand

Aggregate demand (AD) consists of consumption expenditure, investment expenditure, exogenous government expenditure and NX.

\begin{matrix} A D = C (Y - t Y + τ M \frac{e P ​ *}{P}) + I (\frac{e P ​ *}{P}, r) \\ + G + N X [\frac{e P ​ * (1 + τ)}{P}, (Y - t Y + τ M \frac{e P ​ *}{P})] . \end{matrix}

(1)

Now, consumption expenditure is expressed as a positive function of disposable income, that is, the income after payment of taxes (tY ) including tariff revenue ( $τ M \frac{e P *}{P} $ )⁴ as well. Investment demand is an inverse function of the real exchange rate and interest rate. The NX are negatively related to the disposable income. Consequently, any change in tariff-inclusive real exchange rate $(\frac{e P *(1+ τ)}{P}) $ has an ambiguous effect on NX.⁵

Any excess demand in the product market causes adjustment in output level, that is, output tends to increase overtime in response to excess demand in the commodity market.

Thus, we obtain

\dot{Y} = α (A D - Y ​), α >0 .

(1')

Here, ‘α’ represents the speed of adjustment of output in response to excess demand.

Money Market

The money market equilibrium is

\frac{M_{s}}{Q [e P^{*} (1+ τ), P]} = L (r, Y ​) . ​

(2)

The left-hand side of Equation (2) represents real money balance, the ratio of stock of money (M_s) to the consumer price index (Q). The consumer price index can be expressed as a function of tariff-inclusive exchange rate, domestic price and foreign price. The right-hand side of Equation (2) represents demand for money which is positively related to the output and varies inversely with the interest rate.

Interest Rate Parity Condition with Endogenous Risk Premium

In this article, domestic and foreign currency bonds are considered to be imperfect substitutes. Hence, equilibrium in the foreign market requires that the domestic interest rate equals the sum of the foreign interest rate, expected change in exchange rate and a risk premium, ρ, that reflects the difference between the riskiness of domestic and foreign bonds:

r = r ​ *+ \frac{\dot{e}}{e} + ρ (B D, N X ​), ρ_{1} = \frac{\partial ρ}{\partial (B D)} >0, ρ_{2} = \frac{\partial ρ}{\partial (N X)} \leq 0 ​

(3)

In this model, risk premium is endogenous in the sense that it depends on the government BD and the NX (see Sikdar, 2014). Dornbusch (1983) also considered endogenous risk premium which depends on the wealth and external debt of a country. However, we abstract from effects of wealth and debt as well. The justification is as follows. The accumulation of debt depends on the BD, while wealth dynamics is positively related to NX. We have incorporated both NX and BD as determinants of risk premium. Risk premium arises because risk averse individuals need to be compensated for bearing currency risk that an uncovered foreign currency investment involves. An investment in a developing country is considered to be riskier than investment in home market (see Mark, 2001).

Now risk premium is given by

ρ = ρ (B D, N X), ρ_{1} = \frac{\partial ρ}{\partial (B D)} >0 and ρ_{2} = \frac{\partial ρ}{\partial (N X)} \leq 0, ​

where B D = G - t Y

N X = N X [\frac{e P^{*} (1 + τ)}{P}, (Y - t Y + τ e P^{*} M)] ​

(4)

An increase in government expenditure raises BD leading to increase in risk premium. On the other hand, an increase in tax rate or output level raises the tax revenue of government which in turn reduces BD. This leads to decrease in risk premium.

Now overtime adjustment of exchange rate depends on the interest rate differential and endogenous risk premium as represented by Equation (3'),

\frac{\dot{e}}{e} = r - r ​ * - ρ (B D, N X ​) ​

(3')

From Equation (3'), it is clear that an increase in domestic interest rate leads to $\dot{e} >0, $ while an increase in BD as well as risk premium implies $\dot{e} \leq 0 $ . Moreover, an increase in NX reduces risk premium leading to $\dot{e} >0 $ .

Dynamic Adjustment and Stability

Based on Equation (1'), the dynamic adjustment of output can be represented as a function of output and exchange rate as well, and it is given by

\begin{matrix} \dot{Y} = f (Y, e) \\ w h e r e \\ f_{1} = {\frac{d \dot{Y}}{d Y} |}_{e} = - α \\ f_{2} = {\frac{d \dot{Y}}{d e} |}_{Y} = ϕ_{3} + r_{e} ϕ_{4} [w h e r e, ϕ_{3} = α (C_{e} + I_{e} + N X_{e}) ≷ 0, \\ a n d ϕ_{4} = I_{r} \leq 0, r_{e} = \frac{\partial r}{\partial e} > 0, \\ C_{e} = \frac{\partial C}{\partial e} ≷ 0, I_{e} = \frac{\partial I}{\partial e} \leq 0, a n d, N X_{e} = \frac{\partial (N X ​)}{\partial e} ≷ 0] . \end{matrix}

(5)

Let us interpret partial effect of each variable on output dynamics. An increase in the output level generates excess supply in the product market which in turn causes a decrease in output overtime and hence f₁ < 0. An increase in exchange rate raises the consumer price index leading to decrease in real money balances and hence interest rate rises. This higher interest rate and balance sheet effect of exchange rate depreciation together result in lower investment demand. Moreover, the effect of exchange rate depreciation on the tariff revenue depends on the elasticity of import demand. Hence, both consumption expenditure and NX change ambiguously in response to higher exchange rate. So the exchange rate depreciation has an ambiguous effect on aggregate demand. In this article, however, we emphasize the negative effect of exchange rate depreciation on aggregate demand which entails a decrease in output overtime, that is, f₂ < 0.

On the basis of Equation (5), we obtain a locus of combination of output and exchange rate such that the commodity market is at equilibrium, that is, $\dot{Y} =0 $ . Let us explain this. An increase in exchange rate may lead to $\dot{Y} \leq 0 $ as mentioned earlier. Hence, output gradually falls overtime to restore equilibrium in the commodity market. Therefore, we get a negative relation between exchange rate and output level to maintain commodity market equilibrium, as represented by the downward sloping YY schedule in Figure 1(a) or 1(b). Hence, the slope of YY curve is

{\frac{d e}{d Y} |}_{\dot{Y} =0} = - \frac{f_{1}}{f_{2}} \leq 0 .

Based on Equation (3'), the exchange rate dynamics can be written as a function of output and exchange rate and it is represented as

\begin{array}{l} \begin{matrix} \dot{e} = g (Y, e) \\ w h e r e \\ g_{1} = {\frac{d \dot{e}}{d Y} |}_{e} = δ_{1} + δ_{4} r_{Y} [h e r e, δ ​_{1} = - (ρ_{1} B D_{Y} + ρ_{2} N X_{Y}) ≷ 0, B D_{Y} \\ = \frac{\partial (B D)}{\partial Y} \leq 0, N X_{Y} = \frac{\partial (N X)}{\partial Y} \leq 0, a n d r_{Y} = \frac{\partial r}{\partial Y} > 0] \end{matrix} \\ \begin{matrix} g_{2} = {\frac{d \dot{e}}{d e} |}_{Y} = δ_{2} + δ_{4} r_{Y} [h e r e, δ_{2} = - ρ_{2} N X_{e}, a n d N X_{e} \\ = \frac{\partial (N X)}{\partial e} ≷ 0, δ_{4} = \frac{\partial \dot{e}}{\partial r} = 1] . \end{matrix} \end{array}

(6)

Let us analyse the partial effect of each variable on exchange rate dynamics. An increase in output raises demand for money which results in higher domestic interest rate. This increase in interest rate has a positive impact on exchange rate dynamics. Moreover, higher output causes higher tax revenue and hence lower BD as well. On the other hand, NX decrease due to increase in output. Therefore, there are two opposite effects on risk premium. If negative effect of lower BD dominates the positive effect of lower NX, then the risk premium falls which in turn entails $\dot{e} >0 $ . Opposite case may appear if risk premium increases and if this increase in risk premium outweighs the increase in interest rate. From this interpretation, it is clear to say that any change in output has ambiguous effect on exchange rate dynamics and hence the sign of g₁ is ambiguous. An increase in exchange rate raises consumer price index (Q) which causes a lower real money balance and hence a higher domestic interest rate. However, exchange rate depreciation has an ambiguous effect on NX and hence, on risk premium. Hence, there are two effects on $\dot{e}$ . Here, we consider the stable case in which exchange rate depreciation leads to $\dot{e} >0$ and hence g₂ > 0.

On the basis of Equation (6), we also obtain a locus of combination of output and exchange rate such that balance of payment equilibrium has to be maintained, that is, $\dot{e} =0 $ . Let us explain this. An increase in output has ambiguous effect on $\dot{e}$ . If g₁ > 0, then the exchange rate will appreciate to restore the foreign exchange market equilibrium. Consequently, we get a negative relation between output and exchange rate as represented by downward sloping BB schedule in Figure 1(a). Hence, the slope of the BB curve is

{\frac{d e}{d Y} |}_{\dot{e} =0} = - \frac{g_{1}}{g_{2}} \leq 0 .

In contrast, if g₁ < 0, exchange rate will depreciate to maintain the balance of payment equilibrium. Therefore, we get a positively sloped BB schedule as shown in Figure 1(b). In this case, the slope of the BB curve is

{\frac{d e}{d Y} |}_{\dot{e} =0} = - \frac{g_{1}}{g_{2}} >0 .

In Figure 1(a) or 1(b), the steady state equilibrium is represented by the point E at which $\dot{Y} =0$ and $\dot{e} =0 .$

Now we concentrate on the stable arm of the system as it gives economically meaningful results. In the presence of perfect foresight, the existence of unique convergent saddle path requires the presence of one positive and one negative characteristic root such that the determinant $Δ = | \begin{matrix} f_{1} & f_{2} \\ g_{1} & g_{2} \end{matrix} | \leq 0 . $

This condition is satisfied if the $\dot{Y} =0$ locus is steeper than the $\dot{e} =0$ locus as shown in Figure 1(a) or 1(b). The saddle path SS is downward slopping and flatter than the $\dot{e} =0 $ locus. The equation of the saddle path is $(e - {\bar{e}}_{}) = (\frac{λ_{1} - f_{1}}{f_{2}}) (Y - {\bar{Y}}_{}) = (\frac{g_{1}}{λ_{1} - g_{2}}) (Y - {\bar{Y}}_{}) . $

Saddle path is negatively sloped in Figure 1(a). In contrast, Figure 1(b) shows positively sloped saddle path. For a given level of Y, the economy chooses appropriate level of exchange rate on the saddle path SS and moves towards the stationary equilibrium, E.

Figure 1.

Source: Authors’ own.

Comparative Static Exercises

In this section, we will examine implications of monetary expansion, fiscal expansion and tariff liberalization and world interest rate hike for exchange rate, output and employment.

Expansionary Monetary Policy

An expansionary monetary policy lowers the domestic interest rate which in turn results in higher investment demand and hence, higher aggregate demand. This causes $\dot{Y} >0$ as obtained from Equation (1'). Consequently, the YY schedule shifts rightward as shown in Figure 2(a) or 2(b). On the other hand, the decrease in domestic interest rate makes domestic bonds less attractive relative to foreign bonds. It causes an outflow of foreign capital. According to Equation (3'), we obtain $\dot{e} \leq 0$ which in turn leads to upward shift of the BB schedule as represented by Figure 2(a) or 2(b).

Therefore, expansionary monetary policy has ambiguous effect on the steady state output level and exchange rate. In this article, however, we focus on the case in which monetary expansion results in decrease in output level and increase in exchange rate such that the BB schedule shifts more than the YY schedule in Figure 2(a) or 2(b).

In Figure 2(a) or 2(b), the new steady state equilibrium point E₂ shows higher exchange rate and lower output. Let us explain the dynamic adjustment process. An expansionary monetary leads to immediate jump of the exchange rate at given output and hence, in the short run, the system instantly moves from the point E₁ to the point E' on the new saddle path S’ S’. The increase in exchange rate reduces output overtime and the economy converges to the point E₂ in the long run.

According to Figure 2(a), this decrease in output reinforces the initial increase in real money supply and hence, exchange rate undershoots its steady state value in the short run as represented by point E' in Figure 2(a), and increases thereafter. In contrast, Figure 2(b) shows that this output contraction offsets the initial effect of monetary expansion on exchange rate to some extent. Consequently, exchange rate overshoots its steady state value in the short run as represented by point E’ in Figure 2(b), and decreases thereafter.

Figure 2.

Source: Authors’ own.

Expansionary Fiscal Policy

An increase in government expenditure (G) raises aggregate demand and hence, from Equation (1') we obtain $\dot{Y} >0 $ . Therefore, YY schedule shifts rightward. On the other hand, this fiscal expansion raises BD which in turn causes an increase in risk premium. As a result, foreign bonds become more attractive which results in an outflow of foreign capital and hence exchange rate depreciates. According to Equation (3'), we obtain $\dot{e} \leq 0$ which entails an upward shift of the BB schedule as represented by Figure 3(a) or 3(b).

Clearly, the steady state effect of fiscal expansion on both exchange rate and output level is ambiguous. For instance, Figure 3(a) shows output expansion with exchange rate appreciation while Figure 3(b) depicts the contractionary effect of fiscal expansion on output level with higher exchange rate.

The fiscal expansion may generate a contractionary effect on aggregate demand if balance sheet effect of exchange rate depreciation on investment expenditure outweighs the expansionary effect of higher government expenditure.

Let us interpret the dynamic adjustment process. Figure 3(a) illustrates the case in which fiscal expansion causes immediate decrease in exchange rate at given output and consequently, the economy moves from the initial equilibrium point E₁ to the point E’ on the new saddle path in the short run. This exchange rate appreciation entails increase in output overtime as investment expenditure rises due to balance sheet effect of exchange rate appreciation. This output expansion causes further decrease in exchange rate and hence, exchange rate undershoots its steady state value in the short run. According to Figure 3(b), in the short run, expansionary fiscal policy leads to immediate increase in exchange rate at given output and hence, the economy moves from the initial equilibrium point E₁ to the point E’ on the new saddle path. This exchange rate depreciation reduces output overtime as the economy gradually moves from the point E’ to the new steady state point E₂. In this case, the decrease in output offsets the initial effect on exchange rate to some extent and hence, exchange rate overshoots its steady state value in the short run.

Figure 3.

Source: Authors’ own.

Tariff Liberalization

The tariff liberalization policy is captured in terms of a fall in tariff rate which in turn reduces domestic currency price of importable leading to an increase in import demand. If import demand is price elastic, the value of import spending increases which in turn causes trade balance deterioration. In addition, price elastic import demand results in higher value of tariff revenue which entails higher consumption expenditure as well. The opposite case appears if import demand is price inelastic. However, the decrease in tariff rate reduces the consumer price index leading to an increase in real money balances. Hence, the restoration of the money market equilibrium leads to fall in interest rate which in turn results in higher investment demand. Therefore, tariff liberalization policy has an ambiguous effect on aggregate demand. The YY curve shifts rightward if decrease in tariff rate raises aggregate demand, as represented in Figure 4(a). Otherwise, the YY curve will shift leftward as shown in Figure 4(b). Similarly, the tariff liberalization policy has an ambiguous effect on exchange rate dynamics since domestic interest rate falls and risk premium changes ambiguously in response to ambiguous change in trade balance. If import demand is price inelastic, trade balance improves due to decrease in tariff rate. In this case, risk premium falls which generates a positive effect on exchange rate dynamics. If the decrease in risk premium outweighs the fall in interest rate, we obtain $\dot{e} >0 $ which leads to downward shift of the BB schedule, as represented by Figure 4(a). In contrast, if import demand is price elastic, we obtain $\dot{e} \leq 0 $ . In this case, the BB schedule shifts upward as shown in Figure 4(b). It is clear to say that tariff liberalization policy has an ambiguous effect on the steady output level and exchange rate as well.

Figure 4(a) shows higher output and lower exchange rate at the new steady state point E₂. In contrast, Figure 4(b) illustrates the contractionary effect of tariff liberalization on output with higher exchange rate as represented by the new steady state point E₂.

Let us consider the dynamic adjustment process. According to Figure 4(a), tariff liberalization policy leads to the immediate decrease in exchange rate at given output and consequently, the economy moves from the initial equilibrium point E₁ to the point E’ on the new saddle path in the short run. This exchange rate appreciation results in increase in output overtime as investment expenditure rises due to positive balance sheet effect of exchange rate appreciation. This output expansion leads to further decrease in exchange rate and hence, exchange rate undershoots its steady state value in the short run. In contrast, Figure 4(b) depicts that in the short run, tariff liberalization policy causes immediate increase in exchange rate at given output and hence, the economy moves from the initial equilibrium point E₁ to the point E’ on the new saddle path. This exchange rate depreciation reduces output overtime as the economy gradually moves from the point E’ to the new steady state point E₂. In this case, the decrease in output offsets the initial effect on exchange rate to some extent and hence, exchange rate overshoots its steady state value in the short run.

Figure 4.

Source: Authors’ own.

Increase in World Interest Rate

An increase in world interest rate reduces interest differential and makes foreign bonds more attractive relative to domestic bonds. Hence, from Equation (4'), we immediately get $\dot{e} \leq 0 $ leading to exchange rate depreciation. So the BB schedule shifts upward as represented in Figure 5(a) or 5(b).

Let us explain the dynamic adjustment process. According to Figure 5(a) or 5(b), an increase in world interest rate leads to immediate increase in exchange rate at given output and hence, the economy moves from the initial equilibrium point E₁ to the point E’ on the new saddle path in the short run. This exchange rate depreciation reduces output overtime as the economy gradually moves from the point E’ to the new steady state point E₂ in the long run. This decrease in output may lead to further increase in exchange rate and hence, exchange rate undershoots its steady state value in the short run as represented by Figure 5(a). In contrast, Figure 5(b) illustrates the case in which the decrease in output offsets initial effect of world interest rate hike on the exchange rate to some extent and hence, exchange rate overshoots its steady state value in the short run.

Figure 5.

Source: Authors’ own.

Conclusion

Now, we sum up major findings of our article. The results in this article critically depend on the difference in the speeds of adjustments in the exchange rate, interest rate and output level and multitudes of cross effects generated by changes in these macroeconomic variables. The comparative static exercises show how the endogenous risk premium and the balance sheet effect of exchange rate depreciation together play an important role in shaping macroeconomic developments induced by dynamics of the exchange rate and output level in response to a variety of external and policy-induced shock. An expansionary monetary policy has an ambiguous effect on the exchange rate and output level. The exchange rate may overshoot or undershoot in the short run. An expansionary fiscal policy may prove to be contractionary even in a model based on the principle of effective demand. We also note that tariff liberalization may prove to be counterproductive in terms of its effect on the level of employment. An increase in the world interest rate which may be occasioned by a global financial crisis is output reducing which arises due to the balance sheet effect of exchange rate depreciation. The article can be extended in a couple of directions. One possible extension is to introduce the details of aggregate supply in a stock-flow consistent model. Other possible extension is taking an explicit account of long-run dynamics through capital accumulation.

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.

Funding

The authors received no financial support for the research, authorship and/or publication of this article.

Footnotes

Acknowledgements

The authors would like to thank an anonymous referee for his/her constructive comments. However, the usual disclaimer applies.

Appendix

Notes

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