Degree of capital mobility, wage indexation, and monetary-fiscal policies in a small open economy

Won Ick Choi, Purdue University

Abstract

In this research, we consider optimal mixtures of wage indexation, monetary policy, and fiscal policy to minimize or eliminate the social welfare loss which is caused by labor market friction. We generalize the existing models by introducing various degrees of capital mobility and various degrees of the private agents' perceptions about the stochastic disturbances. We also introduce bond market information into a money supply rule. First of all, we study optimal mixtures of wage indexation and monetary policy under three different informational structures in Chapters 3 and 4. In informational structure Case 1, where both public and private agents have perfect information about the economy, we find that since public authority can have an optimal policy from the equilibrium level of output and from the money market equilibrium along with the labor market equilibrium condition, the degree of capital mobility and the degree of the private agents' perceptions about the stochastic disturbances do not affect the optimal policy. In this case, the optimal policy can be either wage indexation or monetary policy. In informational structure Case 2, where the public authority cannot observe both productivity shock and money supply shock, while private agents can, whatever the private agents' perceptions about the disturbances are, the public authority can minimize (but not eliminate perfectly) the social welfare loss by two alternatives: monetary policy and a mixture of wage indexation and monetary policy. In informational structure Case 3, where both public and private agents cannot observe both shocks, whatever the private sectors' perceptions about the stochastic disturbances are, the public authority can perfectly eliminate the social welfare loss by either monetary policy or a mixture of wage indexation and monetary policy. In informational structure Case 1, the degree of capital mobility does not affect the optimal policy, while, in informational structure Case 2 and 3, the degree of capital mobility affect all policy parameters. Especially, we notice that when the degree of capital mobility goes to infinity, we do not have to introduce bond market information into money supply rule. In Chapter 5, we introduce fiscal considerations into the basic model in Chapter 3 and Chapter 4 to see the effects of a fiscal authority. When we consider optimal policies in the face of each of the stochastic disturbances, full wage indexation is optimal except for productivity shock, whatever the private agents' perceptions about the disturbance are. When all shocks occur simultaneously, the public authority can use the combination of full wage indexation and a regressive tax system to eliminate the welfare loss whatever private agents' perceptions about the shocks are. From this result, we learn that while monetary policy is important in Chapters 3 and 4, it is not crucial in Chapter 5.

Degree

Ph.D.

Advisors

Carlson, Purdue University.

Subject Area

Economic theory

COinS