STABILIZATION POLICY, EXCHANGE-RATE EXPECTATIONS, AND INTERNATIONAL TRANSMISSION

This paper analyzes the transmission effects of monetary and fiscal po licy in a large country on output abroad using a two-country sticky-pr ice monetary model with adjustment lags incorporated into the goods se ctors of the countries. In addition, the paper considers alternative m odels of exchange rate expectations and examines their influence on th e transmission process. In the case of monetary expansion in the home country, the general result for all expectations models is that the fo reign country may experience either expansion or contraction. The reas on is that the foreign country is exposed to two conflicting effects, a positive trade linkage effect coming from the home country and a los s of competitiveness due to the depreciation of home country's currenc y. Moreover, the final outcome depends critically on the sensitivity o f the trade balance to the exchange rate because the lower this sensit ivity, the smaller the loss of competitiveness due to the depreciation of the home country's currency. In the case of fiscal expansion in th e home country, the normal result for all expectations models is that output expands in the foreign country. The reason is that the foreign country experiences a positive trade linkage effect coming from the ho me country, and in the case of perfect foresight and regressive exchan ge rate expectations, the home currency normally appreciates, increasi ng the foreign country's competitiveness. However, if the semi-interes t elasticity of money demand is sufficiently larger in the home countr y, it is possible for the home country's currency to depreciate, causi ng a loss of competitiveness in the foreign country, and the overall e ffect on the foreign country could be contractionary. Finally, in the case of adaptive and distributed lag expectations, fiscal expansion in the home country has no impact effect on the exchange rate, and the f oreign country experiences only the positive trade linkage effect comi ng from the home country. (C) Society for Policy Modeling, 1997