Importing Aggregate Demand – Christian Wolf

Speaker

Christian Wolf (MIT)

Abstract

How exposed are open economies to aggregate demand abroad? In equilibrium, foreign booms can be absorbed either by domestic activity (“quantities") or by real exchange rate appreciation (“prices").  We show that failures of Ricardian equivalence and global financial market imperfections, two frictions popular in much recent work, have opposite effects on the split: elevated marginal propensities to consume push towards quantities, while financial frictions increase price adjustment. As the flexible-price equilibrium generally features a mix of quantity and price responses, policy needs to be contractionary to achieve flexible-price outcomes if the spending effect dominates, and vice-versa if financial frictions are severe. In quantitative explorations the spending effect wins the race, necessitating aggressive domestic policy action. Absent such a response, the foreign boom passes through almost one-to-one to domestic activity, and leads to domestic inflation that can even exceed the foreign price increase. 

Room

Media Room (A-211)