An Open Macro Model with a Goods Inventory

Abstract

Economists have two major stands in international monetary economics. One is the monetary approach, the other is the asset market approach. This paper trys to integrate the two approach, by introducing a goods inventory as an asset. Dornbusch (1976) analyzed an interaction between an asset and a good market by postulating that the asset market is continuously in equilibrium, while the goods market adjust slowly to equilibrium. By this model, he explained the observed volatility and overshooting of exchange rates. His model, however, accomodates price adjustment but ignored quantity adjustment in the goods market. In this paper, I present a general framework for an open economy analysis, by modeling an open economy with a goods inventory, similar to Van Duyne (1979). In this model, a goods inventory functions not only as a buffer between effective demand and output but also as an asset. The asset market has money, a goods inventory, domestic bonds and foreign bonds. Assuming perfect substitutability between domestic and foreign bonds, interest rate parity is introduced. Major lessons of the paper are as follows. In a small open economy with a goods inventory as an asset, an increase in the foreign interest rate increases the domestic interest rate, decreases the price of the goods inventory, and depreciates the current exchange rate in the short run, and thereby decreases income and improves current account in the medium run. A monetary expansion increases the goods inventory price, decreases the interest rate, and thereby increases income and improves current account. An increase in a tax-financed government expenditure does not change the asset prices in the short run, and in the long run increases income and deteriorates current account due to an increase in domestic absorption.