© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic

Research 1997. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF,
UK and 350 Main Street, Malden, MA 02148, USA.
Bulletin of Economic Research 49 : 1, 1997, 0307-3378

THE REAL BALANCE EFFECT AND THE

NON-NEUTRALITY OF MONEY IN A SIMPLE
MODEL OF A SMALL OPEN ECONOMY

Phillip Lawler

ABSTRACT

The paper examines the implications of the real balance effect for
the neutrality of money in a small open economy model which
contains an explicit treatment of aggregate supply. Two specific
results emerge. First, an unanticipated monetary expansion is
neutral in both the long and short runs, whilst an anticipated
increase in the money supply has real short-run effects. Secondly,
the non-neutrality associated with an anticipated monetary expan-
sion manifests itself in a fall in output and employment during the
transition to the new steady-state.

I. INTRODUCTION

The neutrality or otherwise of money is, of course, a much debated issue

and has been examined in a variety of contexts – see, for example,
Sidrauski (1967), Lucas (1972), Sargent and Wallace (1975), Fischer
(1979), and Marini and van der Ploeg (1988). One potential source of
non-neutrality, identified and discussed by Begg (1980), is the presence
of real money balances as a determinant of aggregate demand within the
economy. The present paper explores the consequences of the real
balance effect in a model of a small open economy.
The framework itself, similar in essential form to those comprising
much of the open economy macroeconomic literature (e.g. Dornbusch,
1976; Buiter and Miller, 1981) is highly simplified, although, unlike
many comparable models, it contains a detailed specification of the
supply side of the economy. In most respects the model is constructed in
such a fashion as to favour the neutrality proposition. Prices and wages
are assumed to adjust instantaneously to maintain continuous goods and

1
2 BULLETIN OF ECONOMIC RESEARCH

labour market equilibrium; price and/or wage rigidities which can

provide a source of non-neutrality (e.g. Buiter, 1980) are thus abstracted
from. Furthermore, perfect foresight is assumed, hence precluding the
influence of money on output and employment associated with informa-
tion lags and price misperceptions (Sargent and Wallace, 1975). The
model also assumes a fixed capital stock and the lack of any direct
influence of real asset holdings other than money on demand; conse-
quently there is no ‘Tobin effect’ (Tobin, 1965) and more general port-
folio diversification effects are also absent. Finally, a further potential
source of non-neutrality is ignored in that whilst the supply of labour is
assumed to respond to variations in the consumption real wage, it is
insensitive to variations in the real interest rate.
Despite the absence of these well-known sources of non-neutrality,
money is not neutral (in the short run) in the current model. Given the
arguments of the aforementioned paper by Begg, that the presence of
the real balance effect generates a non-neutrality, is perhaps not particu-
larly surprising. What is surprising, however, is the particular fashion in
which this non-neutrality manifests itself. In contrast to the received
wisdom with regard to the anticipated versus unanticipated money issue,
an unanticipated monetary expansion exhibits the neutrality property,
whilst an anticipated increase in the money supply has real effects.
Moreover this non-neutrality reflects itself in a fall in output and
employment below their long-run equilibrium values during the transi-
tion to the new steady-state.
The remainder of the paper is organized as follows. Section II
outlines the structure of the model. Section III examines the steady-state
and the long-run comparative statics of a monetary expansion. The
adjustment process following the announcement of a future increase in
the money stock is then analysed in Section IV. Finally, Section V
summarizes the arguments and provides some concluding remarks.

II. STRUCTURE OF THE MODEL

The relationships comprising the framework are more or less standard

in (non-optimizing) open-economy macroeconomic models. However, in
addition to the inclusion of real money holdings as a determinant of
demand, the supply side of the economy is modelled explicitly. Produc-
tion technology transforms two variable inputs, labour and an imported
intermediate input, into the domestic final good, with the output and
employment decisions of domestic firms determined by the vector of
relative prices which they face. As will be seen, in the presence of the
real balance effect, an anticipated increase in the stock of money
produces relative price adjustments which are then reflected in changes
in the levels of output and employment. In fact the induced supply-side
effects of the monetary expansion work through two distinct channels.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
 REAL BALANCE EFFECT IN AN OPEN ECONOMY 3

The first derives from the effect of changes in the real exchange rate on
the price of the intermediate good relative to that of the final good
(Findlay and Rodriguez, 1977), whilst the second route is via the influ-
ence of the real exchange rate on the consumer real wage and labour
supply (e.g. Casas, 1975; Sachs, 1980). Whilst in their absence the
monetary expansion would be associated with transitory relative price
changes and, in this sense, would not be neutral, these effects do provide
the source of the induced variations in output and employment which
are the focus of interest in this paper.

II.1. Aggregate supply

The economy in question produces a single consumption good by use of
two variable inputs, labour and an imported intermediate good,
employed in combination with a fixed stock of capital. Production tech-
nology is assumed to be described by an aggregate Cobb–Douglas
production function1 which, given the assumption of a fixed capital
stock, can be expressed as
Y\ALa M a 1 2
0sa1s1, 0sa2s1, a1+a2s1
where Y is aggregate production of the domestic final good, L is aggre-
gate labour input, and M is aggregate input of the intermediate good.2
The economy is perfectly competitive, with firms acting as price-takers
in the markets for the final good and the inputs used in the production
process. The assumption of perfect competition, together with the
Cobb–Douglas production technology, gives rise to the following rela-
tionships (expressed in logarithmic form) describing first aggregate
supply and, secondly, the demand for labour:
y \µa1wRµa2 c (1)3
l D \µ(1+a1)wRµa2 c (2)
ai\ai /(1µa1µa2) i\1, 2.
wR represents the product real wage – i.e. the nominal wage, w, deflated
by the price of domestic output, p; hence wR=wµp. c represents the
real exchange rate – i.e. c=eµp, where e is the nominal exchange rate

1
The choice of Cobb–Douglas technology is on grounds of analytical tractability.
However, as is straightforward to demonstrate, the essential results of the paper follow
with any general CES production function.
2
Given the assumption that the domestic economy is a price-taker in world markets for
importables, we may interpret M more generally as a vector of imported inputs, provided
the relative prices between such inputs remain constant.
3
Lower-case letters represent the logarithms of their upper-case counterparts.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
4 BULLETIN OF ECONOMIC RESEARCH

(units of domestic currency per unit of foreign currency).4 Labour

demand is l D.
Labour supply, l S, is an increasing function of the consumption real
wage, that is the nominal wage deflated by the consumer price index, z,
comprising the price of the domestically produced commodity and that
of an imported consumption good:
l S\r(wµz)
(3)
z\up+(1µu) (e+p*)
where p* is the foreign currency price of the imported consumption
good, and u is the share of the domestic good in domestic consumption.
Labour market equilibrium is assumed to be maintained at all points
in time by instantaneous wage adjustment. Equating (2) and (3)5 we find
the relationship between wR and c consistent with labour market equi-
librium, which may then be substituted into (1) and (2) to express
output and employment, l (\l D\l S), purely as functions of the real
exchange rate or competitiveness:
µ[a2+r{(1µu)a1+a2}]c
y\ (4)
(1+a1+r)

µr[(1µu) (1+a1)+a2]c
l\ . (5)
(1+a1+r)
Hence employment and output are both negatively related to compet-
itiveness. As c rises both the demand and supply of labour fall, implying
an unambiguous reduction in employment. This induced fall in employ-
ment of labour is reflected in equation (4), as is the direct effect of a
depreciation of the real exchange rate on usage of the intermediate
input.

II.2. The demand for domestic output and goods market equilibrium
The form of the relationship describing the demand for domestic output,
d, is familiar from other open-economy macroeconomic models of this
genre (e.g. Obstfeld and Stockman, 1985), though with real money
balances an additional determinant of demand:6
4
Given the small country assumption, the foreign currency price of the imported input
is given exogenously and, by appropriate choices of units, can be normalized at unity.
Hence the input’s domestic currency price can be represented simply by e. An identical
normalization is applied to the price of the imported consumption good (see below); thus
c represents domestic competitiveness as well as the relative price of the imported input.
5
Normalizing the foreign currency price of the imported consumption good, like that of
the input, at unity.
6
Examples of open-economy models in which the real balance effect is present are
those of Casas (1975) and Kiguel and Dauhajre (1988).

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
 REAL BALANCE EFFECT IN AN OPEN ECONOMY 5

d\gyR+nc+d(mµz)µs(rµż) (6)7
where yR is domestic real income, m is the domestic nominal stock of
money, and r is the domestic nominal interest rate.
Domestic real income is defined as the sum of profits and nominal
labour income deflated by the price index. Using the relationships
developed in the previous subsection we can express domestic real
income as a function of the real exchange rate alone:

µ(1+r) [(1µu) (1+a1)+a2]c

yR\ . (7)
(1+a1+r)

Uncovered interest parity is assumed to hold. Hence the domestic

nominal interest rate is equal to the exogenously given foreign rate, r*,
plus the expected rate of depreciation of the domestic currency, i.e.:
r\r*+ė. (8)
Now imposing goods market equilibrium ( y\d), equations (4), (6), (7)
and (8) allow us to arrive at one of the basic dynamic equations of the
model:
suċ\ccµde+dmµsr* (9)
where

[a2+r{(1µu)a1+a2}]
c\[n+duµg(1µu)]+(1µg) .
(1+a1+r)

The parameter c identifies the effect of real exchange rate changes

on net demand (demand less supply) for the domestic final good.
Provided (a) a depreciation of the real exchange rate (rise in c), output
held constant, increases the demand for domestic output
(n+duµg(1µu)a0), and (b) an autonomous increase in output
increases demand less than proportionately (gs1), then c is unambigu-
ously positive. We assume, as is conventional in the open-economy
macroeconomic literature, that both these conditions hold, implying
that, beginning from a situation of goods market equilibrium, a rise in c
(ċ and e constant) creates excess demand in the goods market. The
remaining terms in equation (11) are straightforward in interpretation,
with the terms in e and m both reflecting the assumed effect of real
money holdings on demand through the real balance effect. The terms
in r* and ċ arise from the influence of the real interest rate8 on demand;
we may view the rate of change of competitiveness as adjusting continu-
7
Dots over variables are used to represent right-hand time derivatives. Thus ż repre-
sents the actual and (given the assumption of perfect foresight) expected rate of change
of the price index.
8
A rise in ċ, given r*, implies a rise in the domestic real interest rate.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
6 BULLETIN OF ECONOMIC RESEARCH

ously, for given values of the other variables of the model, to maintain
goods market equilibrium.

II.3. The demand for money and money market equilibrium

The final component of the model is supplied by consideration of the
money market. A conventional demand for money function is assumed,
with the demand for nominal money balances positively related to real
income and the price index, negatively related to the domestic nominal
interest rate:
mD\hyRµlr+z. (10)
Imposing money market equilibrium (m\mD) and using equations (8)
and (9), together with the definition of z yields:
lė\µWc+eµmµlr* (11)
where

[a2+r{(1µu)a1+a2}]
W\[u+h(1µu)]+h .
(1+a1+r)

As can be seen directly by inspection, W is unambiguously positive.9

Equations (9) and (11) completely describe the dynamics of the
model. However, before discussing the question of adjustment dynamics
in detail, we first turn to examine the long-run comparative statics of an
increase in the nominal stock of money.

III. LONG-RUN EQUILIBRIUM AND COMPARATIVE STATICS

Setting the dynamic terms in equations (9) and (11) equal to zero and
solving the two equations simultaneously allows us to derive reduced
form expressions for the long-run equilibrium values of e and c, ē and c̄
respectively:

(lc+sW)r*
ē\m+ (12)
cµdW

(ld+s)r*
c̄\ . (13)
cµdW

From (12) it is readily apparent that an increase in the money supply

9
Like c, W is comprised of two terms, the first relating to the effect of a rise in c (e
constant) on the demand for money at an unchanged level of output, the second reflecting
the influence of changes in c on the demand for money via induced output changes.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
 REAL BALANCE EFFECT IN AN OPEN ECONOMY 7

produces a proportional depreciation of the equilibrium nominal

exchange rate. However, (13) indicates that the equilibrium real
exchange rate, c̄, is independent of m. Since all real variables of the
model can be expressed as a function of the real exchange rate or
competitiveness, it follows that, in the long run, money is neutral with
respect to the real economy and an increase in the domestic money
supply simply results in a proportionate increase in the values of all
nominal variables.
Whilst money is neutral in the long run it is not super-neutral.
Although in formulating the model we have assumed the rate of growth
of the money supply to be zero, the framework could be easily extended
to allow for a non-zero trend monetary growth rate. In such an instance,
an increase in the rate of growth of the money stock could be shown to
produce a rise in the steady-state value of competitiveness,10 with
consequent implications for equilibrium output and employment. The
intuition underlying this result is straightforward. A higher rate of
monetary expansion implies a higher rate of domestic inflation which
requires an increased rate of depreciation of the domestic currency to
maintain competitiveness constant. Through uncovered interest parity
this rise in ė leads to a rise in r and reduces desired real money holdings
which implies, via the real balance effect, a decline in domestic demand.
To maintain goods market equilibrium a depreciation of the real
exchange rate is required.
However, we note that, assuming the initial equilibrium to be one of
current account balance, the improvement in domestic competitiveness
would imply a current account surplus in the new equilibrium. As a
consequence, this equilibrium would not be robust to the introduction of
a role for financial asset holdings other than money in the determination
of domestic expenditure. This is not to suggest, of course, that such a
role would imply super-neutrality, but simply that, in such circumstances,
the non-neutrality would take a more complex form than in the present
model.
Having demonstrated the neutrality of money in the long run we now
turn to examine whether this neutrality is also a feature of the short run.
To do so we must examine the transitional dynamics of the model.

IV. ADJUSTMENT DYNAMICS AND THE SHORT-RUN IMPACT OF A

MONETARY EXPANSION

Equations (11) and (13) can together be expressed in matrix form as

CD C DC D
ċ a11 a12 cµc̄
\ (14)
ė a21 a22 eµē
10
Assuming cµdWa0. See later for a discussion of this condition.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
8 BULLETIN OF ECONOMIC RESEARCH

where a11\c/sua0, a12\µd/sus0, a21\µW/ls0, a22\1/la0. The

characteristic equation of the transition matrix in (14) has two roots, m1
and m2 , where
m1 , m2\12 (a11+a22)¹12 [(a11+a22)2µ4(a11 a22µa12 a21)]1/2.
It is straightforward to show that the discriminant of this expression is
positive and hence m1 and m2 are real and distinct. The determinant of
the transition matrix is (cµdW)/lsu and the signs of the two roots
depend crucially on the sign of this expression. If cµdWa0 then, given
that a11 and a22 are both positive, m1 and m2 are both positive and the
dynamics are globally unstable. However, if cµdWs0 then one root is
positive, the other negative, and the model is saddlepoint-stable.
Now in open-economy models of the type presented here it is conven-
tional to view the nominal exchange rate as a non-predetermined,
forward-looking, or ‘jump’ variable. However, as a consequence of our
assumption that goods and labour market equilibrium are continuously
maintained by instantaneous price and wage adjustment, competitive-
ness must also be viewed as a non-predetermined variable and, with two
non-predetermined variables, a determinate dynamic path requires two
unstable roots.11 Consequently, a unique convergent solution requires
cµdWa0. In fact, this condition is also relevant for the static structure
of the model, implying that a fall in the relative price of the domestic
commodity – i.e. a rise in c (with ċ and ė constant), and allowing e to
vary to clear the money market – produces an increase in net demand
for the domestically produced good. Such an implication seems reason-
able and, hence, in accordance both with what might be viewed as a
‘sensible’ static property and with dynamic uniqueness, we assume
cµdWa0.
We now consider the dynamics of adjustment following a pre-
announced increase in the domestic money stock. The increase in the
money supply is announced at t\0, with the expansion actually taking
place at t\T. In the special case T\0, the disturbance corresponds to
an unanticipated monetary expansion. Until the time of the announce-
ment the money stock is expected to remain at its original value, m1 , for
all time; whilst at t\0 the future increase in m to m2 – and, given the
assumption of perfect foresight, its implications for the economy – are
fully perceived by all agents.
The nature of the adjustment process following the announcement of
the increase in the nominal money stock derives from the fact that both
the nominal exchange rate and competitiveness are non-predetermined
variables, together with the imposition of the transversality condition
that the values of e and c remain bounded for all time. This trans-
11
See Buiter (1984) for a suggested method of providing a unique stable solution in
perfect-foresight models with more non-predetermined variables than unstable roots, but
also Lawler (1993) for an objection to this proposal.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
 REAL BALANCE EFFECT IN AN OPEN ECONOMY 9

versality condition restricts any initial movement of e and c to be

consistent with long-run convergence of the model’s variables to their
new equilibrium values.12 Over the interval (0, T) the dynamics associ-
ated with the original equilibrium drive the paths of e and c, whilst from
time T onwards the dynamics associated with the new equilibrium
become relevant. Given the unstable nature of the model’s dynamics,
the transversality condition requires both e and c to achieve their new
equilibrium values precisely at time T. This requirement, in turn, deter-
mines unique (for any given value of T) initial movements of e and c
and the subsequent path of the economy.
The transitional dynamics are analysed in Figure 1. The original equi-
librium of the economy is represented by E1(ē1 , c̄), with the associated e
and c stationaries (ė\0, ċ\0 respectively) both positively sloped. The
assumption that cµdWa0 implies that ė\0 is steeper than ċ\0, giving
rise to the globally unstable dynamics apparent from the diagram.13

Fig. 1.
12
Implicit in this is the assumption that the possibility of future anticipated jumps in
either the nominal or real exchange rates, associated with instantaneously infinite capital
gains or losses, is eliminated by efficient intertemporal arbitrage in financial and goods
markets.
13
The condition cµdWa0 requires that the real balance effect be not ‘too strong’. As
d declines in value the c stationary becomes less steep and in the limit, as dh0,
approaches the horizontal.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
10 BULLETIN OF ECONOMIC RESEARCH

E2(ē2 , c̄) represents the new long-run equilibrium and lies directly to the
right of E1 . The long-run convergence condition implies that the
economy must attain E2 precisely at time T. This requirement, in turn,
implies that the vector (e, c) must jump at the instant of the announce-
ment of the monetary expansion to a point on the single phase line, E1 F,
which passes through E2 , following which the dynamics of the model
take the economy along E1 F until, at time T, the new equilibrium, E2 , is
attained.
If the monetary expansion is unanticipated (i.e. T\0) then the
stability condition implies that e and c must achieve their new equi-
librium values instantaneously; thus on implementation of the policy the
economy moves directly from E1 to E2 . An unanticipated increase in the
money supply is therefore neutral in the short run as well as in the long
run. However, for Ta0 – in which case the policy corresponds, follow-
ing Fischer’s (1979) terminology, to a partially anticipated monetary
expansion14 – the perception of the future rise in the money stock leads
at t\0 to adjustments in e and c which take the economy initially to a
point along E1 F, such as A or B (point A being associated with a smaller
value of T than is B), which lies strictly to the left of E2 . As a conse-
quence the interval (0, T) is characterized by changing values of the
nominal and real exchange rates. The fact that c departs from its equili-
brium value during the transition process implies that in this case, in
contrast to an unanticipated policy, money is not neutral with respect to
the real economy in the short run.
Furthermore it is readily apparent from the diagram, in particular the
nature of the phase line E1 F, that competitiveness must lie above its
steady-state value throughout the adjustment process.15
This result has the rather startling implication that, given the relation-
ship between y, l and c outlined in Section II, the monetary expansion
actually leads to a reduction in output and employment below their
respective equilibrium values during the interval between the announce-
ment of the policy and its implementation. This outcome, of course,
14
The term ‘partially’ anticipated is appropriate due to the fact that the economy has a
past history. Viewed from time T the announcement of the increase in the money stock
occurs at some point in the finite past. Of course, as T increases and, in particular,
approaches infinity the policy can be viewed as fully anticipated. Note that the contrast
between the effects of unanticipated and partially anticipated policies here closely
resembles that in Fischer’s paper, despite the rather different structure of the models.
15
Note that since c is a continuous function of time (from t\0 onwards), so must
output be. Hence for any value of t less than, but arbitrarily close to, T output must be
arbitrarily close to its steady-state value. To ensure consistency between the continuity
requirement and the goods market equilibrium condition as demand increases via the real
balance effect there must be a compensating fall in another component of demand. This
can be accomplished, given equation (6), only by a rise in the real interest rate, associated
with a rise in ċ at time T. Since ċ(t)\0 for teT, it follows that the (left-hand) time
derivative of c(t) must be negative at t\T. But, with the dynamics of adjustment governed
by two real roots, the path of c can have, at most, one turning point; hence it must be the
case, given continuity, that c(t)ac̄ for 0rtsT.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
 REAL BALANCE EFFECT IN AN OPEN ECONOMY 11

contrasts strongly with the output and employment effects of an antici-

pated monetary expansion in a wide variety of papers, both those which
assume some short-term price stickiness (e.g. Blanchard (1981) in the
context of a closed economy, Obstfeld and Stockman (1985, Section 3)
in their open-economy model) and those based upon the assumption of
continuous market clearing (e.g. Fischer (1979), Begg (1980), both of
which are concerned purely with a closed economy). However, we stress
that the propagation mechanisms present in these papers are rather
different from those operating in the current model.
The significance of the real balance effect for the adjustment process
discussed above is apparent by noting, as indicated at an earlier point
(footnote 13), that in its absence the c stationary is horizontal and
described by c\c̄. With d\0 the expectation of the future monetary
expansion merely leads to an instantaneous depreciation of the nominal
exchange rate to a value between ē1 and ē2 , accompanied by an equi-
proportionate change in the price of domestic output, leaving compet-
itiveness unchanged. Thereafter e and p rise gradually at the same rate
as the economy moves along the c stationary until, at time T, the new
long-run equilibrium is achieved. Consequently, throughout the adjust-
ment process competitiveness and hence, given equations (4) and (5),
output and employment remain at their steady-state values; in the
absence of the real balance effect, money is neutral in both the short
and long runs.

V. SUMMARY AND CONCLUSIONS

The above analysis considered the question of the neutrality of money in

the context of a simple model of a small open economy. It was shown
that the presence of the real balance effect gave rise to a clear distinc-
tion between the effects of unanticipated and anticipated monetary
policy. In the case of the former, money was neutral in both the long
and short runs. However, an anticipated change in the money stock had
real effects over the interval between the perception and the implemen-
tation of the policy. Thus the association between anticipated money
and neutrality and between unanticipated money and non-neutrality,
conventional in market-clearing models, was reversed.
The second significant result which followed from the analysis relates
to the specific nature of the non-neutrality associated with anticipated
monetary policy. In particular, it was demonstrated that an anticipated
increase in the domestic money supply had a contractionary impact, in
the sense of inducing a fall in output and employment below their long-
run equilibrium values during the transition to steady-state. This
outcome reflected the influence of the real exchange rate on aggregate
supply and highlights the potential importance of providing an explicit
treatment of the supply side of the economy in open-economy models.

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
12 BULLETIN OF ECONOMIC RESEARCH

It is well-recognized, of course, that the analysis has been conducted

using a highly simplified model. Nonetheless the results derived in the
paper provide, at the least, an interesting theoretical qualification to the
conventional wisdom concerning the impact of monetary policy in a
small open economy.

Department of Economics, Received September 1992

University of Wales, Swansea Final version accepted May 1995

APPENDIX

In this Appendix we derive an explicit algebraic solution for the paths of

the model’s variables. On the imposition of the long-run convergence
condition, the solution to (14) may be written as:
cµc̄\A1 exp (m1 t)+A2 exp (m2 t) (A.1a)
eµē1\[(m1µa11) A1 exp (m1 t)
+(m2µa11) A2 exp (m2 t)]/a12
H 0rtsT
(A.1b)

c\c̄
e\ē2 H teT (A.2a)
(A.2b)

The solutions for the paths of c and e given by equations (A.1) and
(A.2) must be consistent at t\T. Imposing this consistency requirement
allows us to determine the values of the arbitrary constants:
A1\a12(m2µm1)/(m1µm2) exp (m1T) (A.3a)
A2\µa12(m2µm1)/(m1µm2) exp (m2T) (A.3b)
We now use equations (A.1)–(A.3) to examine the nature of the
adjustment process, considering first the path of the nominal exchange
rate, then the dynamics of competitiveness. In what follows we take,
without loss of generality, m1 to represent the root of greatest absolute
value (i.e. m1am2) which, as is straightforward to demonstrate, implies
(m1µa11)a0 and (m2µa11)s0.

The nominal exchange rate

Equation (A.1b) together with (A.3) allows us to derive the following
results directly:
e(0)µē1\[(m1µa11)
Åexp (µm1T)µ(m2µa11) exp (µm2T)] (m2µm1)/(m1µm2)a0
(A.4a)

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 REAL BALANCE EFFECT IN AN OPEN ECONOMY 13

e(0)µē2\µ[(m1µa11) {1µexp (µm1T)}

µ(m2µa11) {1µexp (µm2T)}] (m2µm1)/(m1µm2)s0 (A.4b)
Equations (A.4a) and (A.4b) indicate that the nominal exchange rate
undergoes an immediate jump depreciation upon the announcement of
the future increase in the money supply to a value between ē1 and ē2 .
The influence of T, the lag between the anticipation of the increase in
the money stock and its actual occurrence, is readily apparent. For T\0,
e jumps immediately to its new equilibrium value. However, as T
increases, the extent of the initial discrete depreciation of the nominal
exchange rate diminishes in magnitude and, in the limit, as Thl,
e(0)hē1 .
Differentiating equation (A.1b) with respect to t yields
ė\[m1(m1µa11) exp {m1(tµT)}
µm2(m2µa11) exp {m2(tµT)}] (m2µm1)/(m1µm2)a0.
(A.5)
Thus, following its initial jump, the nominal exchange rate depreciates
gradually over the interval (0, T) towards its new equilibrium value;
hence the path of e is monotonic.

Competitiveness
Evaluating equation (A.1a) at t\0 yields
c(0)µc̄\a12[exp (µm1T)µexp (µm2T)] (m2µm1)/(m1µm2)a0. (A.6)
Equation (A.6) implies that, on the perception of the future increase in
m, the real exchange rate, like the nominal exchange rate, depreciates
immediately. As for e, the initial change in competitiveness depends on
the value of T, but the nature of this dependence is rather more
complex in the present case; for small values of T, c(0) is an increasing
function of T, but for some value of T, c(0)µc̄ achieves a maximum and
thereafter declines with T (see phase line E1 F in Figure 1).
Further information concerning the behaviour of c may be obtained
upon differentiation of equation (A.1a) with respect to t:
ċ\a12[m1 exp {m1(tµT)}µm2 exp {m2(tµT)}] (m2µm1)/(m1µm2). (A.7)
ċ(t) may be positive or negative, which reflects the fact that the path of
c may possess a turning point. In fact equation (A.7) can be used to
define a value T̂, where
T̂\ln (m1 /m2)/(m1µm2) (A.8)
such that:

© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.
14 BULLETIN OF ECONOMIC RESEARCH

for 0sTsT̂ ċ(t)s0, 0rtsT

for T̂sT ċ(t)a0, 0rtsTµT̂
ċ(t)s0, TµT̂stsT.
Hence, for values of T less than T̂, following its instantaneous deprecia-
tion at t\0 the real exchange rate appreciates continuously and
gradually back towards its equilibrium value. However, if TaT̂ then the
initial jump depreciation is followed by an interval over which com-
petitiveness continues to improve, before reaching a turning point after
which it gradually declines until it achieves its steady-state value at t\T.

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© Blackwell Publishers Ltd and the Board of Trustees of the Bulletin of Economic Research 1997.