The Effects of Monetary and Fiscal Policy on Aggregate Demand in a Small Open Economy: An Application of the Structural Error Correction Model

This paper empirically analyzes the short-run effects of monetary and fiscal policy on aggregate demand, using the two-step structural error correction method. This method has an advantage over the standard reduced-form error correction method in providing a meaningful interpretation for impulse responses. The results are in sharp contrast to those of the traditional Mundell-Fleming and Dornbusch models: after the monetary (fiscal) policy is relaxed, the home currency depreciates (appreciates) for a substantial period of time, and the aggregate demand first expands (contracts) then gradually returns toward its original path.
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Volume/Issue: Volume 2000 Issue 165
Publication date: October 2000
ISBN: 9781451858044
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Topics covered in this book

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Business and Economics , Economics- Macroeconomics , Money and Monetary Policy , Public Finance , WP , aggregate demand , fiscal policy , open economy , Monetary and fiscal policy , structural error correction models , nominal exchange rate , Phillips-curve price adjustment equation , equation method , aggregate demand function , GMM estimation , expansionary monetary policy shock , aggregate demand specification , magnifying depreciation , fiscal policy disturbance , level of significance , money demand shock , aggregate demand to monetary and fiscal policy shock , Real exchange rates , Exchange rates , Fiscal stimulus , Demand for money

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Summary

This paper empirically analyzes the short-run effects of monetary and fiscal policy on aggregate demand, using the two-step structural error correction method. This method has an advantage over the standard reduced-form error correction method in providing a meaningful interpretation for impulse responses. The results are in sharp contrast to those of the traditional Mundell-Fleming and Dornbusch models: after the monetary (fiscal) policy is relaxed, the home currency depreciates (appreciates) for a substantial period of time, and the aggregate demand first expands (contracts) then gradually returns toward its original path.

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