Flexible Exchange Rate and Growth of a Small Open Monetary Economy with Imported Good and Externalities

This paper proposes a growth model of a small open economy with economic structure, flexible exchange rate, money policy and imported good. The model integrates the basic features of the Solow growth model, Uzawa’s two-sector model, the monetary growth model with the MIU approach, and the neoclassical growth model for a small open economy. We simulate the model and demonstrate that the system has a unique saddle equilibrium point. We follow transitional behavior of the economy over a short-run period of time. We examine effects of changes in the money policy, the propensity to consume import good, the propensity to hold real money, the price of the imported good, the externalities of the industrial sector, the propensity to save. The comparative dynamic analysis provides some important insights. For instance, we show that as the money policy is increased, both the real money held by the household and the value of physical wealth is increased. This conclusion is consistent with the conclusion on the relation between money and physical wealth by Tobin (1956). As our model is more comprehensive than the Tobin model, it explains some phenomena which the Tobin model cannot explain. In our model as the monetary policy is increased, the output of the service sector and the sector’s two inputs are increased, while the output of the industrial sector and the sector’s two inputs are reduced; the trade balance is improved; the capital intensities of the two sectors and wage rate are reduced; the consumption levels of the industrial good, the service, and the imported goods are all increased; the inflation rate is reduced and the domestic currency is more appreciated. The inflation policy benefits the national economy as well as the household.