Dynamic response to external shocks in classical and Keynesian economies

The authors analyze the impact of three classes of external shocks in open economies, using a rational expectations framework that nests three prototype economies: a neoclassical full-employment benchmark, with intertemporally optimizing consumers and firms an instant clearing of asset, goods, and factor markets; a full-employment case with partly liquidity-constrained consumers and investors; and a Keynesian economy, with liquidity constraints and wage rigidity, which results in transitory deviations from full employment. Using parameters for a representative open economy, they simulate the model to compare the dynamic effects of foreign transfers, a terms-of-trade windfall in the form of a lower price for an imported production input, and a decline in the foreign real interest rate. They contrast the role of Keynesian and neoclassical factors in determining the dynamic adjustment to shocks, by analyzing the effects of permanent/transitory and anticipated/unanticipated disturbances in the three prototype economies. The results illustrate three main points: (a) both permanent and transitory disturbances cause changes in long-run capacity and output; (b) transitory and permanent shocks may have opposite effects on the current account. In particular, a permanent increase in foreign transfers or a permanent terms-of-trade windfall result in a current account deficit; if temporary, they cause a surplus; and (c) liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to external shocks.