A model of Dornbusch is adapted to analyze the consequences for output and competitiveness of certain aspects of the U.K. government's medium term financial strategy and some other policy actions. This includes the announcement of a sequence of reductions in the target rate of monetary growth, an increase in VAT and a move to make the U.K. banking system more competitive. The impact of a discovery of domestic oil is also modeled. We consider the consequences of varying the degree of inertia in the underlying rate of inflation and of different rates of international capital mobility. A real interest rate equalization tax stabilizes the real exchange rate but not the level of output. Once and for all changes in the level of the nominal money stock to accommodate changes in the demand for real money balances prevent 'overshooting' of the real exchange rate and fluctuations in output. It may, however, undermine the credibility of an announced policy of monetary disinflation.

Monetary Policy and International Competitiveness

In the previous chapter we looked at the consequences of introducing international trade into our model in the framework of a regime of ‘pegged’ exchange rates. However, since 1972, the UK exchange rate has not been pegged, but has been determined by a ‘managed float’: that is, by a foreign exchange market in which the authorities intervene, from time to time, as an additional buyer or seller of foreign exchange. At this stage we do not wish to discuss why the UK authorities chose to act in this way. We therefore consider only the limiting case of a ‘perfectly clean’ float even though, since the collapse of the Bretton Woods system (the ‘occasionally jumping peg’) most countries’ floats have been more or less ‘dirty’.

D. C. Rowan

Papers

The International Sector and Flexible Rates