An Intertemporal Version of Mundell's Two-Country Flexible Exchange Rates Model with Disequilibrium Microfoundations: Is Policy Interdependence Inevitable?

As a companion to a previous paper, monetary and fiscal policy are analyzed in (a) a small open economy and (b) a two-country world, where in addition to a fixed wage causing unemployment, countries now produce specialized products whose prices are fixed, causing excess supply. There are two periods, and perfect foresight. Markets clear in the second period. Exchange rates are flexible, and there is perfect capital mobility. Both monetary and fiscal policy raise domestic output whether the country is small or not, but do not affect foreign output or interest rates. Flexible exchange rates thus recover their "insulating" properties.