Why Standard Models Travel Poorly
Much of contemporary macroeconomics assumes that domestic marginal cost anchors inflation, monetary dominance holds, and the nominal exchange rate acts as a shock absorber.
In many developing economies, however, the nominal exchange rate has a persistent depreciating trend and behaves more like a shock transmitter. Expenditure-switching effects are limited, dominant currency pricing weakens the expansionary effects of depreciation, and fiscal dominance is pervasive.
Under these conditions, monetary policy has weaker real effects, and economic overheating, fiscal sustainability, and financial stability cannot be understood through standard macro alone.
Standard Macro
- Domestic marginal costs anchor inflation
- Monetary dominance gives policy traction
- Exchange rates largely absorb shocks
- Import dependence is secondary
Developing Economies
- Foreign exchange scarcity
- High import dependence
- Fiscal dominance
- Financial dollarisation
- Exchange rates largely transmit shocks
Macro Implications
- Growth and cycles are foreign exchange constrained
- Weak monetary transmission
- Conventional indicators are misleading: overheating and fiscal sustainability
- External and domestic balance sheets interact
Towards a New Framework
My work develops new analytical frameworks to better account for the macro-dynamics of developing economies and to improve economic diagnosis and measurement. Because domestic demand pressures can be weakly reflected in CPI inflation, I develop the concept of a Composite Output Gap to identify what I call Overheating on Ice: excess domestic demand that emerges through external pressure before it becomes visible in conventional inflation measures.
Taking persistent foreign-exchange constraints to their logical conclusion yields an Open-Economy Golden Rule of Public Finance. At the margin, the foreign-exchange-adjusted marginal product of capital must equal the cost of foreign borrowing plus an FX scarcity premium. The external constraint therefore changes the efficient scale of public investment.
Overheating on Ice
Economic overheating can emerge through foreign-exchange pressure before it appears in conventional CPI inflation.
Composite Output Gap
A measure of slack that combines domestic and external constraints on economic activity.
Open-Economy Golden Rule
Public investment must satisfy both productive and foreign-exchange constraints.
Missing-Imports Problem
Resource-spending models can misdiagnose adjustment when the imported supply response is omitted.
Monetary Origins of Dutch Disease
Dutch disease can arise from monetary financing and fiscal dominance rather than resource spending alone.
Stock-Flow-Consistent Fiscal Rule
Identifies the primary balance required for debt stability while remaining consistent with goods-market equilibrium at potential output.
Because standard fiscal rules are derived from the intertemporal government budget constraint, the goods market and external constraints have no bearing on their policy recommendations. My work derives a stock-flow-consistent fiscal rule to reduce the likelihood of fiscal distress and debt crises.
Finally, imports play a dual role in open economies: they absorb domestic demand and expand productive capacity. Omitting the latter role gives rise to what I call the Missing-Imports Problem, and recognising this channel changes how we interpret both the theory and the empirical evidence on Dutch disease.