Academic journal article Atlantic Economic Journal

Money Demand, Perfect Capital Mobility, and Fiscal Policy

Academic journal article Atlantic Economic Journal

Money Demand, Perfect Capital Mobility, and Fiscal Policy

Article excerpt

In an interesting paper, Holmes and Smyth [JPE, 1972] propose that the transactions demand for money should be a function of disposable income (national income after tax) rather than national income based on theoretical and empirical viewpoints. They further show that this finding casts doubt on the standard conclusion that a tax cut expands aggregate demand.

It is well known in the traditional literature [Mundell, Can. J. of Eco. and Political Science, 1963! that fiscal policy is totally ineffective in changing output under flexible exchange rates with perfect capital mobility. This note attempts to show that this belief is sensitive to plausible specification in the money demand function along the lines of the argument of Holmes and Smyth. The model in the context of flexible rates with perfect capital mobility is given by:

y = C(y - T) + I([r.sup.*] + G + B(y,e); 1 > [C.sub.1] > 0, [B.sub.1] < 0, [B.sub.2] >0 (1)

M = L(y - [theta]T,[r.sup.*]; [L.sub.1] > 0 (2)

G = T, (3) where y = national income; C = consumption; T = tax revenue; I = investment; [r.sup.*] = world interest rate; G = government spending; B = balance of trade; e = price of foreign currency in terms of domestic currency; M = money stock; L = money demand; and [theta] = index parameter. Equations (1) and (2) represent the economy's IS and LM curves, respectively. …

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