Monetary Policy: The Implications of Capacity Constraints and J‐Curve Effects

We present a stylized model to analyse the short‐ and long‐run effects of monetary policy on international debt and competitiveness. The features of this non‐linear model include both currency and asset substitution in a two‐country framework, paying special attention to the dynamics of international debt. We find, in contrast to conventional wisdom, that, in addition to raising competitiveness and reducing debt, a monetary contraction can generate inflation in the presence of capacity constraints. Furthermore, if the inflation effect is sufficiently strong, there may be adverse short‐run responses. The policy analysis explicitly considers the short‐run dynamics of competitiveness, debt, prices and trade. We find there is a second J‐curve effect which only occurs when the standard J‐curve effect is present together with capacity constraints. The existence of cyclical short‐run behaviour presents a warning to policy‐makers when assessing the progress towards target equilibrium to bear in mind that adverse short‐run movements may be consistent with the long‐run desired aim (i.e. there may be initial movements in the “wrong” direction which are consistent with the “expected” long‐run outcome).