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).