Introduction:

Macroeconomic real-financial markets interaction in world capitalism is the topic we focus on. We start from a closed economy representation on the basis of IS-LM modelling, with a stock market integrated, and extend that approach of finance-led capitalism to international repercussions in a model of two large open economies incorporating exchange rate dynamics of the Dornbusch (1976) kind.

The point of departure are ideal type neoclassical models with perfect foresight and perfect substitutability of assets. Every modelling step induces dynamic behaviour of saddle point type. The rational expectations school generates stability in such kind of models via the jumpvariable technique (JVT) proposed by Sargent and Wallace (1973). Economically poorly motivated jumps in non-predetermined variables of the exactly needed size and in the right point in time fulfill the stability delivering job. As this solution technique stands on shaky grounds, with respect to heroical assumptions of computation capabilities of agents, implicit welfare criterions when multiple equilibria are faced or the usage of bubbles as part of the solution procedure, cautious policy measures should instead stabilize the working of the systems whose private sectors are basically no shock absorbers when avoiding the JVT. The starting point of our two-country world economy analysis is the closed economy model of Blanchard (1981) which integrates a stock market into Keynesian short-run analysis and uses the hypothesis of rational expectations. The modelling approach to Finance-led World Capitalism focuses on the short-run evolution. Therefore a fixed price level will be assumed. How inflation dynamics alter the model results will be shown in the last part of the paper. Everything besides price rigidity mirrors a perfectly flexible working neoclassical world. Investors are endowed with perfect foresight as a special solution of model consistent expectations and all assets are perfect substitutes. Infinite capital mobility within and across countries implies the non-existence of arbitrage opportunities. The model will exhibit saddle path dynamics as perfect foresight models usually do.

Contrary to Blanchard’s (1981) original contribution, we aim to analyse and solve the model without the (questionable) jump-variable technique. The solution technique of the rational expectations school that needs appropriate jumps in non-predetermined variables, is economically barely motivated and most often simply mechanically applied to saddle point dynamics in macro models. Carefully considered policy interventions of the policy-maker can be supposed to be a better strategy to stabilize the basically unstable economic system.

The two country world allows to investigate international repercussions in real as well as financial markets. The foreign exchange market’s behaviour is modelled by the uncovered interest rate parity which sketches today’s very high international capital mobility as the extreme case of infinitely fast reallocating capital. That is why the chosen modelling approach can be regarded as a synthesis of Blanchard’s stock market dynamics and Dornbusch’s (1976) exchange rate dynamics. International interest rate differentials are equated by capital movements and subsequently exchange rate variations. The exchange rate feeds back to the evolution of aggregate demand. The fully developed two country model might be regarded as representation of two large interacting currency blocks like the US and Euroland. At a first modelling stage the world system has to face diverging dynamics.