The employment - isolation effect under a flexible exchange rate

This article considers the international diffusion of business cycle on the basis of a rigorous dynamic microeconomic foundation. The seminal work of Laursen and Metzler (1950) suggests that the employment-isolation effect under the flexible exchange rate system is imperfect even if international capital mobility is completely prohibited. Assuming a small country model instead of the two country model by Laursen and Metzler (1950), we obtain the following results: (i) The business fluctuation of the world economy diffuses to the small country through a change in the inflation rate resulting from the change in the real exchange rate. In this sense, the employment isolation is imperfect. (ii) Domestic monetary expansion does not necessarily improve the employment level. This is because the depreciation of the real exchange rate (worsened terms of trade) should always be compensated by the lowered inflation rate and thus reduces the consumption demand.