This chapter extends the model of Chapter 2 by allowing for simultaneous rationing of the household in both the credit and labor markets. As before, the small-country assumption is used to rule out the possibility of rationing in the traded-goods market. In addition, we assume that firms are net buyers in the bond market. This, in combination with the short-side rule, implies that firms are not rationed in the credit market. Also, because there is unemployment, firms are not rationed in the labor market.

The analysis of domestic-policy effectiveness in this environment is important because, in practice, demand for many durable goods (e.g., automobiles) is likely to be very sensitive to the household's credit ration. Despite the assumption that the household does not store goods (i.e., views all goods as perishable), the analysis in this chapter is suggestive of the impact of domestic policies on the interest-sensitive sectors that produce traded goods in a small, open economy. The model of this chapter is essentially the same as that in Chapter 2, so only a brief description of economic agents follows.

The model

Recall that the small, open economy produces a traded composite commodity by employing labor and goods inputs. Purchasing-power parity and the assumption of a rigid world price (normalized to one) implies that the exchange rate e is the domestic price level. The exchange rate is fixed, and there is no capital mobility.