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With the advent of increased exchange rate flexibility, the role of policy and the transmission of economic disturbances under flexible rates have become topics of considerable interest. J. Marcus Fleming (1962) and Robert Mundell (1963), in their early analysis of the theory of policy in open economies, emphasized the importance of the degree of capital mobility. Subsequently, a number of authors have analyzed the implication of the degree of capital mobility for exchange rate and income determination in open economies; see, for example, Pentti Kouri and Michael Porter (1974), William Branson (1975, 1979), Lance Girton and Dale Henderson (1976), and Turnovsky (1976). The polar case of perfect capital mobility has received most attention. Capital is perfectly mobile when investors consider domestic bonds, denominated in domestic currency, and foreign bonds, denominated in foreign currency, to be perfect substitutes. Two factors may cause perfect substitutability to break down. One is exchange risk: the values of the two bonds are defined in terms of different currencies and the exchange rate at the date of maturation is uncertain. The second is default risk: investors may perceive that foreign bonds are more subject to the risk of default than are domestic bonds. For one thing, in the event of default the investor must pursue his claim through a foreign legal system, which is likely to be costly. Robert Aliber (1973) terms differences in default risk arising from the foreignness of assets as political risk.' Where domestic and foreign securities are assumed to be only imperfect substitutes, it is important to distinguish the degree of imperfection due to each of these sources of risk. While this distinction has been noted in optimal portfolio models developed by authors such as Kouri (1976), and Michael Alder and Bernard Dumas (1977), it has not been brought out in the current macro literature. The objective of the present paper is to investigate the macroeconomic consequences of this distinction and to show how it may be crucial in assessing the effects of various macroeconomic disturbances under varying degrees of capital mobility. We find that well-known results about the effects of increased capital mobility on the efficacy of monetary policy are correct when the increased mobility is due to a reduction in exchange risk, but not necessarily so when it is due to a reduction in default risk. Section I formulates a general equilibrium macroeconomic model which embodies the distinction between these two sources of risk. We assume that the economy is small, so that it treats certain characteristics of the foreign economy as parametric. Section II carries out certain comparative static exercises with this model. Specifically, it considers some important relationships between the available policy instruments and endogenous variables, and shows how these are affected by the degree of capital mobility in the two senses in which this term is defined. In particular, we show that, as long as there is a possibility of default, there exists an independent role for forward market intervention. In the limiting case of no default risk, *Yale University and University of Illinois, respectively. 'See Peter Kenen (1965) for an early analysis of the forward market incorporating potential default. Political risk may derive from the threat of exchange controls as well as from the threat of outright debt repudiation. In either case, the risk may not be the loss of the total net worth of the investment. When the threat derives from exchange controls, the expected value of net worth may even be preserved, but if payment is delayed, forward cover obtained for the investment will no longer be appropriate. For our purposes it is the risk that repayment not occur on the date for which the forward cover is arranged, thereby exposing the investor to exchange risk, that is relevant. Our analysis could easily be modified to incorporate a preservation of some or all net worth in the event of default. See Eaton and Mark Gersovitz (1981) for a model in which the probability of default is endogenous.
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