9 Another important relative price that is endogenized in the model is the real exchange rate. The real exchange rate plays a role in the allocation of expenditure over different goods at a given moment of time, similar to the way the real interest rate inflt,ences the intertemporal expenditure of expenditure for given ii. ra-temporal allocation (cf van Wijnbergen (1989) for a detailed exposition of the theory underlying this model). This is a rather different approach from most other empirical models, where the real exchange rate, if it is endogenized at all, is often derived from current account considerations. In our setup, the real exchange rate also influences the current account, but in a rather complicated manner, through its impact on aggregate supply and investment behavior. No empirical evidence could be found to support the Laursen-Metzler notion that the real exchange rate also influences consumption expenditure.

It is in fac. more natural to think of the real exchange rate as the relative price clearing the market for "Mexican" goods. Its equilibrium value is thus not derived from current account considerations, but from commodity market clearing conditions. The level of external transfers, the composition of government expenditure over home and foreign goods, and commercial policy all have an important impact on the real exchange rate in this approach. Explicit nominal exchange rate policies targeting the real exchange rate may, if successful, cause persistent commodity market disequilibrium ( van Wijnbergen (1989)).

In the following pages, we provide a simplified exposition of the analytical structure of the model. We then discuss the empirical application to Mexican data.

# A.1 Real Interest Rates, Fiscal Policy and Output Growth.

As long as domestic interest rates are not completely linked to foreign interest rates (plus exchange rate depreciation) there is an additional degree of freedom in macroeconomic policy. Then changes in domestic real interest rates can resolve potential discrepancies between fiscal deficits and externlal ta'gets through their impact on the net private savings surplus (i.e private saving minus private investment). In the process, private investment and hence output growth will be affected. This _is_ one of the more important links between fiscal policy and output growth embedded in the model.The mechanism is shown in Figure 1. Underlying this figure is the following identity derived from the national accounts, but with behavioral content built into private savings and investment: The private sector's surplus of savings over investment, NPS-PS-PI, is shown as a function of the real rate of interest. A higher real interest rate will slow down private sector investment and increase private savings, thus increasing NPS. Empirical evidence on these effects is presented in Section 4.3. This is represented by the upward sloping line "NPS" in Figure 4.1.

The sum of NPS and the fiscal surplus (FS; this equals minus the deficit) equals the external deficit that is compatible with given real interest rates and with FS. The external deficit is represented by the line CA in Fig. 4.1. The horizontal line TCA is the target value for the current