1. Adding the TB to the macro model creates expenditure switching effects through the real exchange rate.
2. The IS-LM-FX model is the workhorse model for international macro.
3. Under flexible rates, monetary expansion lowers interest rates, depreciating the currency and stimulating the the TB. Fiscal policy raises interest rates, appreciates the currency, and lowers the the TB. Both policies can be used as stabilization policies.
4. Under fixed rates, monetary policy is powerless because the central bank cannot affect interest rates. However, fiscal policy is powerful; an expansionary fiscal policy requires a reinforcing expansionary monetary policy to maintain the peg. Fixed rates give policymakers less flexibility than flexible rates.
5. In either regime, the government can implement stabilization policies. However, there are more policy options under flexible rates. Furthermore, it is difficult to implement stabilization policies because of inside and outside lags.
The analysis of macroeconomic policy is different in an open economy than in a closed economy. The trade balance generates an additional source of demand, and its fluctuations are driven by changes in output and the real exchange rate. Expenditure switching is a key mechanism at work here: as international relative prices change, demand shifts from foreign to home goods and vice versa.
The open economy IS-LM-FX framework is a workhorse model for analyzing the macroeconomic responses to shocks and to changes in monetary and fiscal policies. Exploring these responses, in turn, draws out some clear contrasts between the operation of fixed and flexible exchange rate regimes.
Under flexible exchange rates, monetary and fiscal policies can be used. Monetary expansions raise output and also lower the interest rate, which stimulates investment and causes a depreciation, which in turn stimulates the trade balance. Fiscal expansions raise output; raise the interest rate, which depresses investment; and cause an appreciation, which in turn lowers the trade balance.
With two policy tools available, the authorities have considerable flexibility. In particular, their ability to let the exchange rate adjust to absorb shocks makes a strong case for a floating exchange rate. Now we can understand the logic behind Robert Mundell’s quote at the start of the chapter.
Under fixed exchange rates, monetary policy cannot be used because the home interest rate has to remain equal to the foreign interest rate in order for the exchange rate to remain fixed. But fiscal policy has great power under a fixed exchange rate. Fiscal expansions raise output and force the monetary authority to expand the money supply to prevent any rise in the interest rate and any appreciation of the exchange rate. In contrast to the floating case, in which interest rate increases and exchange rate appreciation put downward pressure on investment and the trade balance, the demand stimulus is even greater.
With only one policy tool available, the authorities in fixed rate regimes have much less flexibility. They also expose the economy to more volatility because any demand shock will entail an immediate and reinforcing monetary shock. The tendency of fixed exchange rate systems to amplify demand shocks helps us understand the logic behind Alec Ford’s quote at the start of the chapter.
Whatever the regime, fixed or floating, our findings suggest that macroeconomic policy can in principle be used to stabilize an open economy when it suffers from external shocks. Under floating exchange rates, however, more policy options are available (monetary and fiscal policy responses are feasible) than under fixed exchange rates (only a fiscal policy response is feasible).
Despite these relatively simple lessons, real-world policy design is not straightforward. Policy makers have difficulty identifying shocks, devising the right response, and acting quickly enough to ensure that policy actions have a timely effect. Even then, under some conditions, the economy may respond in unusual ways.
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