When the euro was created in 1999, there were celebrations across the nations of Europe—with a few notable exceptions. You see, some countries chose not to adopt the new currency. The most important of these was Britain, but other European countries, such as Sweden, also decided that the euro was not for them.

Why did Britain say no? Part of the answer was national pride: if Britain gave up the pound, it would also have to give up currency that bears the portrait of the queen. But there were also serious economic concerns about giving up the pound in favor of the euro. British economists who favored adoption of the euro argued that if Britain used the same currency as its neighbors, the country’s international trade would expand and its economy would become more productive. But other economists pointed out that adopting the euro would take away Britain’s ability to have an independent monetary policy and might lead to macroeconomic problems.

As this discussion suggests, the fact that modern economies are open to international trade and capital flows adds a new level of complication to our analysis of macroeconomic policy. Let’s look at three policy issues raised by open-economy macroeconomics.

Historically, fixed exchange rates haven’t been permanent commitments. Sometimes countries with a fixed exchange rate switch to a floating rate. In other cases, they retain a fixed rate but change the target exchange rate. Such adjustments in the target were common during the Bretton Woods era described in the preceding For Inquiring Minds. For example, in 1967 Britain changed the exchange rate of the pound against the U.S. dollar from US$2.80 per £1 to US$2.40 per £1. A modern example is Argentina, which maintained a fixed exchange rate against the dollar from 1991 to 2001 but switched to a floating exchange rate at the end of 2001.

A reduction in the value of a currency that is set under a fixed exchange rate regime is called a devaluation. As we’ve already learned, a depreciation is a downward move in a currency. A devaluation is a depreciation that is due to a revision in a fixed exchange rate target. An increase in the value of a currency that is set under a fixed exchange rate regime is called a revaluation.

A devaluation, like any depreciation, makes domestic goods cheaper in terms of foreign currency, which leads to higher exports. At the same time, it makes foreign goods more expensive in terms of domestic currency, which reduces imports. The effect is to increase the balance of payments on current account. Similarly, a revaluation makes domestic goods more expensive in terms of foreign currency, which reduces exports, and makes foreign goods cheaper in domestic currency, which increases imports. So a revaluation reduces the balance of payments on current account.

Devaluations and revaluations serve two purposes under fixed exchange rates. First, they can be used to eliminate shortages or surpluses in the foreign exchange market. For example, in 2010 some economists and politicians were urging China to revalue the yuan because they believed that China’s exchange rate policy unfairly aided Chinese exports.

Second, devaluation and revaluation can be used as tools of macroeconomic policy. A devaluation, by increasing exports and reducing imports, increases aggregate demand. So a devaluation can be used to reduce or eliminate a recessionary gap. A revaluation has the opposite effect, reducing aggregate demand. So a revaluation can be used to reduce or eliminate an inflationary gap.

Under a floating exchange rate regime, a country’s central bank retains its ability to pursue independent monetary policy: it can increase aggregate demand by cutting the interest rate or decrease aggregate demand by raising the interest rate. But the exchange rate adds another dimension to the effects of monetary policy. To see why, let’s return to the hypothetical country of Genovia and ask what happens if the central bank cuts the interest rate.

Just as in a closed economy, a lower interest rate leads to higher investment spending and higher consumer spending. But the decline in the interest rate also affects the foreign exchange market. Foreigners have less incentive to move funds into Genovia because they will receive a lower interest rate on their loans. As a result, they have less need to exchange U.S. dollars for genos, so the demand for genos falls. At the same time, Genovians have more incentive to move funds abroad because the interest rate on loans at home has fallen, making investments outside the country more attractive. As a result, they need to exchange more genos for U.S. dollars, so the supply of genos rises.

Figure 34-12 shows the effect of an interest rate reduction on the foreign exchange market. The demand curve for genos shifts leftward, from D₁ to D₂, and the supply curve shifts rightward, from S₁ to S₂. The equilibrium exchange rate, as measured in U.S. dollars per geno, falls from XR₁ to XR₂. That is, a reduction in the Genovian interest rate causes the geno to depreciate.

The depreciation of the geno, in turn, affects aggregate demand. We’ve already seen that a devaluation—a depreciation that is the result of a change in a fixed exchange rate—increases exports and reduces imports, thereby increasing aggregate demand. A depreciation that results from an interest rate cut has the same effect: it increases exports and reduces imports, increasing aggregate demand.

In other words, monetary policy under floating rates has effects beyond those we’ve described in looking at closed economies. In a closed economy, a reduction in the interest rate leads to a rise in aggregate demand because it leads to more investment spending and consumer spending. In an open economy with a floating exchange rate, the interest rate reduction leads to increased investment spending and consumer spending, but it also increases aggregate demand in another way: it leads to a currency depreciation, which increases exports and reduces imports, and further increases aggregate demand.

Up to this point, we have discussed macroeconomics, even in an open economy, as if all demand shocks originate from the domestic economy. In reality, however, economies sometimes face shocks coming from abroad. For example, recessions in the United States have historically led to recessions in Mexico.

The key point is that changes in aggregate demand affect the demand for goods and services produced abroad as well as at home: other things equal, a recession leads to a fall in imports and an expansion leads to a rise in imports. And one country’s imports are another country’s exports. This link between aggregate demand in different national economies is one reason business cycles in different countries sometimes—but not always—seem to be synchronized. The prime example is the Great Depression, which affected countries around the world.

The extent of this link depends, however, on the exchange rate regime. To see why, think about what happens if a recession abroad reduces the demand for Genovia’s exports. A reduction in foreign demand for Genovian goods and services is also a reduction in demand for genos in the foreign exchange market. If Genovia has a fixed exchange rate, it responds to this decline with exchange market intervention. But if Genovia has a floating exchange rate, the geno depreciates. Because Genovian goods and services become cheaper to foreigners when the demand for exports falls, the quantity of goods and services exported doesn’t fall by as much as it would under a fixed rate. At the same time, the fall in the geno makes imports more expensive to Genovians, leading to a fall in imports. Both effects limit the decline in Genovia’s aggregate demand compared to what it would have been under a fixed exchange rate.

One of the virtues of a floating exchange rate, according to advocates of such exchange rates, is that they help insulate countries from recessions originating abroad. This theory looked pretty good in the early 2000s: Britain, with a floating exchange rate, managed to stay out of a recession that affected the rest of Europe, and Canada, which also has a floating rate, suffered a less severe recession than the United States.

In 2008, however, a financial crisis that began in the United States led to a recession in virtually every country. In this case, it appears that the international linkages among financial markets were much stronger than any insulation from overseas disturbances provided by floating exchange rates.