1. Imagine that you run the central bank in a large open economy with a floating exchange rate. Your goal is to stabilize income, and you adjust the money supply accordingly. Under your policy, what happens to the money supply, the interest rate, the exchange rate, and the trade balance in response to each of the following shocks?
The government raises taxes to reduce the budget deficit.
The government restricts the import of foreign cars.
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2. Over the past several decades, the economies of the world have become more financially integrated. That is, investors in all nations have become more willing and able to take advantage of financial opportunities abroad. Consider how this development affects the ability of monetary policy to influence the economy.
If investors become more willing and able to substitute foreign and domestic assets, what happens to the slope of the CF function?
If the CF function changes in this way, what happens to the slope of the IS curve?
How does this change in the IS curve affect the Fed’s ability to control the interest rate?
How does this change in the IS curve affect the Fed’s ability to control national income?
3. Suppose that policymakers in a large open economy want to raise the level of investment without changing aggregate income or the exchange rate.
Is there any combination of domestic monetary and fiscal policies that would achieve this goal?
Is there any combination of domestic monetary, fiscal, and trade policies that would achieve this goal?
Is there any combination of monetary and fiscal policies at home and abroad that would achieve this goal?
4. This appendix considers the case of a large open economy with a floating exchange rate. Now suppose instead that a large open economy has a fixed exchange rate. That is, the central bank announces a target for the exchange rate and commits itself to adjusting the money supply to ensure that the equilibrium exchange rate equals the target.
Describe what happens to income, the interest rate, and the trade balance in response to a fiscal expansion, such as an increase in government purchases. Compare your answer to the case of a small open economy with a fixed exchange rate.
Describe what happens to income, the interest rate, and the trade balance if the central bank expands the money supply by buying bonds from the public. Compare your answer to the case of a small open economy with a fixed exchange rate.
1 The quotation is from Maurice Obstfeld and Kenneth Rogoff, Foundations of International Macroeconomics (Cambridge, MA: MIT Press, 1996)—a leading graduate-level textbook in open--economy macroeconomics. The Mundell–Fleming model was developed in the early 1960s. Mundell’s contributions are collected in Robert A. Mundell, International Economics (New York: Macmillan, 1968). For Fleming’s contribution, see J. Marcus Fleming, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,”’ IMF Staff Papers 9 (November 1962): 369–379. Fleming died in 1976, so he was not eligible to share in the Nobel award.
2 This assumption—and thus the Mundell–Fleming model—does not apply exactly to a large open economy such as that of the United States. In the conclusion to this chapter (and more fully in the appendix), we consider what happens in the more complex case in which international capital mobility is less than perfect or a nation is so large that it can influence world financial markets.
3 For more on how the gold standard worked, see the essays in Barry Eichengreen, ed., The Gold Standard in Theory and History (New York: Methuen, 1985).
4 Barry Eichengreen and Jeffrey Sachs, “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 45 (December 1985): 925–946.
5 Dollarization may also lead to a loss in national pride from seeing American portraits on the currency. If it wanted, the U.S. government could fix this problem by leaving blank the center space that now has portraits of George Washington, Abraham Lincoln, and others. Each nation using U.S. currency could insert the faces of its own local heroes.
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