12.7 A Concluding Reminder


In this chapter we have examined how a small open economy works in the short run when prices are sticky. We have seen how how monetary, fiscal, and trade policy influence income and the exchange rate, and how the behaviour of the economy depends on whether the exchange rate is floating or fixed. Since Canada is a small open economy, the Mundell–Fleming model applies very well—as we have seen in earlier sections of this chapter. In closing, however, we should note that many countries, including the United States, are neither closed economies nor small open economies: they lie somewhere in between.

A large open economy like the United States combines the behaviour of a closed economy and the behaviour of a small open economy. When analyzing policies in a large open economy, we need to consider both the closed-economy logic of Chapter 11 and the open-economy logic developed in this chapter. The results are, as one would guess, a mixture of the two polar cases we have already examined.

To see how we can draw on the logic of both the closed and small open economies and apply these insights to the United States, consider how a monetary contraction affects the economy in the short run. In a closed economy, a monetary contraction raises the interest rate, lowers investment, and thus lowers aggregate income. In a small open economy with a floating exchange rate, a monetary contraction raises the exchange rate, lowers net exports, and thus lowers aggregate income. The interest rate is unaffected, however, because it is determined by world financial markets.

The U.S. economy contains elements of both cases. Because the United States is large enough to affect the world interest rate, a monetary contraction does raise the interest rate and depress investment. At the same time, a monetary contraction also raises the value of the U.S. dollar, thereby depressing net exports. Hence, although the Mundell–Fleming model does not precisely describe an economy like that of the United States, it does predict correctly what happens to international variables such as the exchange rate, and it shows how international interactions alter the effects of monetary and fiscal policies.