Impact of Policies in Short-Run Open Economies

Summary of Macroeconomics Chapter 14 Lecture on Open Economy in the Short Run

In Chapter 14, the focus is on understanding the impact of economic policies in an open economy during short-run scenarios. The chapter plays a crucial role in setting up the theoretical foundation for applying different exchange rate systems and monetary policies, which are further explored in Chapter 15. It highlights how fiscal and monetary policies function differently under various exchange rate systems—fixed versus floating—and provides the groundwork for analyzing these dynamics through equations that illustrate market equilibrium in such economic conditions.

Key Points from the Lecture

Exchange Rate Systems and Economic Policy

• Fixed Exchange Rate:

  • Under a fixed system, the country's central bank has no control over monetary policy, making fiscal policy more significant.
  • Central banks maintain the exchange rate by buying or selling domestic currency to match the target exchange rate.
  • The interest rate must align with international rates to preserve the credibility of the fixed rate.
  • Endogenous variables in the model include output (Y), interest rate (I), and money supply (M).
  • Fiscal policy is relatively more potent as it doesn't face crowding out from rising interest rates.

• Floating Exchange Rate:

  • The central bank does not engage in maintaining a specific exchange rate; hence, monetary policy is highly effective.
  • Interest rates can be adjusted by the central bank, impacting the domestic currency's value through the interest parity condition.
  • Changes in interest rates affect all components of aggregate demand except government spending.
  • Endogenous variables here include output (Y), exchange rate (E), and either money supply (M) or interest rate (I), depending on the policy focus.
  • Fiscal policy is less effective due to potential crowding out of investment and exports.

Mathematical and Theoretical Foundations

• The lecture used three critical equations to analyze an open economy:
  • Goods Market Equilibrium
  • Money Market Equilibrium
  • Interest Parity Condition
• Short-run analysis takes the price level as given, both domestically and internationally ("P" and "P*"), contrary to the long-run.

Economic Outcomes Based on Policy Actions

• Under Fixed Rates:

  • Fiscal expansions have more pronounced multipliers, although this effect is diminished by import spending due to the propensity to import.
  • There's no crowding out of investment due to fixed global interest rates.

• Under Floating Rates:

  • The central bank's manipulation of interest rates significantly affects the exchange rate and thereby the entire demand spectrum.
  • Fiscal policy might lead to crowding out because central bank actions could offset government spending effects by adjusting the interest rate.

Graphical Analysis

• Use of IS-LM Model to illustrate shifts in the economy due to policy measures.
  • The lecture discusses how the IS curve incorporates changes in the exchange rate influenced by interest rate adjustments (IS* curve).
  • An expansive monetary policy lowers interest rates and devalues the currency, resulting in higher output.

Comparison to Long-Run Analysis

• Adjustment to changes in consumption and its effect on exports and the real exchange rate differ fundamentally between fixed and floating systems.

Conclusion and implications for Chapter 15

• The chapter concludes by bridging these short-run analyses with practical experiences to be discussed in Chapter 15, providing a continuation of the theoretical exploration into applied scenarios within different exchange rate systems and economic stability strategies.

This comprehensive analysis aids in understanding the dynamic interplay between fiscal and monetary policies in an open economy, framed by the type of exchange rate system in practice.