welcome to this introduction to chapter 14 in the book macroeconomics this chapter is about the open economy in the short run and this chapter completes the analysis of our macroeconomic model and it is focusing on the role of economic policy in the open economy in the short run and it also lays the theoretical foundation for chapter 15 which is an applied chapter disc discussing the experiences with alternative exchange rate systems and monetary Union because it will turn out that the exchange rate system matters very much for how we can conduct economic policy in the open economy and really the main point of this chapter is to show that the roles of fiscal and monetary policy are fundamentally different depending on whether we have a fixed or a floating exchange rate so if you have a fixed exchange rate you really do not have any monetary policy and therefore fiscal policy becomes very important if you have a floating exchange rate then monetary policy is very powerful because it affects many different components of aggregate demand and fiscal policy is less powerful how powerful fiscal policy is depends on the exact assumptions that we make in our analysis so to analyze the open economy in the short run we use the same equations as before we have the goods market equilibrium condition we have the money market equilibrium condition and we have the interest parity condition and now in the short run analysis we take the price level at home and abroad as given so p and P star are exous contrary to the long run where those were ardous and that means that production is endogenously determined in the short run production is determined by demand which consists of consumption investment government demand and net exports and since we have three equations we must have three endogenous variables so what the other endogenous variables well that will depend on the exchange rate system if we have a credibly fixed exchange rate then E and E are exogenously given and then the interest parity condition says that the interest rate has to be the same as abroad and that will mean that the Central Bank loses control over the money supply so m is endogenous so in these three equations with a fixed exchange rate the endogenous variables are going to be y i and m if you instead have a floating exchange rate then the central bank can set either the money supply or the interest rate and then you can view the interest parity condition as an equation determining the exchange rate endogenously so with a floating exchange rate the endogenous variables are y and e and then either M or I so that is summarized here and this is a kind of mathematical explanation let's think more about the economics of this so let us consider first a fixed exchange rate so how does the Central Bank maintain a fixed exchange rate well they do that by operations in the currency market so a fixed exchange rate means that the Central Bank announces an official Target value for the currency and then the Central Bank buys and sells domestic currency so as to keep the exchange rate very close to that announced value called the central parity and if we then look at the interest parity condition and we fix the exchange rate we see immediately that that says that the interest rate has to be the same as abroad provided it's a credibly fixed exchange rate so it's not expected to change in the future and this means that the central bank will not have any control of the interest rate or the money supply but the money supply will be endogenously determined by the demand for money and intuitively this is because if you fix the value of your currency in terms of the currency of the rest of the world and then you set an interest rate for example below the world interest rate then you're offering the speculators a free lunch or a million free lunches because then they can just borrow in your small open economy and then land abroad and make infinite amounts of money so that's just not possible so therefore you have to set the same interest rate as abroad and we can then substitute I star for I in the is equation and then really we only need to look at the is equation to determine the level of production in the economy and we can then assume some consumption function some tax function some import functions and we can then study the effects of fiscal policy this is the multiplier that you get for an increase in government consumption or investment where to is the margin tax rate C1 is the marginal propensity to consume and Q is the marginal propensity to import and here we see that the multiplier effect of fiscal policy in the open economy it is going to be smaller than in the Clos economy because Q is a positive number that appears in the denominator of the multiplier this is because as consumers increase their consumption they will spend some of that money on import so some of this increase in demand that follows from an expansionary fiscal policy some of that increase in demand will leak abroad so the multiplier effect is smaller compared to the closed economy on the other hand there's not going to be any crowding out of Investments because the interest rate is fixed abroad and therefore as production increases there will not be any Central Bank raising the interest interest rate and there will not be any crowding out of investment and in that sense fiscal policy is going to be quite powerful and play an important role when we have a fixed exchange rate so with a fixed exchange rate fiscal policies important and you do not have any monetary policy except the possibility to change the value of the currency which I have not discussed but that is called a devaluation or reevaluation but aside from that you do not have any monetary policy of your own when you fix the exchange rate so let us turn to a floating exchange rate a pure floating exchange rate means that you do not have any Target value for the currency and that the Central Bank does not intervene in the currency market so the central bank is free to set the interest rate or the money supply and we can view the interest parity condition as an equation determining the exchange rate and we see here that if you raise the interest rate this is going to raise the value of the currency because it becomes more attractive to buy the currency and lend in the currency of the small open economy if the interest rate is higher and therefore the interest rate has a positive effect on the exchange rate for given foreign interest rate in given expected future exchange rate and here we have Rewritten the model where we have written the interest parity condition as an equation determining the exchange rate now for graphical analysis is useful to substitute the expression for the exchange rate into the is equation so we substitutes for E there and then we get what we call the is star equation so the difference here is that we have now substituted here the expression for the exchange rate and now we see that the interest rate appears in several places it's here it affects consumption it's here it affects investment and it's here it affects the exchange rate and thereby net exports so the interest rate has Direct effects on domestic demand because it affects consumption and investment but it also works through what we can call the exchange rate channel that as you raise the interest rate the value of your currency increases and that will reduce net exports so you see that monetary policy is quite powerful affecting all the components of aggregate demand except government expenditure so we can illustrate this using the islm diagram where we have the is curve drawn for a given exchange rate and then we can draw the is star curve which was this equation here which includes the effect of the interest rate on the exchange rate and that is star curve is then going to be flatter because now the interest rate has a stronger effect on aggregated mod when you take account of the exchange rate Channel and on the left here we have Illustrated the interest parity condition so here on the horizontal axis we have the exchange rate and here we vertical axis the interest rate and if if you raise the interest rate that will increase the value of your currency that is what the interest parity condition says so this illustrates our model of the open economy in the short run so what determines the slope of the is star curve well that is of course how the interest rate affects consumption how the interest rate affects investment and also the effect of the interest rate on the exchange rate and thereby on net exports and in this analysis so far we have implicitly assume that the expected future exchange rate is constant now it may be quite realistic that if you raise the interest rate and the currency appreciates that also affects the expected future value of the currency so an increasing interest rate could raise the expected future value value of the exchange rate if that is the case then that will reinforce the effect through the exchange rate Channel it will make the effect of the interest rate on net exports even stronger and therefore the is star Curve will become more flat and I've Illustrated that here if the expected future exchange rate also increases then the is star Curve will be very flat and monetary policy will will be very powerful in the sense that a small increase in the interest rate has a very big effect on production and under certain conditions the is star curve can even become completely flat this is discussed in chapter 14 and also in the appendix to to the chapter okay so now we can illustrate the equilibrium here we draw the LM curve for a given money supply and we see how the level of production the interest rate and the exchange rate are determined we can also look at uh expansionary monetary policy that increases money supply and pushes down the interest rate and we see that it also leads to a depreciation of the currency and an increase in production so that is monetary policy what about fiscal policy well compared to the case of a fixed exchange rate the effect of fiscal policy on production is going to be smaller because now we're going to have crowding out of Investments and exports and I illustrate that here as usual the fiscal policy shifts out the is curve but then in the background you have the central bank that will react by raising the interest rate and if the is store curve is very flat and that increase in the interest rate will counteract much of the effect of fiscal policy so there will be typically crowding out of both investment and exports but of course that depends on what the Central Bank does it depends on whether the Central Bank raises the interest rate or not and it also depends on how exchange rate expectations are formed because under certain conditions you could have it completely flat is store curve and then fiscal policy will be completely ineffective now that case I view that as a fairly extreme case typically the evidence shows that fiscal policy does matter consider for example the United States the US has had a flexible exchange rate for a long time and the evidence that was reviewed in chapter 11 suggests that fiscal policy does affect the economy in the US so I think it's reasonable to say that fiscal policy does affect the economy also when you have a floating exchange rate but it's less powerful compared to when you have a fixed exchange rate so here is a summary of the effect of monetary and fiscal policy with a fixed exchange rate and with a floating exchange rate we can also relate this analysis to the analysis of the long run that we had in the previous chapter chapter in Chapter 13 so in that chapter we used this graph where you have the net exports on the horizontal axis and the real exchange rate on the vertical axis and then we said that for production to be on the natural level then net exports have to be equal to what you produce minus what you use yourself for consumption investment and government demand so that determines then the natural level of the real exchange rate and this is initially here E1 now suppose that consumers become more worried about the future so they consume less well that will reduce consumption and that means that there will be more Goods to export so you need to increase the exports and the real exchange rate has to depreciate so that's what the long run analysis said that if there's a fall in domestic consumption you need a real depreciation now how does that happen how is this adjustment achieved well that will depend on the exchange rate system and that is discussed in the book how this happens because the adjustment will be quite different depending on whether you have a fixed or a floating exchange rate okay so good luck with your studies of stabilization policy in the open economy