Jim Whitney Economics 311

Open-economy macroeconomics: short-run policy effects with fixed exchange rates

    Example 1: Expansionary monetary policy:

  (1) +M/P => LM shifts right => +Y, -r
   (2) -r => K-outflows => NFI shifts right => pressure for currency depreciation
   (3) -M/P to prevent depreciation => LM shifts back
   (4) +r back to initial equilibrium => NFI shifts back as well.
Overall results: monetary policy does not work

 

    Example 2: Expansionary fiscal policy:

        (1) +G => IS shifts right => +Y,+r
        (2) +r => incentive for K-inflows => NFI shifts left
        (3) LM shifts right as Fed supplies domestic currency prevent appreciation. (until r returns to initial level.)
        (5) NFI shifts right due to expansionary monetary policy. (R returns to initial fixed level.)
Overall results: +Y, no SR change in r, -NX, no SR change in R.
    But note: Yb>Yf => pressure for self-correction via inflation in the long run. As long as the expansionary fiscal policy persists, the short-run process keeps repeating itself, and the nation's money supply keeps growing until inflation pushes R up until it passes through point * in the foreign-sector diagram. At that point, the economy will have its excess spending financed by capital inflows, just as it would have via nominal currency appreciation with floating exchange rates.