Expansionary fiscal policy with open capital markets and floating exchange rates

Example: Reaganomics of the 1980s economy.

    Note1: ER overshooting occurs: the tendency of an adjusting ER to initially go beyond its new long-run equilibrium level.
    Why? Becuase NX are less elastic in the SR than in the LR.
    Implication: This helps explain the excessive variability of ERs. It takes awhile for foreign suppliers to satisfy all of the economy's credit needs. In the meantime, the currency is overvalued and domestic i-rates are above i-rates abroad.

    Note2: -NXlr = +G: In the LR, crowding out of tradables replaces crowding out of investment and can completely offset the fiscal policy stimulus.
    Why? Because in the LR, ERs stabilize again, removing the fear of additional ER changes, so savers are willing to finance all of the economy's credit needs at the global interest rate.
    Implication: The domestic i-rate returns to the global i-rate, so investment returns to its initial level. Output returns to Yf in the LR, so the increase in government spending completely crowds out other spending--in this case net exports as the country borrows from abroad.