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Figure 13.8)
1. How do fiscal and monetary policies affect a country’s real exchange rate and net exports?
2. How do the macroeconomic policies of one country affect the economies of other countries?
B. Three steps in analyzing these questions
1. Use the domestic economy’s IS-LM diagram to see the effects on domestic output and the
domestic real interest rate
2. See how changes in the domestic real interest rate and output affect the exchange rate and
net exports
3. Use the foreign economy’s IS-LM diagram to see the effects of domestic policy on foreign
output and the foreign real interest rate
1. Look at a temporary increase in domestic government purchases using the classical (RBC)
model
a. The rise in government purchases shifts the IS curve up and to the right and the FE line
to the right (Figure 13.8; like text Figure 13.9)
Figure 13.8
2. How do these changes affect a foreign country’s economy?
a. The decline in net exports for the domestic economy means a rise in net exports for the
foreign country, so the foreign country’s IS curve shifts up and to the right
b. In the classical model, the LM curve shifts up and to the left as the price level rises to
3. In either the classical or Keynesian model, a temporary increase in domestic government
purchases raises domestic income (temporarily) and the domestic real interest rate, as in a
closed economy
a. It also reduces domestic net exports, so government spending crowds out both
1. Look at a reduction in the domestic money supply in a Keynesian model
2. Short-run effects on the domestic and foreign economies (Figure 13.9; like text Figure 13.10)
Figure 13.9
a. The domestic LM curve shifts up and to the left
b. In the short run, domestic output is lower and the real interest rate is higher
c. The exchange rate appreciates, because lower output reduces demand for imports, thus
3. Long-run effects on the domestic and foreign economies
a. In the long run, wages and prices in the domestic economy decline and the LM curve
returns to its original position
b. All real variables, including net exports and the real exchange rate, return to their
original levels
1. The United States has been on a flexible-exchange-rate system since the early 1970s
2. But fixed exchange rates are still used by many countries
3. There are two key questions we’d like to answer
a. How does the use of a fixed-exchange-rate system affect an economy and
1. The government sets the exchange rate, perhaps in agreement with other countries
2. What happens if the official rate differs from the rate determined by supply and demand?
a. Supply and demand determine the fundamental value of the exchange rate (Figure 13.10;
like text Figure 13.11)
Figure 13.10
b. When the official rate is above its fundamental value, the currency is said to be overvalued
1994 and Asia in 1997–1998
(3) Thus an overvalued currency can’t be maintained for very long
3. Similarly, in the case of an undervalued currency, the official rate is below the fundamental
value (text Figure 13.13)
a. In this case, a central bank trying to maintain the official rate will acquire official reserve
assets
1. The best way for a country to make the fundamental value of a currency equal the official
rate is through the use of monetary policy
2. Rewrite Eq. (13.1) as
enom ePFor /P(13.6)
3. For an overvalued currency, a monetary contraction is desirable
a. In a Keynesian model, a monetary contraction causes a real (and nominal) exchange rate
appreciation in the short run and a nominal exchange rate appreciation in the long run
(with no long-run effect on the real exchange rate)
b. Conversely, a monetary expansion causes a nominal exchange rate depreciation in both
4. This implies that countries can’t both maintain the exchange rate and use monetary policy
to affect output
a. Using expansionary monetary policy to fight a recession would lead to an overvalued
currency
5. However, a group of countries may be able to coordinate their use of monetary policy
a. If two countries increase their money supplies together to fight joint recessions, there
6. Overall, fixed exchange rates can work well if countries in the system have similar
macroeconomic goals and can coordinate changes in monetary policy
1. Flexible-exchange-rate systems also have problems, because the volatility of exchange rates
introduces uncertainty into international transactions
Data Application
A very detailed and comprehensive review of the world’s experience under flexible exchange
2. There are two major benefits of fixed exchange rates
a. Stable exchange rates make international trades easier and less costly
b. Fixed exchange rates help discipline monetary policy, making it impossible for a country
to engage in expansionary policy; the result may be lower inflation in the long run
Policy Application
3. But there are some disadvantages to fixed exchange rates
a. They take away a country’s ability to use expansionary monetary policy to combat
recessions
b. Disagreement among countries about the conduct of monetary policy may lead to the
4. Which system is better may thus depend on the circumstances
a. If large benefits can be gained from increased trade and integration, and when countries
can coordinate their monetary policies closely, then fixed exchange rates may be
desirable
b. Countries that value having independent monetary policies, either because they face
1. Under a currency union, countries agree to share a common currency
a. They often cooperate economically and politically as well, as was the case with the
13 original U.S. colonies
2. To work effectively, a currency union must have just one central bank
a. Since countries don’t usually want to give up control over monetary policy by not having
3. But the major disadvantage of a currency union is that all countries share a common
monetary policy, a problem that also arises with fixed exchange rates
4. Application: European monetary unification
a. In 1991, countries in the European Community adopted the Maastricht treaty, which
provides for a common currency
(1) The currency, called the euro, came into being on January 1, 1999
(2) Eleven countries took part in the union, initially
1. Argentina’s economy has suffered periodic crises
2. Argentina’s inflation rate in the 1970s and 1980s was very large, with prices rising by
a factor of 10 billion from 1975 to 1990
3. Inflation was reduced to near zero in the 1990s as the budget deficit was reduced and a
currency board was implemented
a. A currency board is a monetary arrangement under which the supply of domestic
currency in circulation is strictly limited by the amount of foreign reserves held by the
4. The 1990s were a time of economic prosperity for Argentina, with fast economic growth
and low inflation
5. But the end of the decade saw Argentina slip into deep recession and the government’s
budget deficit increased sharply
6. Eventually, Argentina defaulted on foreign debts and in January 2002 it abandoned the
currency board, allowing the peso to float relative to the dollar
2002 to 2011), so ultimately the currency board failed to deliver long-term price stability
1. How do fiscal and monetary policies affect a country’s real exchange rate and net exports?
2. How do the macroeconomic policies of one country affect the economies of other countries?
B. Three steps in analyzing these questions
1. Use the domestic economy’s IS-LM diagram to see the effects on domestic output and the
domestic real interest rate
2. See how changes in the domestic real interest rate and output affect the exchange rate and
net exports
3. Use the foreign economy’s IS-LM diagram to see the effects of domestic policy on foreign
output and the foreign real interest rate
1. Look at a temporary increase in domestic government purchases using the classical (RBC)
model
a. The rise in government purchases shifts the IS curve up and to the right and the FE line
to the right (Figure 13.8; like text Figure 13.9)
Figure 13.8
2. How do these changes affect a foreign country’s economy?
a. The decline in net exports for the domestic economy means a rise in net exports for the
foreign country, so the foreign country’s IS curve shifts up and to the right
b. In the classical model, the LM curve shifts up and to the left as the price level rises to
3. In either the classical or Keynesian model, a temporary increase in domestic government
purchases raises domestic income (temporarily) and the domestic real interest rate, as in a
closed economy
a. It also reduces domestic net exports, so government spending crowds out both
1. Look at a reduction in the domestic money supply in a Keynesian model
2. Short-run effects on the domestic and foreign economies (Figure 13.9; like text Figure 13.10)
Figure 13.9
a. The domestic LM curve shifts up and to the left
b. In the short run, domestic output is lower and the real interest rate is higher
c. The exchange rate appreciates, because lower output reduces demand for imports, thus
3. Long-run effects on the domestic and foreign economies
a. In the long run, wages and prices in the domestic economy decline and the LM curve
returns to its original position
b. All real variables, including net exports and the real exchange rate, return to their
original levels
1. The United States has been on a flexible-exchange-rate system since the early 1970s
2. But fixed exchange rates are still used by many countries
3. There are two key questions we’d like to answer
a. How does the use of a fixed-exchange-rate system affect an economy and
1. The government sets the exchange rate, perhaps in agreement with other countries
2. What happens if the official rate differs from the rate determined by supply and demand?
a. Supply and demand determine the fundamental value of the exchange rate (Figure 13.10;
like text Figure 13.11)
Figure 13.10
b. When the official rate is above its fundamental value, the currency is said to be overvalued
1994 and Asia in 1997–1998
(3) Thus an overvalued currency can’t be maintained for very long
3. Similarly, in the case of an undervalued currency, the official rate is below the fundamental
value (text Figure 13.13)
a. In this case, a central bank trying to maintain the official rate will acquire official reserve
assets
1. The best way for a country to make the fundamental value of a currency equal the official
rate is through the use of monetary policy
2. Rewrite Eq. (13.1) as
enom ePFor /P(13.6)
3. For an overvalued currency, a monetary contraction is desirable
a. In a Keynesian model, a monetary contraction causes a real (and nominal) exchange rate
appreciation in the short run and a nominal exchange rate appreciation in the long run
(with no long-run effect on the real exchange rate)
b. Conversely, a monetary expansion causes a nominal exchange rate depreciation in both
4. This implies that countries can’t both maintain the exchange rate and use monetary policy
to affect output
a. Using expansionary monetary policy to fight a recession would lead to an overvalued
currency
5. However, a group of countries may be able to coordinate their use of monetary policy
a. If two countries increase their money supplies together to fight joint recessions, there
6. Overall, fixed exchange rates can work well if countries in the system have similar
macroeconomic goals and can coordinate changes in monetary policy
1. Flexible-exchange-rate systems also have problems, because the volatility of exchange rates
introduces uncertainty into international transactions
Data Application
A very detailed and comprehensive review of the world’s experience under flexible exchange
2. There are two major benefits of fixed exchange rates
a. Stable exchange rates make international trades easier and less costly
b. Fixed exchange rates help discipline monetary policy, making it impossible for a country
to engage in expansionary policy; the result may be lower inflation in the long run
Policy Application
3. But there are some disadvantages to fixed exchange rates
a. They take away a country’s ability to use expansionary monetary policy to combat
recessions
b. Disagreement among countries about the conduct of monetary policy may lead to the
4. Which system is better may thus depend on the circumstances
a. If large benefits can be gained from increased trade and integration, and when countries
can coordinate their monetary policies closely, then fixed exchange rates may be
desirable
b. Countries that value having independent monetary policies, either because they face
1. Under a currency union, countries agree to share a common currency
a. They often cooperate economically and politically as well, as was the case with the
13 original U.S. colonies
2. To work effectively, a currency union must have just one central bank
a. Since countries don’t usually want to give up control over monetary policy by not having
3. But the major disadvantage of a currency union is that all countries share a common
monetary policy, a problem that also arises with fixed exchange rates
4. Application: European monetary unification
a. In 1991, countries in the European Community adopted the Maastricht treaty, which
provides for a common currency
(1) The currency, called the euro, came into being on January 1, 1999
(2) Eleven countries took part in the union, initially
1. Argentina’s economy has suffered periodic crises
2. Argentina’s inflation rate in the 1970s and 1980s was very large, with prices rising by
a factor of 10 billion from 1975 to 1990
3. Inflation was reduced to near zero in the 1990s as the budget deficit was reduced and a
currency board was implemented
a. A currency board is a monetary arrangement under which the supply of domestic
currency in circulation is strictly limited by the amount of foreign reserves held by the
4. The 1990s were a time of economic prosperity for Argentina, with fast economic growth
and low inflation
5. But the end of the decade saw Argentina slip into deep recession and the government’s
budget deficit increased sharply
6. Eventually, Argentina defaulted on foreign debts and in January 2002 it abandoned the
currency board, allowing the peso to float relative to the dollar
2002 to 2011), so ultimately the currency board failed to deliver long-term price stability
