Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 181
4. 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
5. Overall, fixed exchange rates can work if countries in the system have
similar macroeconomic goals and can coordinate changes in monetary
policy but the failure to cooperate can lead to severe problems
D. Application: Policy coordination failure and the collapse of fixed exchange
rates—the cases of Bretton Woods and the EMS
1. The Bretton Woods system worked well from 1959 to 1971
a. The system fixed exchange rates, with the U.S dollar serving as
an official reserve asset throughout the world
b. The dollar was fixed at $35 per ounce of gold
c. Canada participated between 1962 and 1970 with an exchange
2. The European Monetary System (EMS) set up fixed exchange rates
among Western European countries
a. Germany, the leader of the EMS, got into trouble in 1992
because reunification brought higher inflation, leading Germany
to tighten monetary policy
b. This undervalued the mark, putting pressure on other EMS
182 Chapter 10
(1) At first the government spent a Lot of official reserves
trying to defend the pound
(2) But eventually Great Britain decided to leave the EMS and
3. In both the Bretton Woods and EMS cases, the failure of the dominant
country in the system to pursue monetary policies that were desired by
other countries posed a threat to the system of fixed exchange rates
E. Fiscal policy and the fixed exchange rate
1. Short run effects of a fiscal expansion
a. All else equal, a fiscal expansion would create an undervalued
exchange rate
2. Long-run effects of a fiscal expansion
a. With output exceeding the full-employment level, the domestic
price level increases
b. Given the nominal exchange rate and the foreign price level, an
3. Application: Provincial fiscal policies
a. The Ontario government controls about 20% of all government
spending and taxation in Canada and therefore is capable of
exerting a sizable influence on the Canadian economy
b. According to the Mundell-Fleming model then, what would be
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 183
d. With exchange rates fixed, a fiscal expansion in Ontario will
increase output in Ontario as well as in all other provinces in
Canada
VII. Choosing an Exchange Rate System (Sec. 10.7)
A. Fixed versus flexible exchange rates
1. Flexible-exchange-rate systems have problems, because the volatility
of exchange rates introduces uncertainty into international transactions
Data Application
Maurice Obsffeld and Kenneth Rogoff, “The Mirage of Fixed Exchange Rates,” Journal
2. There are two major benefits of fixed exchange rates
a. Stable exchange rates make international trades easier and less
Policy Application
Some prominent economists have called for a return to fixed exchange rates. Ronald I.
McKinnon puts forth his suggestion that the major industrial countries return to a system
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
184 Chapter 10
5. 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
floating exchange rate
Policy Application
Rather than fixing exchange rates against a group of countries, an option for a smaller
country like Canada is to peg its currency to that of a larger trading partner. Richard
Harris, in Trade, Money, and Wealth in the Canadian Economy, C.D. Howe, Toronto,
1993, argues that Canada should peg its dollar to the US dollar. He believes that, for
Canada, the benefits of real exchange rate stability outweigh the costs of giving up an
independent monetary policy.
B. Currency unions
1. Under a currency union, countries agree to share a common currency
a. They often cooperate economically and politically as well
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
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
a. Thus if one country is in recession while another is concerned
4. Application: European Monetary Union (EMU): Lessons for North
America
a. Common currency, the euro is managed by the European
Central Bank
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 185
C. The self-correcting small open economy
1. Unlike a closed economy, an open economy is subject to unexpected
events such as changes in foreign incomes, foreign interest rates, the
2. Despite this, the need for stabilization policies may not be greater than
3. Flexible exchange rates:
a. Under flexible exchange rates, unexpected events which shift
4. Fixed exchange rates:
a. Under fixed exchange rates, unexpected events which shift the
IS curve will have a magnified effect on the domestic output
D. Application: Macroeconomic policy responses to the 2008-2009 financial
crisis
a. Financial crisis exposed Canada (and the world economy) to
two major shocks.
i. Fall in the financial market liquidity around the world pushed up
world interest rates (LM curve for Canada shifts to the left)
E. More advanced models of the open economy
1. More advanced models of the open economy would allow for
a. The FE line to respond to unexpected events such as changes
in world energy prices
186 Chapter 10
2. However, the conclusions drawn from the relatively simple model
(presented in Section 10.4) will continue to hold in more sophisticated
and advanced models incorporating the above features
VIII. Key Diagram 9: The IS-LM Model of A Small Open Economy
A. Diagram Elements
i. The IS curve gives combinations of real output and the real interest
rate that equalize the aggregate quantities of goods supplied and
B. Factors that Shift the Curves
i. Any factor that raises the full employment output shifts the FE line
to the right
IX. Appendix 10.A: An Algebraic Version of the Open-Economy IS–LM Model
A. The IS curve is modified, but the LM curve and FE line are unchanged
1. The LM equation is given by
a. Y =
γ
+ (1/P
l
Y)M + (
l
r/
l
Y)r (10.A.1)
2. Desired consumption and investment are given by
(10.A.7)
6. Writing this more simply,
r =
α
’IS –
β
’ISY (10.A.8)
α
’IS = (co + io +G – cYto + xo + xYFYFor + xrrFor)/(cr + ir + xr) (10.A.9)
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 187
c. For a given output and real interest rate, any factor that
increases net exports shifts the open-economy IS curve up, as it
increases the intercept term α’IS
B. Fiscal and monetary policy in the algebraic model: Flexible exchange rates
1. In the text we analyzed the effects of fiscal and monetary expansions
using a version of the Mundell-Fleming model in which the domestic
interest rate r is always equal to the foreign rate rFor
2. Equation (10.A.4) implies that r equals rFor when xr is very large
output
C. Fiscal and monetary policy in the algebraic model: Fixed exchange rates
1. Under fixed exchange rates, the LM equation simply determines the
domestic money supply for alternative values of domestic output and
the interest rate
6. Equation (10.A.16) confirms the results explained in the text
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. How Does Using the US Dollar as its Currency Affect Panama’s Economic
Policy?
Panama uses the US dollar as its official currency. How does this affect Panama s
ability to control its economy?
By choosing to use the US dollar as its official currency, Panama closely ties its
economy to its larger northern neighbour. This has implications in many areas. Panama,
188 Chapter 10
2. How Predictable Are Exchange Rates?
Economists’ theories of exchange rates are very well developed, especially after
hundreds of years of experience. How precisely do you think financial market
participants, such as currency traders, can forecast exchange rates?
It turns out that despite all our economic theories and extensive empirical work,
forecasts of exchange rates are notoriously bad over short horizons. For long time
periods, like two years or more, exchange-rate forecasts aren’t too bad when based on
ANSWERS TO TEXTBOOK PROBLEMS
Review Questions
1. The nominal exchange rate is the rate at which two currencies can be exchanged
for each other in the market. The real exchange rate is the price of domestic goods
2. The two major types of exchange-rate systems are fixed exchange rates and
flexible exchange rates. In a fixed-exchange-rate system, exchange rates are set
3. Purchasing power parity, PPP, is the idea that similar foreign and domestic goods,
or baskets of goods. should have the same price when priced in terms of the same
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 189
4. An increase in domestic income leads people to buy more goods, including
imported goods, so net exports decline. An increase in foreign income leads
foreigners to buy more goods, including goods exported from the domestic country,
5. Foreigners demand dollars in the foreign exchange market to be able to buy
Canadian goods and services (Canadian exports) and Canadian real and financial
assets (Canadian capital inflows). Americans supply dollars to the foreign
6. The IS–LM model for the open economy differs from the closed-economy IS–LM
model in that international influences may shift the IS curve. Factors that raise a
7. Expansionary fiscal policy increases output and the real interest rate in the short
run (using a Keynesian model), both of which lead to a reduction of net exports.
8. In the short run, expansionary monetary policy increases output (using a
Keynesian model), which tends to decrease net exports, leading to an increased
supply of the domestic currency in the foreign exchange market, causing it to
9. The MundelI-Fleming model implies that net exports are very responsive to small
international differences in interest rates. Under a floating exchange rate, a change
in fiscal policy will have no effect on output, because its effect on the exchange
190 Chapter 10
10. The fundamental value of a currency is the value of the exchange rate that would
be determined by free-market forces of demand and supply without government
11. A country is limited in changing its money supply under a fixed-exchange-rate
system, because only one level of the money supply is consistent with the official
exchange rate being equal to its fundamental value. As a result, a country isn’t free
12. The open-economy trilemma is a list of features a country can choose in its
monetary system: (1) a fixed exchange rate; (2) international capital mobility; (3)
autonomy for domestic monetary policy. A fixed exchange rate may be desirable if
it encourages trade. Capital mobility adds to efficiency and promotes growth.
Numerical Problems
1. The price level in the West is Pw = 5 guilders per ordinary soap bar. The price level
in the East is PE = 100 florins per deluxe soap bar. The real exchange rate is 2
ordinary soap bars per deluxe soap bar.
2. a. The financial market expected the exchange rate to appreciate.
3. Begin by writing the equation for the IS curve, which is Sd – Id = NX.
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 191
a. With G = 100 and Ϋ = 900, the IS curve gives 800r = 640 – 540 – 100 = 200, so
r = .25. Then e = 20 – 600r = 170, NX = 150 – 90 – 85 = –25, C = 300 + 450 –
50 = 700, and I = 200 – 75 = 125.
b. With Ϋ = 940, the IS curve gives 800r = 640 – 564 + 100 = 176, so r = .22.
4. Begin by writing the equation for the IS curve, which is Sd – /d = NX.
Sd = Y − Cd − G = Y – {200 + 0.6[Y – (20 + 0.2Y)] – 200r} − G = 0.52Y – (188 + G)
+ 200r
Using these in the IS curve equation gives:
to find equilibrium, so we’ll write it as 200r = 0.5Y – 924/P.
a. With G = 152 and Ϋ = 1000, the IS curve gives 1000r = 790 – 600 = 190. so r =
0.19
From the LM curve, P = 924/(500 – 38) = 2. Then NX = 150 – 80 – 95 = –25, C
= 200 – 0.6(1000 – 220) – 38 = 630, and / = 300 – 57 = 243.
b. In the short run with G = 212 and P = 2, the IS curve gives 1000r = (638 + 212)
– 0.6Y, and the LM curve is 200r = 0.5Y – 462. Take five times the LM equation
192 Chapter 10
5. a. r = 0.175 (17.5%). Using either IS or LM, the value of r at = 300.
b. Domestic output falls to Y = 175. With fixed price level and fixed exchange rate,
short run equilibrium occurs on IS at r = 0.225. Using the equation of LM, if Y =
Analytical Problems
1. a. Import restrictions cause net exports to increase. The IS curve, then, shifts to
the right. The result is a temporary increase in the domestic interest rate above
the foreign interest rate. This presents arbitrage opportunities which cause a
capital inflow into the domestic economy. As a result, the domestic currency
b. The answer to part (a) is not affected if the domestic price level is allowed to
adjust. The reason is that unless we believe the exchange rate responds only
c. Import restrictions cause net exports to increase. The IS curve shifts to the
right. The result is a temporary increase in the domestic interest rate above the
foreign level. If the exchange rate is fixed, the resulting capital inflow creates an
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 193
d. The fact that output has increased means that the domestic price level
increases. As a consequence, the real exchange rate increases. This causes
net exports to fall (exports fall and imports rise) and the IS curve shifts back to
2. a. The actions of legislators in Country B cause Country A exports to fall. A fall in
net exports shifts IS to the left causing a temporary fall in the domestic interest
rate below the foreign interest rate. The result is a capital outflow from Country
b. Assuming a relatively speedy response of the exchange rate to the change in
the domestic interest rate, allowing the price level to change has no impact on
the solution to part (a).
c. The fall in exports caused by foreign legislation causes IS to shift to the left.
d. Since output has fallen, the domestic price level falls. This causes the real
exchange rate to fall which in turn causes exports to increase, imports to
3. a. The monetary expansion in Country Y causes the world interest rate to
decrease. The implication is that the domestic interest rate in Country X is
194 Chapter 10
b. The fiscal expansion in Country Y causes the world interest rate to increase.
The implication is that the domestic interest rate in Country X is below the new,
output increases, net exports increase, and the interest rate increases.
4. An increase in full employment output shifts the FE line to the right. In the short
run, there is no other change. In the long run, the economy is below the full