CHAPTER 25
ECONOMIC POLICY IN THE OPEN ECONOMY
UNDER FIXED EXCHANGE RATES
Learning Objectives:
■ Indicate the appropriate assignment of policy instruments to economic targets in a fixed
exchange rate system.
■ Explain general equilibrium in the macroeconomy using the IS/LM/BP model.
I. Outline
Introduction
– The Case of the Chinese Renminbi Yuan
Targets, Instruments, and Economic Policy in a Two-Instrument, Two-Target Model
General Equilibrium in the Open Economy: The IS/LM/BP Model
The Effects of Fiscal Policy under Fixed Exchange Rates
The Effects of Monetary Policy under Fixed Exchange Rates
The Effect of Official Changes in the Exchange Rate
Summary
Appendix: The Relationship between the Exchange Rate and Income in Equilibrium
II. Special Chapter Features
Titans of International Economics: Robert A. Mundell (born 1932)
III. Purpose of Chapter
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IV. Teaching Tips
A. In recent years various news sources have emphasized that the Chinese renminbi yuan
has been pegged to the U.S. dollar since 1994 and that the Chinese trade surplus with the United
B. The discussion of the Mundell model in the first section is essentially an introduction to
C. The IS and LM curves may be familiar to some of your students but probably not to all of
them. The standard four-quadrant derivation of these curves is not done in the chapter, but you
may want to do so to make the material clearer.
D. It is a good idea to discuss the BP curve thoroughly, making certain that the students
E. If you are constrained by time, we suggest focusing primarily on the imperfectly mobile
capital case where BP is flatter than LM, since it characterizes the U.S. situation. Given the
number of countries with fixed exchange rates and strict capital controls, the perfectly immobile
case is also of interest to students.
F. A critical message of this chapter is that the effectiveness of a particular policy
G. You should make the point that sterilization operations by the central bank under a fixed-
rate system can at best delay the responses discussed in this chapter.
V. Answers to End-of-Chapter Questions and Problems
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1. The system must come to rest at the combination of interest rate and income where all
three sectors are simultaneously in equilibrium. If the domestic equilibrium (intersection of IS
and LM) is above the BP curve, under fixed rates there will be a surplus in the balance of
2. Monetary policy is ineffective in this scenario because changes in the money supply
trigger changes in the domestic rate of interest as the LM curve shifts along the IS curve. With a
3. With an increase in the money supply, the domestic rate of interest temporarily falls
below the international rate of interest as the LM curve moves rightward along the IS curve. In
4. In the case of perfectly immobile capital, the level of income is determined by the
balance-of-payments constraint, i.e., the vertical BP curve. Income can only be increased by
5. Fiscal policy is least effective when capital is perfectly immobile (see Question #4). It is
6. A devaluation of the currency leads to an expansion of exports and a contraction of
imports, which shifts the IS curve to the right and shifts the BP curve down (to the right). A
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7. Because capital is nearly, if not perfectly mobile between states in the United States, the
appropriate BP curve would essentially be horizontal at the U.S. rate of interest.
8. Because, under a fixed exchange rate system, the central bank stands ready to support the
currency at its pegged rate, the country must maintain sufficient foreign exchange reserves to
meet any balance-of-payments deficits that occur at the stated rate. Because there may be
9. Under a fixed exchange rate regime, expansionary fiscal policy would cause the IS curve
to shift to the right, leading to an increase in the Japanese interest rate and income. Since the BP
curve is flatter than the LM curve, the new IS-LM intersection will lie above the BP curve. In
If the BP curve were steeper than the LM curve, the initial fiscal expansion would still
worsen the current account, but there would be a Japanese BOP deficit at the intersection of the
10. In this scenario, it is difficult if not impossible for a country to influence in any
significant way the domestic interest rate and thereby to have much divergence from the
international rate. Since the BP curve in this case would be nearly horizontal (slightly upward–
11. This is one of the cases in the phenomenon known as the “impossible trinity.” If the
country wishes to maintain a fixed exchange rate and it also permits free flows of short-term
capital into and out of the country, then monetary policy cannot be independent because effective
control of the money supply is lost. For example, contractionary monetary policy would raise
VI. Sample Exam Questions
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1. “Attempts to stimulate an economy with expansionary monetary policy will lead only to
a loss of some of the country’s international reserves and to no permanent change in income
under a fixed-rate system.” Agree? Disagree? Explain.
2. Since under a fixed exchange rate system the exchange rate does not change, does this
mean that the BP curve never shifts? Why or why not? If it in fact does shift, what effects do
3. “A country that must adopt foreign exchange controls because of a misaligned exchange
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4. Using the Mundell diagram dealing with internal balance (IB) and external balance (EB),
5. Fiscal policy is most effective in a fixed-rate system when capital is perfectly mobile
6. Explain, in the IS/LM/BP framework with fixed exchange rates, the impact of an
autonomous increase in foreign demand for a country’s exports upon the country’s national
