Macroeconomics

A Short-Run Model of a Large

Open Economy

Panel (a) shows

that the IS and LM curves deter-

mine the interest rate r

1

and

income Y

1

. Panel (b) shows that

r

1

determines the net capital out-

flow CF

1

. Panel (c) shows that

CF

1

and the net-exports schedule

determine the exchange rate e

1

.

F I G U R E

1 2 - 1 5

Real interest

rate, r

Exchange rate, e

Income, output, Y

Net capital

outflow, CF

Net exports, NX

Y

1

IS

LM

r

1

CF

1

NX

1

r

r

1

CF(r)

e

1

NX(e)

CF

(a) The IS–LM Model

(b) Net Capital Outflow

(c) The Market for Foreign Exchange

---

Fiscal Policy

Figure 12-16 examines the impact of a fiscal expansion. An increase in govern-

ment purchases or a cut in taxes shifts the IS curve to the right. As panel (a) illus-

trates, this shift in the IS curve leads to an increase in the level of income and an

increase in the interest rate. These two effects are similar to those in a closed

economy.

Yet, in the large open economy, the higher interest rate reduces the net capi-

tal outflow, as in panel (b). The fall in the net capital outflow reduces the supply

of dollars in the market for foreign exchange. The exchange rate appreciates, as

in panel (c). Because domestic goods become more expensive relative to foreign

goods, net exports fall.

Figure 12-16 shows that a fiscal expansion does raise income in the large

open economy, unlike in a small open economy under a floating exchange rate.

The impact on income, however, is smaller than in a closed economy. In a closed

economy, the expansionary impact of fiscal policy is partially offset by the

crowding out of investment: as the interest rate rises, investment falls, reducing

C H A P T E R   1 2

The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime

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