Macroeconomics

A Fiscal Expansion in a Large

Open Economy

Panel (a) shows

that a fiscal expansion shifts the IS

curve to the right. Income rises from

Y

1

to Y

2

, and the interest rate rises

from r

1

to r

2

. Panel (b) shows that

the increase in the interest rate caus-

es the net capital outflow to fall

from CF

1

to CF

2

. Panel (c) shows

that the fall in the net capital out-

flow reduces the net supply of dol-

lars, causing the exchange rate to

rise from e

1

to e

2

.

F I G U R E

1 2 - 1 6

Real interest

rate, r 

Exchange

rate, e

Income,

output, Y

Net capital

outflow,

CF

Net exports, 

NX

Y

1

Y

2

IS

1

IS

2

LM

r

2

r

1

CF

2

CF

2

CF

1

CF

1

NX

2

NX

1

CF(r)

e

2

e

1

NX(e)

r

r

2

r

1

2. ... raises 

the interest 

rate, ...

4. ... raises 

the exchange 

rate, ...

5. ... and 

reduces net 

exports.

3. ... which 

lowers net 

capital

outflow, ...

1. A fiscal 

expansion ...

(a) The IS–LM Model 

(b) Net Capital Outflow

(c) The Market for Foreign Exchange

---

the fiscal-policy multipliers. In a large open economy, there is yet another off-

setting factor: as the interest rate rises, the net capital outflow falls, the currency

appreciates in the foreign-exchange market, and net exports fall. Together these

effects are not large enough to make fiscal policy powerless, as it is in a small

open economy, but they do reduce the impact of fiscal policy.

Monetary Policy

Figure 12-17 examines the effect of a monetary expansion. An increase in the

money supply shifts the LM curve to the right, as in panel (a). The level of

income rises, and the interest rate falls. Once again, these effects are similar to

those in a closed economy.

Yet, as panel (b) shows, the lower interest rate leads to a higher net capital out-

flow. The increase in CF raises the supply of dollars in the market for foreign

exchange. The exchange rate falls, as in panel (c). As domestic goods become

cheaper relative to foreign goods, net exports rise.

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Business Cycle Theory: The Economy in the Short Run