Macroeconomics

12-7

A Concluding Reminder

In this chapter we have examined how a small open economy works in the short

run when prices are sticky. We have seen how monetary, fiscal, and trade policy

influence income and the exchange rate, as well as how the behavior of the econ-

omy depends on whether the exchange rate is floating or fixed. In closing, it is

worth repeating a lesson from Chapter 5. Many countries, including the United

States, are neither closed economies nor small open economies: they lie some-

where in between.

A large open economy, such as that of the United States, combines the behav-

ior of a closed economy and the behavior of a small open economy. When ana-

lyzing policies in a large open economy, we need to consider both the

closed-economy logic of Chapter 11 and the open-economy logic developed in

this chapter. The appendix to this chapter presents a model for a large open

economy. The results of that model are, as one would guess, a mixture of the two

polar cases we have already examined.

To see how we can draw on the logic of both the closed and small open

economies and apply these insights to the United States, consider how a mone-

tary contraction affects the economy in the short run. In a closed economy, a

monetary contraction raises the interest rate, lowers investment, and thus lowers

aggregate income. In a small open economy with a floating exchange rate, a

monetary contraction raises the exchange rate, lowers net exports, and thus low-

ers aggregate income. The interest rate is unaffected, however, because it is deter-

mined by world financial markets.

The U.S. economy contains elements of both cases. Because the United

States is large enough to affect the world interest rate and because capital is not

perfectly mobile across countries, a monetary contraction does raise the inter-

est rate and depress investment. At the same time, a monetary contraction also

raises the value of the dollar, thereby depressing net exports. Hence, although

the Mundell–Fleming model does not precisely describe an economy like that

of the United States, it does predict correctly what happens to international

variables such as the exchange rate, and it shows how international interactions

alter the effects of monetary and fiscal policies.

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

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