Macroeconomics

A Monetary Expansion in a Large

Open Economy

Panel (a) shows

that a monetary expansion shifts 

the LM curve to the right. Income

rises from Y

1

to Y

2

, and the interest

rate falls from r

1

to r

2

. Panel (b)

shows that the decrease in the inter-

est rate causes the net capital out-

flow to increase from CF

1

to CF

2

.

Panel (c) shows that the increase 

in the net capital outflow raises the

net supply of dollars, which causes

the exchange rate to fall from e

1

to e

2

.

F I G U R E

1 2 - 1 7

Real interest

rate, r 

Exchange

rate, e

Income,

output, Y

Net capital

outflow,

CF

Net exports, NX

2. ... lowers 

the interest 

rate, ...

4. ... lowers 

the exchange 

rate, ...

1. A monetary 

expansion ...

Y

2

Y

1

IS

LM

2

LM

1

NX(e)

e

1

e

2

CF(r)

r

r

1

r

2

r

1

r

2

CF

1

CF

2

CF

2

CF

1

NX

1

NX

2

5. ... and 

raises net 

exports.

3. ... which 

increases net 

capital

outflow, ...

(a) The IS–LM Model

(b) Net Capital Outflow

(c) The Market for Foreign Exchange

---

We can now see that the monetary transmission mechanism works through

two channels in a large open economy. As in a closed economy, a monetary

expansion lowers the interest rate, which stimulates investment. As in a small

open economy, a monetary expansion causes the currency to depreciate in the

market for foreign exchange, which stimulates net exports. Both effects result in

a higher level of aggregate income.

A Rule of Thumb

This model of the large open economy describes well the U.S. economy

today. Yet it is somewhat more complicated and cumbersome than the model

of the closed economy we studied in Chapters 10 and 11 and the model of

the small open economy we developed in this chapter. Fortunately, there is a

useful rule of thumb to help you determine how policies influence a large

open economy without remembering all the details of the model: The large

open economy is an average of the closed economy and the small open economy. To find

how any policy will affect any variable, find the answer in the two extreme cases and

take an average.

For example, how does a monetary contraction affect the interest rate and

investment in the short run? In a closed economy, the interest rate rises, and

investment falls. In a small open economy, neither the interest rate nor investment

changes. The effect in the large open economy is an average of these two cases:

a monetary contraction raises the interest rate and reduces investment, but only

somewhat. The fall in the net capital outflow mitigates the rise in the interest

rate and the fall in investment that would occur in a closed economy. But unlike

in a small open economy, the international flow of capital is not so strong as to

negate fully these effects.

This rule of thumb makes the simple models all the more valuable. Although

they do not describe perfectly the world in which we live, they do provide a use-

ful guide to the effects of economic policy.

C H A P T E R   1 2

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

| 377

M O R E   P R O B L E M S   A N D   A P P L I C A T I O N S

1.

Imagine that you run the central bank in a large

open economy. Your goal is to stabilize income,

and you adjust the money supply accordingly.

Under your policy, what happens to the money

supply, the interest rate, the exchange rate, and

the trade balance in response to each of the fol-

lowing shocks?

a. The president raises taxes to reduce the bud-

get deficit.

b. The president restricts the import of Japanese

cars.

2.

Over the past several decades, investors around

the world have become more willing to take

advantage of opportunities in other countries.

Because of this increasing sophistication,

economies are more open today than in the

past. Consider how this development affects 

the ability of monetary policy to influence 

the economy.

a. If investors become more willing to substitute

foreign and domestic assets, what happens to

the slope of the CF function?

---

378

|

P A R T   I V

Business Cycle Theory: The Economy in the Short Run

b. If the CF function changes in this way, what

happens to the slope of the IS curve?

c. How does this change in the IS curve affect

the Fed’s ability to control the interest rate?

d. How does this change in the IS curve affect

the Fed’s ability to control national income?

3.

Suppose that policymakers in a large open

economy want to raise the level of investment

without changing aggregate income or the

exchange rate.

a. Is there any combination of domestic monetary

and fiscal policies that would achieve this goal?

b. Is there any combination of domestic mone-

tary, fiscal, and trade policies that would

achieve this goal?

c. Is there any combination of monetary and fis-

cal policies at home and abroad that would

achieve this goal?

4.

Suppose that a large open economy has a fixed

exchange rate.

a. Describe what happens in response to a fis-

cal contraction, such as a tax increase. Com-

pare your answer to the case of a small open

economy.

b. Describe what happens if the central bank

expands the money supply by buying bonds

from the public. Compare your answer to the

case of a small open economy.

---

379

Aggregate Supply and the 

Short-Run Tradeoff Between

Inflation and Unemployment

Probably the single most important macroeconomic relationship is the Phillips curve.

—George Akerlof

There is always a temporary tradeoff between inflation and unemployment;

there is no permanent tradeoff. The temporary tradeoff comes not from inflation

per se, but from unanticipated inflation, which generally means, from a rising

rate of inflation.

—Milton Friedman

13

C H A P T E R

M

ost economists analyze short-run fluctuations in national income and

the price level using the model of aggregate demand and aggregate

supply. In the previous three chapters, we examined aggregate demand

in some detail. The IS–LM model—together with its open-economy cousin the

Mundell–Fleming model—shows how changes in monetary and fiscal policy

and shocks to the money and goods markets shift the aggregate demand curve.

In this chapter, we turn our attention to aggregate supply and develop theories

that explain the position and slope of the aggregate supply curve.

When we introduced the aggregate supply curve in Chapter 9, we established

that aggregate supply behaves differently in the short run than in the long run.

In the long run, prices are flexible, and the aggregate supply curve is vertical.

When the aggregate supply curve is vertical, shifts in the aggregate demand

curve affect the price level, but the output of the economy remains at its natur-

al level. By contrast, in the short run, prices are sticky, and the aggregate supply

curve is not vertical. In this case, shifts in aggregate demand do cause fluctua-

tions in output. In Chapter 9 we took a simplified view of price stickiness by

drawing the short-run aggregate supply curve as a horizontal line, representing

the extreme situation in which all prices are fixed. Our task now is to refine this

---

380

|

P A R T   I V

Business Cycle Theory: The Economy in the Short Run

understanding of short-run aggregate supply to better reflect the real world in

which some prices are sticky and others are not.

After examining the basic theory of the short-run aggregate supply curve, we

establish a key implication. We show that this curve implies a tradeoff between

two measures of economic performance—inflation and unemployment. This

tradeoff, called the Phillips curve, tell us that to reduce the rate of inflation poli-

cymakers must temporarily raise unemployment, and to reduce unemployment

they must accept higher inflation. As the quotation from Milton Friedman at the

beginning of the chapter suggests, the tradeoff between inflation and unemploy-

ment is only temporary. One goal of this chapter is to explain why policymak-

ers face such a tradeoff in the short run and, just as important, why they do not

face it in the long run.