What can the government of a small open economy do about business cycles?
government can only use one policy
fiscal policy or monetary policy depending on exchange rate “regime” (fixed
exchange rates or flexible exchange rates)
o flexible exchange rates:
nominal exchange rate – “e” is determined by market forces
(supply & demand)
if pple buy foreign currency (selling Canadian dollars) “e” to
go down, which makes Real Exchancge Rate go down
if pple are buying Canadian dollars “e” goes up, RER goes up
o fixed exchange rates:
central bank
buy or sell canadiam dollars to keep the exchange rate fixed
goal is to shift AD to prevent recession…
Expansionary Monetary policy. Flexible exchange rates
expansionary monetary policy = increase in the Ms
AD shift out increase investment decrease interest rate Ms out to the
right
Income increases more money Md increases Y increases
(closed economy right now) increase in income from AD both curves shifting
out to the right (contractionary same set of steps but opposite direction)
r3 < rw everyone prefers to buy foreign assets =>
pple need to buy foeign currency with Canadian
dollars everyones trying to sell their Canadian
dollars values goes down, RER goes down
net exports increase, AD increase, Y increase, Md
increases
this happens until r3 doesn’t exitst and we get to
this point
- small open economy with flexible exchange rates can
use monetary policy in order to shift the AD curve Expansionary Fiscal policy, flexible exchange rates
Governement sepnding increases, AD increases, income increases, Md increases
(we buy more stuff)
Closed economy
R2 > rw
Want to buy Canadian assets
Pple buy Canadian dollars RER increases, g/s more expensive than foreign
g/s, import more of their goods, export less (NX decrease) AD decreases,
Income goes down, Md decreases
Complete crowding out
Open economy – stays the same expansionary monetary policy, fixed exchange rates
Ms increasing, AD increase, income increase (y), Md inc
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