Week 5 - The Open Economy

 

This week we continue our study of fluctuations in the economy. So far our model assumed a closed economy. This means that we did not allow for countries to trade with other countries. We know that this is not very realistic.

This week we relax that assumption and analyze how our model changes when we allow for countries to trade with others. We start considering the case of a small open economy. A small open economy is that of a country that is small compared to others. Because the country is small, international financial transactions have a large effect in the country. In particular, these transactions completely determine the interest rates in small countries. This is because financial investors look for investment opportunities around the world. When they observe that a country has an interest rate that is above the world interest rate, they invest in financial assets in this country. The flow of money to the country drives the interest rate down again until it is equal to the world interest rate. That is, arbitration makes the interest rates in small open economies exactly equal to what we call the world interest rate. 

The main focus of this week is to analyze the effect of different fiscal and monetary policies in this type of small open economies. As we will see, the effect of these policies is different than in the closed economy that we studied in previous weeks. The effect now depends on what happens to a new variable, exchange rates. Exchange rate is the price of buying domestic currency using other currency. When financial investors send money to a country they need to exchange their currency for the domestic currency. If we do not intervene in the currency market, all that demand for the domestic currency increases its value (the currency appreciates). If our currency is more expensive, our exports suffer because other countries will find our products comparatively more expensive. This means that fiscal or monetary policies that would tend to raise interest rates attract international financial in-flows, which appreciates the currency, which reduces exports, and thus output.

Finally, we study what happens when we do not allow the currency to appreciate because we follow what is called a fixed exchange rate regime.

 

To Do: