[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Chapter 35
POLICY IN THE
OPEN ECONOMY
∂
The previous chapter focused on the foreign exchange market, and on some
of the differences between flexible and fixed exchange rate systems. The
world’s three major economic blocs—the United States, the European
Union, and Japan—all have adopted flexible exchange rate systems. The forces of
supply and demand that were discussed in Chapter 34 operate to determine the relative
values of the dollar, the euro, and the yen. The purpose of this chapter is to
incorporate exports, imports, and international financial capital flows into the model
of short-run fluctuations that was developed in Part Seven.
When short-run fluctuations associated with business cycles were first discussed,
for the sake of simplicity we focused on a closed economy, ignoring the role
of international trade and financial linkages. Now it is time to add the international
dimension to the model to see if any of the basic conclusions we reached in the earlier
chapters need to be altered. Fortunately, the fundamental connections between
inflation, interest rates, and output operate in much the same manner as before.
But by adding in the linkages that tie together the global economy, we can better
understand how U.S. fiscal policy and Federal Reserve decisions affect the value of
the dollar and the U.S. trade balance. In addition, these new linkages with monetary
policy can affect the economy, and international factors can be a source of
economic fluctuations.
The aggregate demand–inflation (ADI) curve and the inflation adjustment (IA)
line form the core framework for understanding economic fluctuations. Our main
objective in this chapter will be to see how international trade in goods and financial
assets affects these two key relationships. We will focus on economies like that of
the United States that have a flexible exchange rate determined by the interplay of
supply and demand in the foreign exchange market.
779