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

The ADI Curve and the Open
Economy
In the closed economy, the components of aggregate spending are consumption,
investment, and government purchases. In the open economy, net exports must be
added to this list. An increase in net exports, just like an increase in government
purchases, leads firms to expand production and employment. If foreigners purchase
more U.S.–produced goods and services, U.S. exports rise. The firms producing
these goods increase production and employment. If U.S. residents switch from
buying goods produced in the United States to buying more foreign goods—
purchasing Olympus rather than Kodak cameras or Heineken beer rather than
Bud—U.S. firms see demand drop, and they respond by cutting back production
and employment. The impact of exports and imports on domestic aggregate demand
is measured by net exports—exports minus imports.
The ADI curve developed in Chapter 31 summarized the relationship between
aggregate demand and inflation in a closed economy. Increases in inflation lead to
increases in the real interest rate, and these reduce household and business spending
on consumption and investment. This connection between inflation and demand
continues to hold in an open economy like the U.S. economy—changes in inflation continue
to result in interest rate changes through the actions of monetary policy. But
these interest rate changes now affect the exchange rate—the value of the dollar
relative to other currencies such as the euro, the yen, or the peso—and net exports.
To understand how they do so is our next task.
INFLATION, THE INTEREST RATE, AND THE
EXCHANGE RATE
How does an increase in inflation affect the exchange rate? When inflation increases,
monetary policy responds to cause the real interest rate to increase. The impact of
inflation on the real interest rate depends on the central bank’s monetary policy
rule, as we learned in Chapter 33. International investors constantly seek out the
most attractive financial investments around the globe; thus, when interest rates
rise in the United States, they sell financial assets in other countries in order to
invest here. As they do so, exchange rates are affected.
If interest rates in the United States rise relative to the rates of return available
in other countries, international investors, rather than lending funds in the capital
markets of Japan or Europe, will lend their funds in U.S. capital markets to take
advantage of those higher rates. But borrowers in the U.S. capital market want to
borrow dollars, not yen or euros. International investors therefore need to buy dollars
in the foreign exchange market if they want to lend those dollars to U.S. borrowers.
1 This increase in the demand for dollars causes the price of dollars to rise,
just as a rightward shift in the demand curve for any other good would cause its
price to rise.
1 See Chapter 34 for a discussion of the foreign exchange market.
780 ∂ CHAPTER 35 POLICY IN THE OPEN ECONOMY