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

exports are a large fraction of total spending, these exchange rate effects are the
main channel of monetary policy.
Although monetary policy may be more effective in the short run in an open
economy, one of our key earlier conclusions continues to hold: as wages and prices eventually
adjust, the economy returns to full employment. So even in an open economy, the
long-run effect of monetary policy is on inflation, not on output or unemployment.
FISCAL POLICY WITH FLEXIBLE
EXCHANGE RATES
Though changes in the exchange rate tend to reinforce the impact of monetary policy,
they act to reduce the impact of fiscal policy. The reason again can be traced to the
way interest rates move. We have already learned that a fiscal expansion that shifts
the ADI curve to the right increases output and eventually inflation. As inflation
starts to rise, the central bank will act to raise interest rates. Since central banks
react to anticipate future increases in inflation, interest rates are likely to rise even
if initially the actual increase in inflation is small. Also, a fiscal expansion raises the
equilibrium full-employment real interest rate. As we learned in Chapter 33, a central
bank that desires to maintain a stable inflation rate will shift its monetary policy
rule when the equilibrium full-employment real interest rate changes. In the case of
a fiscal expansion, this shift will lead to higher interest rates.
As interest rates increase, the exchange rate will appreciate, thereby dampening
net exports. Any decline in net exports works to offset the original fiscal stimulus
to aggregate expenditures. As a consequence, the exchange rate adjustment limits the
impact of fiscal policy on expenditures. In the long run, as the economy returns to full
employment, an increase in the government’s deficit crowds out private investment
and net exports, as the full-employment model of Chapter 26 explains.
Exchange rates, unlike wages and prices, adjust very rapidly, but exports and
imports often do not adjust as quickly. A change in government expenditures
may have an immediate impact on aggregate expenditures, while the offsetting
movements in net exports may occur much later.
Wrap-Up
POLICY IN AN OPEN ECONOMY
In an open economy, the force of monetary policy is strengthened because it may
affect the real exchange rate and, through the exchange rate, the level of aggregate
expenditures. This effect reinforces the impact of monetary policy on aggregate
expenditures through interest rates and credit availability.
In an open economy, the force of fiscal policy is dampened because it may affect
the real exchange rate and, through the exchange rate, the level of net exports.
The change in exchange rates caused by a fiscal expansion reduces net exports,
offsetting some of the expansion’s impact.
COMPARING MONETARY AND FISCAL POLICIES IN THE OPEN ECONOMY ∂ 787