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Abstract

Chapter 24. The main challenges for macroeconomic theory are to explain the long-term economic growth and the short-term business fluctuations observed in the real world. This book offers an introduction to advanced economic analysis of these issues and seeks to bridge the gap between the typical intermediate macroeconomics text and the more advanced texts used at the graduate level. Each chapter ends with an extended summary highlighting the main points to be learned and is followed by a number of exercises intended to deepen the student''s understanding of the material covered. Chapter 24: The AS-AD model of the open economy developed in the previous chapter implies that the long-run equilibrium values of real variables such as real output, the real interest rate and the real exchange rate are unaffected by the exchange rate regime. In this and the next chapter we shall see that a country''s choice of exchange rate regime is nevertheless a fundamental economic policy choice because of its influence on the economy''s short-run dynamics. First of all, the choice of exchange rate regime will determine whether monetary policy can be used as a tool of macroeconomic stabilization policy. Second, the exchange rate regime will affect the way in which the economy adjusts to its long run equilibrium and how it responds to exogenous shocks in the short and medium term. The present chapter focuses on a small specialized economy with fixed exchange rates and perfect capital mobility. We start by studying the characteristics of fixed exchange rates as an economic policy regime and by discussing why a country might want to adopt a fixed nominal exchange rate. We then adapt the AS-AD model of the open economy set up in Chapter 23 to analyse how the economy adjusts to long-run equilibrium under fixed exchange rates. The final parts of the chapter use our AS-AD model to study the effects of macroeconomic policy under fixed exchange rates.

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Abstract

Chapter 24. The main challenges for macroeconomic theory are to explain the long-term economic growth and the short-term business fluctuations observed in the real world. This book offers an introduction to advanced economic analysis of these issues and seeks to bridge the gap between the typical intermediate macroeconomics text and the more advanced texts used at the graduate level. Each chapter ends with an extended summary highlighting the main points to be learned and is followed by a number of exercises intended to deepen the student''s understanding of the material covered. Chapter 24: The AS-AD model of the open economy developed in the previous chapter implies that the long-run equilibrium values of real variables such as real output, the real interest rate and the real exchange rate are unaffected by the exchange rate regime. In this and the next chapter we shall see that a country''s choice of exchange rate regime is nevertheless a fundamental economic policy choice because of its influence on the economy''s short-run dynamics. First of all, the choice of exchange rate regime will determine whether monetary policy can be used as a tool of macroeconomic stabilization policy. Second, the exchange rate regime will affect the way in which the economy adjusts to its long run equilibrium and how it responds to exogenous shocks in the short and medium term. The present chapter focuses on a small specialized economy with fixed exchange rates and perfect capital mobility. We start by studying the characteristics of fixed exchange rates as an economic policy regime and by discussing why a country might want to adopt a fixed nominal exchange rate. We then adapt the AS-AD model of the open economy set up in Chapter 23 to analyse how the economy adjusts to long-run equilibrium under fixed exchange rates. The final parts of the chapter use our AS-AD model to study the effects of macroeconomic policy under fixed exchange rates.

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