Macroeconomics Theories and Policies
Quiz 16 :
Monetary and Fiscal Policy in the Open Economy
The LM curve shows the interest rate and income that represent equilibrium points for the money market.The IS curve consists of combinations of the interest rate and income that depict equilibrium points in the goods market.The BP curve shows the combinations of the interest rate and income that will equate supply and demand in the foreign exchange market for a given exchange rate.
Monetary policy is completely ineffective within a fixed exchange rate regime.Fiscal policy is highly effective within a fixed exchange rate regime.
As long as the fixed exchange rate holds,goods would be rising in price faster in the US than in Europe,reducing the US trade balance.This cannot last forever,because investors will see real returns fall on their assets invested in the US and will reduced their demand for dollars.The US will lose foreign reserves until they fall to such an extent that they have to abandon their exchange rate peg.