EC2B3 Macroeconomics II

Topic 9: International Macroeconomics

(Week 10)

Kevin Sheedy
LSE
Winter Term 2024
 International macroeconomics
• We have explored the gains from international trade in Topic 8
• And seen the determinants of current-account surpluses or deficits
• We studied exchange rates and exchange-rate regimes in Topic 7
• This week, we look at how trade, current accounts, capital flows,
and exchange rates interact with other macroeconomic issues
• Are the effects of macroeconomic shocks different in open economies?
• How do shocks in the rest of the world transmit to an open economy?
• Does the effectiveness of monetary and fiscal policy change in an open
economy compared to a closed economy?
• Which exchange-rate regime to choose? Should capital flows be limited?
• Analyse economies in cases with fully flexible or fully sticky prices
2
 An international
macroeconomic model
 An international macroeconomic model
• Analysis of international trade in Topic 8 had households choosing
consumption/saving and the government setting fiscal policy
• But neglected labour demand & supply, & investment in physical capital
• Add international trade to macroeconomic model from Topic 3:
• Start by assuming fully flexible prices and wages (as in RBC model)
• Nominal prices (including exchange rates) do not matter for real variables
• Assume all economies produce and consume the same basket of goods
• As in Topic 8, and analysis of purchasing power parity (PPP) from Topic 7
• World financial markets: can buy/sell bonds with real interest rate 𝑟 ∗
• Perfect capital mobility: no restrictions on trading assets internationally
• The economy is a small open economy (SOE): it does not influence 𝑟 ∗
4
 Applying the model to an open economy
• Output supply curve 𝑌 𝑠 derived from labour-market equilibrium:
• Labour demand 𝑁 𝑑 and supply 𝑁 𝑠 (𝑟) determine 𝑁 and 𝑌 = 𝑧𝐹(𝐾, 𝑁)
• 𝑁 𝑑 , 𝑁 𝑠 , and 𝑌 𝑠 curves work in same way in open and closed economies
• One subtlety we ignore is that income effects from changes in 𝑤 and 𝑟 may not
net out to zero because of foreign ownership of domestic firms/assets
• Could justify ignoring these income effects if we start from 𝑁𝐹𝐴 = 0 and 𝐶𝐴 = 0

• Recall that Topic 3 closed-economy model explains GDP 𝑌 and the

real interest rate 𝑟 where the 𝑌 𝑑 and 𝑌 𝑠 curves intersect
• But perfect capital mobility means that there would be extremely large
outflows or inflows of capital (financial-account imbalances) if 𝑟 ≠ 𝑟 ∗
• Balance-of-payments equilibrium (𝐵𝑃 = 𝐶𝐴 + 𝐹𝐴 = 0) needs 𝑟 = 𝑟 ∗
• Instead, adjustment of net exports 𝑁𝑋 to get equilibrium in goods market
5
 Goods-market equilibrium in an open economy
• With 𝑌 𝑠 curve, let 𝑌𝑎 and 𝑟𝑎 be predictions
𝑟
of the model for an economy in autarky
𝑌𝑠
• In closed economy: 𝑌𝑎𝑑 = 𝐶 𝑑 + 𝐼 𝑑 + 𝐺
𝑁𝑋 ↓
• Open-economy: 𝑌 𝑑 = 𝐶 𝑑 + 𝐼 𝑑 + 𝐺 + 𝑁𝑋
𝑟𝑎 • 𝑌 𝑑 is domestic demand 𝑌𝑎𝑑 plus 𝑁𝑋
• Balance of payments requires 𝑟 = 𝑟 ∗
• Represented by horizontal 𝐵𝑃 line at 𝑟 ∗
𝑟∗ 𝐵𝑃

• Capital flows until 𝑌 𝑑 & 𝑌 𝑠 meet at 𝑟 = 𝑟 ∗

𝑌𝑎𝑑
• 𝐹𝐴 adjusts, requiring changes in 𝑁𝑋 so
that 𝐶𝐴 = −𝐹𝐴, which shift 𝑌 𝑑 curve
𝑌𝑜𝑑
• Or equivalently, at 𝑟 = 𝑟 ∗ , if 𝑌𝑎𝑑 ≠ 𝑌 𝑠 then
𝑌𝑜 𝑌𝑎
𝑌 exports or imports adjust to get 𝑌 𝑑 = 𝑌 𝑠
6
 A supply shock in an open economy
𝑟 • Does an open economy respond differently
𝑌1𝑠 to shocks? E.g. temporary negative supply
𝑌0𝑠 shock, a decline in TFP 𝑧
𝑁𝑋 ↓
• In closed economy, shock shifts both
𝑌 𝑠 and 𝑌 𝑑 curves to the left
𝑟𝑎
• Shift of 𝑌 𝑑 is smaller than shift of 𝑌 𝑠
𝑟∗ 𝐵𝑃 due to consumption smoothing
• Implies real interest rate 𝑟𝑎 increases

𝑌0𝑑 • In open economy, 𝑟 cannot rise above 𝑟 ∗

𝑌1𝑑 in closed
economy • 𝑁𝑋 declines instead, shifting 𝑌 𝑑
𝑌1𝑑
further left to match shift of 𝑌 𝑠
• 𝑌 falls by more than in closed economy
𝑌
𝑌1 𝑌0
7
 Fiscal policy in an open economy
• Does fiscal policy become more or less
𝑟
powerful in an open economy?
𝑌0𝑠 𝑌1𝑠 • Consider a temporary fiscal stimulus:
an increase in government spending 𝐺
𝑁𝑋 ↓ • In closed economy, both 𝑌 𝑑 and 𝑌 𝑠
𝑟𝑎 shift to the right, but 𝑌 𝑑 by more,
leading to an increase in 𝑟𝑎
𝑟∗ 𝐵𝑃

• In open economy, 𝑟 cannot go above 𝑟 ∗

𝑌1𝑑 in closed • 𝑁𝑋 declines instead, shifting 𝑌 𝑑 to
economy
back to the left so that shift of 𝑌 𝑑
𝑌0𝑑
𝑌1𝑑 matches the shift of 𝑌 𝑠 overall
• Real GDP 𝑌 still rises, but by less
𝑌 than in a closed economy
𝑌0 𝑌1
8
Capital controls
 Capital controls
• Perfect capital mobility: financial account 𝐹𝐴 extremely sensitive
to any gap 𝑟 − 𝑟 ∗ between domestic and foreign interest rates
• Capital controls: restrictions on foreign purchases of domestic
assets or domestic purchases of foreign assets
• Such capital controls make 𝐹𝐴 less sensitive to 𝑟 − 𝑟 ∗
• To see the effects of capital controls, consider the extreme case
where all (private) capital flows are blocked:
• 𝐹𝐴 = 0, and balance of payments then implies 𝐶𝐴 = 0
• Or 𝐹𝐴 determined only by any official foreign-exchange interventions
• Shifts in 𝑌 𝑑 due to 𝑁𝑋 to restore 𝑟 = 𝑟 ∗ blocked by capital controls
• No capital inflows to finance 𝐶𝐴 deficit, or outflows to match 𝐶𝐴 surplus
10
 A negative supply shock with capital controls
𝑟 • Most extreme form of capital controls
𝑌1𝑠
results in same outcome as autarky
𝑌0𝑠 • More generally, capital controls result
in outcomes between those in
autarky and perfect capital mobility
𝑟1

𝑟0 = 𝑟 ∗ 𝐵𝑃 • With temporary negative supply shock,

GDP 𝑌 falls by less with capital controls:
• Real interest rate rises from 𝑟0 to 𝑟1
𝑌0𝑑 • Although GDP falls by less,
𝑌1𝑑
households are better off with
perfect capital mobility because can
smooth consumption with cheaper
𝑌
𝑌1 𝑌0 international borrowing at rate 𝑟 ∗
11
The terms of trade
 Trading different goods between countries
• We have assumed countries produce and consume same goods to
emphasize trade in assets (international borrowing and saving)
• If distinct goods, prices matter for international competitiveness
• Relative price of exports to imports is a country’s ‘terms of trade’
• Price of imports relative to domestically produced goods = 𝑞
• Some domestic goods exported, so 𝑞 is similar to the terms of trade
• In Topic 7, 𝑞 is ‘real exchange rate’ (relative price of same goods in different countries)
• Higher 𝑞 ⇒ imports more expensive, improving export competitiveness
• Quantity of exports sold = 𝑋; quantity of imports purchased = 𝑍
• Net exports measured in terms of domestic goods:
𝑁𝑋 = 𝑋 − 𝑞𝑍 13
 Net exports and the terms of trade
• Domestic and foreign consumers’ spending on
𝑞 goods depends on relative price of imports 𝑞:
• Quantity of exports 𝑋 demanded increases
Demand for exports
net of imports
with 𝑞 as competitiveness improves
• Quantity of imports 𝑍 demanded decreases
with 𝑞 as domestically produced goods
become more competitive

• Assume higher 𝑞 raises net exports:

𝑁𝑋 = 𝑋 − 𝑞𝑍
• Volume effects of 𝑞 on 𝑋 and 𝑍 dominate
𝑁𝑋 import value effect (𝑞 multiplying 𝑍 above)
0 • Marshall-Lerner condition: sum of elasticities
of 𝑋 and 𝑍 with respect to 𝑞 greater than 1
14
 The terms of trade with flexible prices
• Does terms of trade/competitiveness
𝑟
𝑌1𝑠 in closed
matter for economy with flexible prices?
𝑌𝑠
economy • 𝑁𝑋 adjusts to get 𝑌 𝑑 = 𝑌 𝑠 at 𝑟 = 𝑟 ∗
0
𝑌1𝑠 • 𝑞 is flexible: adjusts to get required 𝑁𝑋
𝑁𝑋 ↓ • Take earlier example of fiscal policy:
𝑟𝑎 • Higher 𝐺 requires lower 𝑁𝑋 in
equilibrium, occurs through lower 𝑞
𝑟∗ 𝐵𝑃 • Real appreciation of terms of trade:
loss of competitiveness
𝑌1𝑑 in closed
economy
• But lower 𝑞 raises purchasing power of
𝑌1𝑑 wage 𝑤 (an amount of domestic goods)
𝑌0𝑑
• Shifts 𝑁 𝑠 curve and 𝑌 𝑠 curve to right
𝑌 • Smaller change in 𝑁𝑋 required to
𝑌0 𝑌1
reach 𝐵𝑃 at 𝑟 = 𝑟 ∗ (𝑌 ↑ more here) 15
Sticky prices
and
international
trade
 Volatile exchange rates, sluggish prices
• Nominal exchange rates
(when flexible/floating) are
much more volatile than
nominal prices of goods
• Bretton Woods system of
fixed exchange rates (from
1944) effectively ends in
February 1973

• Contrary to purchasing power

parity (PPP) theory in Topic 7
• Evidence suggests sticky
rather than flexible prices
Deutschmark-US dollar exchange rate and ratio of German and US price levels (CPIs) of goods in short run
Source: Rogoff (1996) • PPP only for long run 17
 Sticky prices and international trade
• Nominal exchange rate fluctuations alter terms of trade when
nominal goods prices are sticky in units of domestic currency
• Exchange rates have implications for international competitiveness
• Important concern given evidence on volatility of exchange rates
• In the short run, the economy may respond differently to shocks
when prices are sticky, and monetary policy has real effects
• Exchange-rate regime has consequences for real variables
• Adapt earlier New Keynesian model to an open economy
• Assume completely sticky prices, as was done in NK model from Topic 4
• To keep things simple, no partial price adjustment or Phillips curve

18
 Prices of exports and imports
• 𝑃 = price of domestic goods in domestic currency
• 𝑃∗ = price of foreign goods in foreign currency
• 𝑒 = nominal exchange rate (domestic price of foreign currency)
• 𝑒 ↑ is depreciation of domestic currency; 𝑒 ↓ is appreciation
• Suppose no ‘pricing to market’ (no price discrimination)
• Exported domestic goods sold at price 𝑃/𝑒 in foreign markets, and
imported foreign goods sold at price 𝑒𝑃∗ in domestic market
• Relative price of foreign goods to domestic goods:
𝑃∗ 𝑒𝑃∗
𝑞= =
𝑃Τ𝑒 𝑃
• Net exports 𝑁𝑋 positively related to competitiveness 𝑞
19
 Sticky prices
• Suppose both 𝑃 and 𝑃∗ are sticky in their respective currencies
• Firms supply the amount of goods demanded (𝑌 𝑑 ): 𝑌 𝑠 is irrelevant
• Changes in nominal exchange rate 𝑒 affect competitiveness 𝑞
• Depreciation of domestic currency (higher 𝑒) increases
competitiveness (higher 𝑞), raising 𝑁𝑋, shifting 𝑌 𝑑 to the right
• If prices are not expected to change in the future, then Fisher
equation implies real interest rate 𝑟 equals nominal interest rate 𝑖
• Monetary policy influences real interest rate 𝑟 through 𝑖 (as in Topic 4)
• Although producer prices are sticky, consumer prices change with exchange rate
• Assume share of spending on imports is sufficiently small (‘home bias’) that this
affect can be ignored when considering expected future inflation
20
Uncovered interest parity (UIP)
 Trade in nominal bonds of different countries
• Central banks’ monetary policies in domestic and foreign
economies determines respective nominal interest rates 𝑖 and 𝑖 ∗
• Investors can hold either domestic or foreign nominal bonds
• Each unit of domestic currency invested in the domestic bond
pays off 1 + 𝑖 units of domestic currency in the future
• If invest in the foreign bond with nominal interest rate 𝑖 ∗ :
• Convert domestic currency to foreign currency and receive 1/𝑒 per unit
of domestic currency, which pays off (1 + 𝑖 ∗ )/𝑒 units of foreign
currency in the future when invested in the foreign bond
• This is expected to be worth 1 + 𝑖 ∗ 𝑒 ′ /𝑒 units of domestic currency in
future, where 𝑒′ is the (expected) future exchange rate
22
Perfect capital mobility and risk-neutral investors
• Assume capital mobility is perfect and investors holding bonds are
risk neutral: they care only about expected returns on assets
• For both domestic and foreign bonds to be willingly held:
∗
𝑒′
1 + 𝑖 = (1 + 𝑖 )
𝑒
• Equates expected returns on bonds expressed in a common currency
𝑒 ′ −𝑒
• ∆= denotes expected change in nominal exchange rate 𝑒
𝑒
• Positive ∆ is expected depreciation of domestic currency
• Requirement that both bonds offer the same expected return is:
1 + 𝑖 = (1 + 𝑖 ∗ )(1 + ∆)
• Assuming ∆ is not too large relative to 𝑖 ∗ , the equation is approximately:
𝑖 ≈ 𝑖∗ + ∆
23
 Uncovered interest parity (UIP)
• With perfect capital mobility and risk-neutral investors, balance-
of-payments equilibrium needs ‘uncovered interest parity’ (UIP):
𝑖 = 𝑖∗ + ∆
• Domestic nominal interest rate 𝑖 is equal to the foreign nominal
interest rate 𝑖 ∗ plus any expected depreciation ∆ of the domestic
currency relative to the foreign currency
• 𝑖 must rise above 𝑖 ∗ to compensate for expected depreciation ∆
• If consumer-price inflation is approximately zero, can state this
requirement in terms of domestic and foreign real interest rates:
𝑟 = 𝑟∗ + ∆
24
 Monetary policy in an open-
economy New Keynesian model
 International New Keynesian sticky-price model
The model with sticky prices has three key components:
• 𝑌 𝑑 curve representing aggregate demand, including net exports
• Position of 𝑌 𝑑 depends on nominal exchange rate 𝑒 because a change in
𝑒 with sticky prices affects competitiveness 𝑞 and net exports 𝑁𝑋
• Higher 𝑒 (ER depreciation) implies a rightward shift of 𝑌 𝑑
• 𝑀𝑀 line representing the central bank’s monetary policy
• As in a closed economy, but now the choice of monetary policy may be
constrained by the country’s exchange-rate regime
• Balance of payments: horizontal 𝐵𝑃 line at 𝑟 = 𝑟 ∗ + ∆
• Uncovered interest parity (UIP) equation
• If no expected change in exchange rate (Δ = 0) then 𝑟 = 𝑟 ∗
26
 Economy with a flexible exchange rate
𝑟
• With a floating/flexible exchange
rate, the central bank has monetary
policy autonomy
𝑒, 𝑁𝑋 • Choose position/shape of 𝑀𝑀 line

𝑀𝑀 • Exchange rate 𝑒 adjusts so that 𝑌 𝑑

𝑟𝑎
curve shifts to where 𝐵𝑃 and 𝑀𝑀
lines intersect:
𝑟∗ + ∆ 𝐵𝑃
• Change in exchange rate affects
terms of trade and hence 𝑁𝑋
𝑌𝑎𝑑
• Determines equilibrium real GDP 𝑌0
and exchange rate 𝑒0
𝑌 𝑑 (𝑒0 )
• Can start from autarky 𝑌𝑎𝑑 with
𝑌 𝑁𝑋 = 0 and then find 𝑁𝑋 and 𝑒
𝑌0 𝑌𝑎
required for 𝐵𝑃 equilibrium 27
 Economy with a fixed exchange rate
𝑟 • With fixed exchange rate: central bank
uses monetary policy to achieve 𝑒 = 𝑒ҧ
• ER fixed means competitiveness does
𝑀𝑀𝑎 not change: no shift of 𝑌 𝑑 due to 𝑒
𝑀𝑀0
• If ER expected to remain fixed then no
𝑟𝑎 expected depreciation or appreciation:
• ∆ = 0 implies 𝐵𝑃 line is at 𝑟 = 𝑟 ∗
𝑟∗ 𝐵𝑃 & 𝑀𝑀

• Required monetary policy stance to

support fixed exchange rate shifts 𝑀𝑀
𝑌 𝑑 (𝑒)ҧ
line to intersect 𝑌 𝑑 on 𝐵𝑃 line
• Equivalent to horizontal 𝑀𝑀 line in
𝑌0
𝑌 same position as 𝐵𝑃
• No monetary policy autonomy 28
 Free capital flows

Fixed Monetary
exchange rate policy autonomy

The Trilemma
 Limits on policy choices in an open economy
• There is an important limitation on the government’s policy
choices in an open economy
• The ‘Trilemma’ – can have only two of the following three:
1. Fixed exchange rate
• Constant nominal exchange rate 𝑒 = 𝑒ҧ
2. Monetary policy autonomy
• Independent choice of money supply or interest rate to pursue domestic
macroeconomic objectives
3. Free capital flows
• Capital mobility, so uncovered interest parity (UIP) holds: 𝑖 = 𝑖 ∗ + ∆
30
 Monetary autonomy and free capital flows
𝑟
• Suppose central bank loosens
monetary policy to boost demand
• E.g. in response to negative shock
• Shifts 𝑀𝑀 line downwards
• Monetary policy autonomy is ability to
𝑀𝑀1
use policy to address domestic goals,
𝑀𝑀2
such as demand management
• E.g., UK after leaving ERM in 1992
𝑟∗ 𝐵𝑃

• With free capital flows, exchange rate

𝑌 𝑑 (𝑒2 )
adjusts so 𝑌 𝑑 intersects 𝑀𝑀 and 𝐵𝑃
𝑌 𝑑 (𝑒1 )
• ER depreciation
• Cannot have a fixed exchange rate
𝑌1 𝑌2
𝑌 • Effectiveness of policy based on
change in competitiveness 31
 Fixed exchange rate and free capital flows
𝑟 • With fixed exchange rate and free capital
flows, monetary policy must adjust 𝑀𝑀
line to intersect 𝐵𝑃 and 𝑌 𝑑 𝑒ҧ
• With perfect capital mobility, must
𝑀𝑀 be on 𝐵𝑃 line with 𝑟 = 𝑟 ∗
𝑀𝑀𝑎
• No exchange rate adjustment means
𝑌 𝑑 cannot shift to achieve this
𝑟∗ 𝐵𝑃 & 𝑀𝑀
• Cannot have independent monetary
policy (choice of 𝑀𝑀 line)
• E.g. EU countries that joined the
𝑌 𝑑 (𝑒)ҧ Exchange Rate Mechanism (ERM), a
system of fixed exchange rates in use
𝑌
𝑌1 before the launch of the euro
32
 Monetary autonomy and fixed exchange rate
𝑟 • With monetary policy autonomy and
a fixed exchange rate, cannot be on
perfect-capital-mobility 𝐵𝑃 line
• Capital controls must prevent large
financial-account imbalance owing
𝑀𝑀1
to interest-rate differential 𝑟 − 𝑟 ∗
𝑀𝑀2 • E.g. China
𝑟1 = 𝑟 ∗ 𝐵𝑃
• Given impediments to private capital
𝑟2 mobility, can use sterilized foreign-
exchange intervention to get 𝑒 = 𝑒ҧ
𝑌 𝑑 (𝑒)ҧ
• Foreign-exchange intervention
takes place of private capital
𝑌1 𝑌2
𝑌 flows in obtaining 𝐹𝐴 consistent
with net exports 𝑁𝑋 33
 Alternatives to monetary policy autonomy
• If a government wants to maintain a fixed exchange rate and
allow capital mobility, are there policies that can substitute for an
autonomous monetary policy?
• Fiscal policy, shifting the 𝑌 𝑑 curve for a given exchange rate 𝑒,
affects real GDP when the exchange rate is fixed
• It turns out that fiscal policy becomes very effective with a fixed
exchange rate: it can substitute well for monetary policy
• While fiscal policy is ineffective with a flexible exchange rate unless
accommodated by a simultaneous shift in monetary policy

34
 Fiscal policy, fixed ER, and free capital flows
𝑟 • Increase in government expenditure
shifts 𝑌 𝑑 curve to the right
𝐺↑ • With fixed exchange rate, monetary
policy adjusts to ensure 𝑀𝑀 line
𝑀𝑀1
intersects both 𝑌 𝑑 curve and 𝐵𝑃 line
𝑀𝑀2 • Real GDP rises from 𝑌1 to 𝑌2

𝑟∗ 𝐵𝑃 & 𝑀𝑀 • Note with a flexible exchange rate

and a given monetary policy (𝑀𝑀
𝑌2𝑑 (𝑒)ҧ
line in same position), exchange-rate
appreciation would shift 𝑌 𝑑 back to
𝑌1𝑑 (𝑒)ҧ original position following higher 𝐺
• Fiscal policy ineffective with
𝑌
𝑌1 𝑌2 flexible ER
35
Currency crises
 Currency crises
• Currency crises occur when a fixed exchange rate policy is put
under pressure by large capital flows and collapses
• E.g., ERM crisis in Europe in early 90s; Asian financial crisis in late 90s
• There are various reasons why currency crises can occur:
1. Government is following macroeconomic policies that are
ultimately inconsistent with defence of the fixed exchange rate
• Currency crisis is inevitable when foreign-exchange reserves exhausted
2. Government will not prioritize defence of the fixed exchange
rate if that jeopardizes other domestic policy objectives
• Currency crisis can then be self-fulfilling, even if sufficient reserves
• We will look at an example of the second type of currency crisis 37
 Self-fulfilling currency crises
• Self-fulfilling currency crises:
• Collapse of fixed exchange rate simply due to this being expected
• But if not expected, no fundamental reason for fixed ER to fail
• Suppose a currency crisis is expected:
• Expectations of depreciation of domestic currency: ∆> 0
• Shifts BP line upwards to 𝑟 ∗ + ∆
• Higher interest rate needed to avoid capital outflows
• Central bank must tighten monetary policy to defend fixed ER
• If government is not willing to sacrifice real GDP and employment to
defend fixed exchange rate then exchange rate depreciates, justifying
the original expectations of a crisis
38
 Expected collapse of fixed exchange rate
𝑟 • Expectation that fixed ER will
collapse shifts 𝐵𝑃 to 𝐵𝑃𝑐𝑐
• Maintaining fixed ER 𝑒 = 𝑒ҧ then
𝑀𝑀𝑐𝑐 requires higher real interest rate 𝑟
𝑀𝑀0 • Central bank tightens monetary
policy: 𝑀𝑀0 shifts to 𝑀𝑀𝑐𝑐
𝑟∗ + ∆ 𝐵𝑃𝑐𝑐
• Movement along 𝑌 𝑑 (𝑒), ҧ leading to
𝑟∗ 𝐵𝑃 real GDP falling from 𝑌0 to 𝑌𝑐𝑐
• If government will not tolerate
recession then abandon fixed ER
𝑌 𝑑 (𝑒)ҧ
• Self-fulfilling currency crisis
• Fixed ER does not collapse if
𝑌 not expected to (no 𝐵𝑃 shift)
𝑌𝑐𝑐 𝑌0
39
 Summary
• Small open economy with perfect capital mobility faces world real
interest rate, and goods market clears by net exports adjusting
• Capital controls make economy behave more like a closed economy
• Nominal exchange rates are much more volatile than goods prices
• Sticky goods prices mean nominal exchange rate affects competitiveness
• Choice of exchange-rate regime has real consequences
• Monetary policy autonomy and perfect capital mobility require a
flexible/floating exchange-rate regime
• Fixed exchange rate requires abandoning monetary policy
autonomy unless capital mobility is restricted
• Fiscal policy effective with fixed exchange rate, but not flexible ER 40