Up to the 1960s the Keynesian model of macroeconomics pertained to a closed economy. That is, an economy that has no international trade or movement of capital. In modern times no country could be found to conform to such a description. The model was defended on the ground that it was a first approximation. It was argued that in the case of some countries such as the United States, the amount of international trade compared to the GDP was so small as to be negligible for the sake of analysis. For countries such as small European countries exports and imports were a substantial proportion of the GDP. Therefore, the approximation would be off the mark. But it was argued that if somehow the external balance was maintained, the internal macroeconomic issues could be analyzed separately from international problems.
Moreover, if exchange rates are flexible, an increase in investment or government spending, and a reduction in saving or taxation, will have a substantially different effect on employment than that predicted by the traditional foreign trade multiplier . The reason lies in the fact that equilibrium in the balance of payments is automatically maintained by variations in the price of foreign exchange. Robert Mundell , “Flexible Exchange Rates andEmployment Policy,” The Canadian Journal of Economics and Political Science, 1961, 509
The dance was very lively and complicated. It was complicated enough without me—with me it was more so.Mark Twain, Innocents Abroad
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Notes
- 1.
Robert Mundell won the Nobel Prize in Economics in 1999, “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”
- 2.
In this chapter and elsewhere we speak of “the exchange rate” when it is well known that there are as many bilateral exchange rates for a currency as there are other currencies. In a fixed exchange rates regime a devaluation or revaluation of a currency would occur with respect to all other currencies. Similarly, depreciation or appreciation of a currency in a flexible regime occurs with respect to all other currencies. It is possible that two currencies are tied together, for example the Chinese yuan (although in recent years China has gradually moved to floating its currency) and the Saudi Arabia’s riyal are tied to the dollar and a devaluation or depreciation of the dollar will have no effect on such exchange rates. Nevertheless, since we are interested in macro effects and not on the effects of devaluation on trade with a particular country, we can continue to talk of the exchange rate as a shorthand.
- 3.
The convention of stating the exchange rate as the number of units of the domestic currency that buys one unit of foreign currency is called the price quotation system. Alternatively, we can express the exchange rate as the number of the units of the foreign currency that buys one unit of the domestic currency. In the example in the text the exchange rate could equivalently be stated as 0.7692=1/1.30 euro per dollar. This convention is referred to as the volume quotation system. For consistency, in this book, we shall adhere to the first system.
- 4.
This statement should be qualified. An increase in the exchange rate (devaluation, depreciation) would improve the trade balance if the Marshall-Lerner condition is satisfied, that is, if the sum of the elasticities of imports and exports with respect to the exchange rate is greater than one. The subject, however, is outside the purview of this book and the reader is referred to books on international economics, for example, Giancarlo Gandolfo (2002), Chap. 7.
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
Copyright information
© 2009 Springer-Verlag Berlin Heidelberg
About this chapter
Cite this chapter
Dadkhah, K. (2009). Macroeconomics of an Open Economy. In: The Evolution of Macroeconomic Theory and Policy. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-77008-4_5
Download citation
DOI: https://doi.org/10.1007/978-3-540-77008-4_5
Published:
Publisher Name: Springer, Berlin, Heidelberg
Print ISBN: 978-3-540-77007-7
Online ISBN: 978-3-540-77008-4
eBook Packages: Business and EconomicsEconomics and Finance (R0)