The IS-LM model in closed and open economy
Michele Piffer∗
January 6, 2023
These notes follow the textbook by Olivier Blanchard, “Macroeconomics”, with
a few minor modifications.1
1
IS-LM model in closed economy
Relevant reading(s) from Blanchard, Macroeconomics, 7th edition: Chapter 5 (full
chapter)
1. Combine the accounting equality
Yd =C +I +G
(1)
with the following ‘theories’ for its components:
C = C̄ + c · (Y − T )
I = I¯ − d · (i + f¯)
G = Ḡ, T = T̄
(2)
(3)
(4)
We get the IS curve in closed economy
Y =
Ā
d
− i
m m
(5)
∗
King’s Business School, King’s College London, UK. Email: michele.piffer@kcl.ac.uk, personal
web page: https://sites.google.com/site/michelepiffereconomics/. These notes can be reproduced
freely for educational and research purposes as long as they contain this notice and are retained for
personal use or distributed for free. All errors are mine. Please get in touch if you find typos or
mistakes.
1
For example,
1. we indicate foreign variables with
levels;
w
rather than ∗ , using the latter to denote equilibrium
2. we do not assume that the function for investments is increasing in Y .
1
with
Ā := C̄ − c · T̄ + I¯ − d · f¯ + Ḡ
m := 1 − c
(6)
(7)
Equivalently, the IS curve can be rewritten as
i=
Ā m
− Y
d
d
(8)
The IS curve is a decreasing line in the space (i, Y ) with intercepts (i, Y ) =
Ā
( Ād , 0) and (i, Y ) = (0, m
), and slope − md . The curve displays combinations of
points in the space (i, Y ) such that the market of goods is in equilibrium. Points
to the right (left) of the IS curve in the space (i, Y ) are interpreted as points
for which the supply side of the economy is producing too much (too little)
relative to aggregate demand, leading firms to adjust production downwards
(upwards). The points along the IS curve are not equilibrium points for the
full model, but only equilibrium points for the market of goods [see Figure
1].
2. We do not formally model the money market, but assume that the central
bank decides the nominal level of interest rate i = ī at which it wants the
money market to clear. Hence, we treat ī as the choice variable of the central
banker, assuming that the central bank can then adjust money supply to lead
the interest rate to ī. This means that in the space (i, Y ), the LM curve is a
horizontal line [see Figure 2].
3. The equilibrium of the full model is pinned down by the central bank selecting
the interest rate ī. This, in turn, implies an equilibrium level of the interest rate
Ā
− md ī:
of i∗ = ī, which implies the equilibrium level of output equal to Y ∗ = m
i∗ = ī
Y∗ =
(9)
Ā
d
− ī
m m
(10)
[see Figure 3]
4. Following a monetary expansion, the central bank decreases the interest rate
from ī1 to ī2 , which increases output [see Figure 4]. To assess what happens
to each component of the aggregate demand curve, remember the equilibrium
condition
Y = C(Y , T̄ ) + I( i , f¯) + G(Ḡ)
(11)
+ −
− −
+
The left hand side increases, hence the right hand side also increases. Closer
inspection leads to note that
2
i
Y
C
I
G
↓
↑
↑
↑
=
We can summarize the effects discussed above as follows:
i ↓→ I ↑→ Y d > Y s → Y ↑→ C ↑→ Y d > Y s → Y ↑→ C ↑→ ...
(12)
What is the model helping us understand about the real world? The model suggests that the unobserved transmission mechanism of monetary policy consists
of at least two channels through which a decrease in the interest rate stimulates
the economy:
(a) the decrease in the interest rate increases investments, which contributes
to the increase in equilibrium output (investment channel);
(b) the increase in output increases consumption, which further increase output and contributes to the increase in equilibrium output (consumption
channel).
5. A fiscal policy expansion via fiscal spending can be approximated in the model
as an increase in Ḡ, holding T̄ constant. Assuming that the central bank leaves
the interest rate unchanged, the fiscal expansion shifts the IS curve to the right,
leading to a higher equilibrium level of output [see Figure 5]. The increase
in G by ∆Ḡ leads to an equilibrium increase in output by
1
∆G > ∆G
(13)
m
due to c < 1, 1/m > 1: this implies a multiplicative effect. Starting from the
equilibrium condition
∆Y ∗ =
Y = C(Y , T̄ ) + I( i , f¯) + G(Ḡ)
+ −
− −
+
(14)
we find that a fiscal stimulus generated via an increase government spending
leads to
i
Y
C
I
G
Surplus := T − G
3
=
↑
↑
=
↑
↓
We can summarize the effects discussed above as follows
Ḡ ↑ Y d > Y s → Y ↑→ C ↑ Y d > Y s → Y ↑→ C ↑ ....
(15)
What is the model helping us understand about the real world? It helps us
understand that, in principle, an increase in public spending does not need to
increase output by the same amount as the increase in government spending,
because it can generate an increase in output that feeds into an increase in
consumption, which further feeds into an increase in output. Hence, there
could be some multiplicative features that can be exploited to support the
economy. Taking this line of thought to the extreme, the government could in
principle spend ∆G in something completely useless, for instance digging holes
in the ground. This could still increase equilibrium output.
6. Can you think outside of the model? Here are some examples of things that
the model does not explicitly account for, but which could well affect the conclusions drawn using the model:
(a) for monetary policy, are we sure that the central bank can decrease the
interest rate, or is the interest rate too close to zero? (zero lower bound)
(b) for fiscal policy, are we sure that the increase in government debt associated with the increase in Ḡ given T̄ fixed has no relevant implications?
What if agents see that the government is spending more and decide to
save more, just in case the government will need to raise taxes in the
future? (Ricardian Equivalence)
(c) for fiscal policy, are we sure that an increase in borrowing from the government will not push interest rates up due to the higher demand for
money, and hence lead to a higher cost of borrowing for firms, which in
turn reduces investments? (crowding out)
The above analysis assumes that economy does not have any trading or financial
relation with the rest of the world. Let’s now extend the analysis to an open
economy.
2
Intro to Open economy
Relevant reading(s) from Blanchard, 7th edition: Chapter 17 (full chapter),
Chapter 18 (only the discussion of the Marshall-Lerner condition, 18-4, “Depreciation, the trade balance, and output”)
4
7. There is no single definition of the nominal exchange rate, it’s a relative
concept. Define Dc the currency of the domestic country, and F c the currency
of the foreign economy:
a) the indirect (or European) definition of the nominal exchange rate is:
EF c,Dc = price of the domestic in terms of foreign =
= number of foreign per 1 unit of domestic =
#F c
=
1Dc
hence EF c,Dc ↑→ Dc appreciates;
b) the direct (or American) definition of the nominal exchange rate is:
EDc,F c = price of the foreign in terms of domestic =
= number of domestic per 1 unit of foreign =
#Dc
=
1F c
hence EDc,F c ↑→ Dc depreciates;
Some books use the indirect definition (Blanchard, Mishkin), others the direct
one (Carlin an Soskice, Delli Gatti, Williamson). We follow Blanchard and use
the indirect (European) definition:
E = EF c,Dc
(16)
which increases when Dc appreciates.
8. To understand what determines the nominal exchange rate E we need to understand who trades Dc for F c and vice versa, i.e. what drives their demand
and supply on the Forex market (foreign exchange market,or currency market). The starting point is the Balance of Payments, which is an account
that registers the transactions of the domestic economy with the rest of the
world.
Balance of Payment = Current Account + Capital Account
BoP = CA + KA
The current account consists of three components: the trade balance/net export (export X minus imports IM , both expressed in domestic currency, with
X − IM = N X), the income balance (net payments on cross-country asset
holdings, i · N F A) and net transfers (foreign aid, T r). The capital account
includes the net capital inflows into the domestic economy for new investments
(Kin − Kout , both expressed in domestic currency). Omitting net transfers for
5
simplicity, the following equation clarifies which of the above items generate a
demand of domestic versus foreign currency:
BoP = CA + KA =
DDc ,SF c
=
X
DF c ,SDc
DDc ,SF c
DDc ,SF c
DF c ,SDc
− IM + i · N F A + Kin − Kout
where I am assuming N F A > 0 for simplicity.
9. Except for small statistical discrepancies, the Balance of Payments must ‘balance’, which means
BoP = CA + KA = 0
BoP = CA + KA = ∆IR
flexible exchange rate
fixed exchange rate
with IR the stock of international reserves, or foreign reserves.
In general
BoP > 0 → DDc > SDc
→ if flexible exchange rate: Dc appreciates
→ if fixed exchange rate:
buy F c, ∆IR > 0 & M s ↑= SDc ↑
BoP < 0 → DDc < SDc
→ if flexible exchange rate: Dc depreciates
→ if fixed exchange rate:
sell F c, ∆IR < 0 & M s ↓= SDc ↓
Some interesting lessons:
(a) Under a flexible exchange rate, a negative CA requires borrowing from the
rest of the world and ensuring Kin > Kout . But this increases the total
level of debt versus the rest of the world (NFA ↓), which further reduces
CA via the income balance. Things can get out of hand, and at some
point the country needs to accept to improve its net exports by cutting
imports/increasing exports. But that’s easier said than done;
(b) Under a fixed exchange rate, if the domestic central bank must fight
against a depreciation, it had better have enough international reserves!
The tendency of an appreciation, instead, implies that the country can accumulate international reserves, i.e. foreign reserves. Since ∆IR = ∆M ,
committments on E imply that M cannot be set freely. This also constrains the central banker’s ability to set i.
6
10. Later, we will introduce the simplifying assumption that, in a flexible exchange
rate regime, the nominal exchange rate is mainly driven by the KA. In fact,
while KA= - CA (unless we are in a fixed exchange rate regime), the absolute
transactions in the CA are usually much lower than in KA, i.e. Kin +Kout >>>
X + IM + r · N SA. Building on this, we postulate that E is pinned down by
the uncovered interest rate parity (UIP) between domestic and foreign
interest rate:
Et
(17)
(1 + it ) = (1 + iw
t ) e
Et+1
What is the idea behind the UIP? A domestic investor might well find it optimal
to invest abroad even if the foreign nominal interest rate is lower than the
domestic one (iw
t < it ) if he expects the domestic currency to depreciate over
time EEe t > 1. In fact, a domestic investor who invests one unit of domestic
t+1
currency abroad at time t will effectively invest Et units of foreign currency
c
). At time t + 1, this delivers a gross return
(remember, we are using E = #F
1Dc
w
of (1 + it )Et units, which is still denominated in foreign currency, which is
equivalent to (1 + iw
t )Et /Et+1 units of domestic currency, given Et+1 the future
exchange rate (which is unknown at time t + 1). Hence, if the investor expects
e
the currency to depreciate enough, then Et /Et+1
> 1, offsetting (1 + it ) >
w
(1 + it ).
The UIP is an equilibrium condition, i.e. an equality that must hold for a certain condition to be satisfied (which, for the UIP, is a no arbitrage condition
between investing domestically and investing abroad). An equilibrium condition is conceptually very different from a causal mechanism, i.e. a force that
drives variables up and down. Later in these notes, we will argue that given an
e
unchanged (iw , Et+1
), an increase in it generates a capital inflow, which leads
the domestic economy to appreciate, Et ↑. This line of thought ‘makes sense’:
as capital flows into the economy, more agents demand for the domestic currency which hence appreciates. Yet, it’s an argument that hints at a causal
mechanism, and has nothing to do with an equilibrium condition. It does not
even strictly require the UIP to hold. Still, it’s useful to note that it is cone
sistent with the UIP: within the UIP, since we are treating Et+1
as fixed, the
appreciation generates the expectation of a depreciation, which makes foreign
investment more profitable in terms of the domestic currency, hence allowing
for it > iw
t to hold in equilibrium. The expected depreciation of the domestic currency guarantees that the return for a domestic investor from investing
abroad is not as low as iw
t .
11. The above point summarizes a ‘theory’ for the determinants of the KA, or at
least an equilibrium condition affecting 2 variables (i, iw ) which play an important role for KA. We now need a ‘theory’ for what drives CA, especially net
exports, because net exports are part of aggregate demand, and we want to
7
use the model to study what drives aggregate output and how economic policy
can affect it. We defined X as exports denominated in the domestic currency.
We now need to distinguish between IM , the value of imports expressed in domestic currency, and IMF c , the value of the same imports expressed in foreign
currency. We assume X = X(E ) and IMF c = IMF c (Y , E ). It then holds that
−
+
+
IM = IMF c /E. Hence, in principle, the effect of E on NX is not clear, since
IMF c (Y , E )
+
N X = X − IM = X(E ) −
+
E
−
(18)
However, we assume that the Marshall-Lerner condition holds: we assume that
in response to a depreciation, the direct effect of E on (X, IMF c ) is stronger
than the revaluation effect that increases the value of IMF c . Or even more,
we assume that IM = IM (Y , E ), i.e. we assume that the increase in imports
+
+
following an appreciation of the domestic currency is stronger than the reevaluation effect (via 1/E) of having to convert foreign denominated imports
into the domestic currency at an appreciated exchange rate. In short, we
assume that
N X(E , Y ) = X(E ) − IM (Y , E )
(19)
−
−
−
+
+
hence, that a depreciation of Dc increases NX. We will assume the functional
form
N X = X̄ − x · E − z · Y
(20)
12. In principle, import and export decisions depend on the real exchange rate
, not on the nominal exchange rate E, with
=
E·P
Pw
(21)
However, we only use the model to study the short term, in which we are
comfortable to assume fixed prices. Hence, we can just apply the normalization
P w = P = 1, which implies
=E
(22)
We will stick to E rather than , but it’s good to appreciate the distinction.
3
IS-LM model in open economy
Relevant reading(s) from Blanchard, Macroeconomics, 7th edition: Chapter
19 (full chapter), Chapter 20 (only 20-2, “Exchange rate crisis under fixed
exchange rate”)
8
Let’s see how the lessons draws from the model in Section 1 change when the
model is made a bit more realistic by allowing the economy to interact with
other economies.
13. Combine the accounting equality
Y d = C + I + G + NX
(23)
with the following ‘theories’ for its components:
C = C̄ + c · (Y − T ),
I = I¯ − d · (i + f¯),
G = Ḡ, T = T̄
N X = X̄ − x · E − z · Y
(24)
(25)
(26)
(27)
We get the IS curve in open economy
Y =
Ā
d
x
− i− E
m m
m
(28)
with
Ā := C̄ − c · T̄ + I¯ − d · f¯ + Ḡ + X̄
m := 1 − c + z
(29)
(30)
The IS curve is a decreasing curve in the space (i, Y ) with intercepts (i, Y ) =
Ā
x
−m
· E), and slope − md . It shifts rightwards
( Ād − xd · E, 0) and (i, Y ) = (0, m
when the domestic currency depreciates (lower E), hence there is an entire set
of IS curves, each one associated with a value of E.2 [see Figure 6]
We should think of the IS curve in different ways depending on whether we
are in a fixed or a flexible exchange rate regime. In a fixed exchange rate
regime, E = Ē, = ¯, hence the IS curve is an equilibrium condition in
two endogenous variables: (Y, i). By contrast, in a flexible exchange rate the
IS curve is an equilibrium condition in three endogenous variables: (Y, i, E).
Again, the IS curve captures the equilibrium condition for the market of goods,
not the equilibrium of the full model.
3.1
Flexible exchange rate regime
14. Under a flexible exchange rate, the central bank has no commitment on
the equilibrium value of E, international reserves do not adjust to balance the
2
Blanchard substitutes E in the IS curve right away, hence the IS curve is not a function of E
anymore. I do not follow this approach, but the solution of course does not change.
9
balance of payments, hence the central bank can set i freely, say at the desired
level ī. Given that we use the UIP to determine E, the model is pinned down
by three equations,
Ā
d
x
− i− E
m m
m
i = ī
E
(1 + i) = (1 + iw ) e
E+1
Y =
(31)
(32)
(33)
in three unknowns, (Y, i, E). Rewrite the UIP as
1 + iw
i=
·E−1
e
E+1
(34)
w
This is a positively sloped line in the space (i, E) with slope 1+i
e , crossing
E+1
w
e
i = i for E = E+1 . Alternatively, we can rewrite the UIP to highlight the
equilibrium exchange rate given the interest rate,
E=
1+i
e
· E+1
1 + iw
(35)
[see Figure 7]
We can solve the model recursively as follows: The central bank sets i = ī,
1+ī
e
which pins down E ∗ = 1+i
w · E+1 . Last, the solution for E pins down a single
IS curve, which crosses i = ī in the equilibrium value of output [see Figure
8]. This gives the analytical solution
i∗ = ī
(36)
1 + ī
e
· E+1
1 + iw
d
x 1 + ī
Ā
e
− ī −
· E+1
Y∗ =
m m
m 1 + iw
E∗ =
(37)
(38)
15. Let’s study what happens if the central bank expands monetary policy. From
the solution, we see that a monetary expansion consists of a decrease in the
interest rate, which leads to a depreciation of the domestic currency and an
increase in output. To understand what is going on, assume that the economy
e
is initially in the following equilibrium: i∗1 = ī1 = iw and E1∗ = E+1
. As the
∗
w
central bank now sets the new interest rate i2 < i , capital outflows depreciate
the domestic currency, leading to E2∗ < E1∗ , generating an expectation of a
future appreciation that allows for i < iw to co-exist. Last, the IS curve shifts
to the right, leading to Y2∗ > Y1∗ due to both an investment effect and an
external channel effect [see Figure 9].
10
To assess what happens to each component of the aggregate demand curve,
remember the equilibrium condition
Y = C(Y , T̄ ) + I( i , f¯) + G(Ḡ) + X(E ) − IM (Y , E )
+ −
− −
−
+
+
+
(39)
The left hand side increases, hence the right hand side also increases. Closer
inspection leads to note that under the flexible exchange rate, a monetary
expansion generates
i
E
Y
C
I
G
X
IM
NX
↓
↓
↑
↑
↑
=
↑
undetermined
undetermined
We can summarize the effects discussed above as follows:
i ↓ → Y d > Y s → Y ↑→ C ↑→ ..
d
s
→ E ↓→ X ↑→ Y > Y → Y ↑ C ↑→ ..
(40)
(41)
What is the model helping us understand about the real world? According to
the model, the unobserved transmission of monetary policy in the real world
may consist of several channels that occur at the same time:
(a) the decrease in the interest rate increases investments, which contributes
to the increase in equilibrium output (investment channel);
(b) the increase in output increases consumption, which further increase output and contributes to the increase in equilibrium output (consumption
channel);
(c) the depreciation of the domestic currency increases exports, which further
contributes to increasing equilibrium output (the export channel);
(d) the increase in output increases imports, which lowers domestic aggregate
demand, hence attenuating the effect of the monetary expansion. The
effect of output on imports might offset the opposite effect exerted on
imports by the depreciation of the domestic currency, leaving the effect
on imports undetermined.
11
16. Let us now use the model to guide our understanding of how the economy
responds to a fiscal expansion. Let’s consider the case of an increase in
government spending that does not affect taxes, and that is hence funded
by government debt. Start again from an equilibrium of i∗1 = ī1 = iw and
e
. An increase in Ḡ from Ḡ1 to Ḡ2 does not affect (i, E), hence
E1∗ = E+1
∗
∗
∗
i2 = i1 , E2 = E1∗ . The IS curve shifts to the right due to G ↑. Equilibrium
output hence increases [see Figure 10].
Let us inspect the transmission mechanism of the fiscal expansion by studying
how each component of aggregate demand changes. As before, we start from
the equilibrium condition
Y = C(Y , T̄ ) + I( i , f¯) + G(Ḡ) + X(E ) − IM (Y , E )
+ −
− −
+
−
+
+
(42)
The left hand side increases, hence the right hand side also increases. Closer
inspection leads to note that under the flexible exchange rate, a fiscal expansion
generates
i
E
Y
C
I
G
X
IM
NX
=
=
↑
↑
=
↑
=
↑
↓
We can summarize the effects discussed above as follows
Ḡ ↑ Y d > Y s → Y ↑ → C ↑→ Y d > Y s → Y ↑→ C ↑ ....
→ IM ↑→ Y d ↓
(43)
(44)
What is the model helping us understand about the real world? The model
is suggesting that in an open economy with a flexible exchange rate, a fiscal
expansion can indeed increase output, but the effect will be partially offset by
an increase in imports. Hence, the decrease in net exports partially crowds out
the increase in fiscal spending.
3.2
Fixed exchange rate regime
17. Let us now move to the case of a fixed exchange rate. Suppose the central
bank commits to the fixed exchange rate Ē. It hence commits to intervening
12
on the Forex (Foreign Exchange) market to ensure that the market clears at
E = Ē. The IS curve now simplifies to
Ā
d
x
− i − Ē
(45)
m m
m
hence, there is now only one IS curve in the space (i, Y ), rather than an entire
set, as long as the exchange rate remains at Ē. Assume that the exchange
e
= Ē, which implies i = iw via the UIP.
rate regime is credible, hence E+1
The central bank is not free to set the interest rate at any desired level ī. The
equilibrium is then given by [see Figure 11]
Y =
E ∗ = Ē
i∗ = iw
Y∗ =
d
x
Ā
− iw − Ē
m m
m
(46)
(47)
(48)
18. Can the central bank expand monetary policy under a fixed exchange rates?
Suppose the central bank tries to lower the interest rate in order to increase
e
= Ē, the UIP shows that the decrease in i requires
output. Assuming E+1
a lower value of E, i.e. an immediate depreciation: this depreciation of the
domestic currency can be interpreted as the result of capital outflows that are
triggered by the now lowered domestic interest rate. But it violates the fixed
exchange rate agreement! This is equivalent to the central banker trying to
move along the IS curve and then having to revert back to the initial equilibrium
[see Figure 12].
We can summarize the effects discussed above as follows:
i ↓→ Kout ↑→ E ↓→ i ↑
(49)
What is the model helping us understand about the real world? One monetary
policy tool (the interest rate) cannot be used both as an independent tool for
monetary policy and as a tool to ensure the fixed exchange rate regime. If the
country decides to fix its exchange rate, it must accept the fact that monetary
policy will not be available any more for economic policy.
19. Consider now the unfortunate case in which the central bank commits to the
exchange rate Ē but loses its credibility, and markets start to expect E+e < Ē.
The loss of credibility leads investors to invest abroad, which is consistent with
the UIP rotating to the left. If the central bank leaves the interest rate at iw ,
the equilibrium exchange rate will indeed decrease, breaking the commitment
of the central bank. Hence, the central bank should increase the interest rate
to i∗2 , which is the level that ensures an equilibrium exchange rate of Ē. Note
13
that to avoid the depreciation in the domestic currency, the central bank must
buy domestic currency from the Forex market, which in turn decreases money
supply (an effect consistent with the increase in the interest rate) and requires
selling foreign reserves. If the central bank does not have a sufficient amount of
foreign reserves, this plan might be infeasible. In addition, it implies a decrease
in output, as seen from the movement along the IS curve [see Figure 13].
Starting from
Y = C(Y , T̄ ) + I( i , f¯) + G(Ḡ) + X(E ) − IM (Y , E )
+ −
− −
+
−
+
+
(50)
the left hand side decreases, hence the right hand side also decreases. Closer
inspection leads to note that a sudden loss of credibility of the fixed exchange
rate regime might require
i
E
Y
C
I
G
X
IM
NX
↑
=
↓
↓
↓
=
=
↓
↑
We can summarize the effects discussed above as follows
E+e ↓→ Kout ↑→ i ↑→ I ↓→ Y d < Y s → Y ↓
(51)
What is the model helping us understand about the real world? The model
suggests that if the fixed exchange rate is not considered credible any more by
financial markets, the central bank must fight back by increasing the interest
rate and offsetting capital outflow by selling foreign currency and lowering
the amount of domestic money available for trade in the Forex market. This
can generate a fall in output, further exacerbated by the fall in consumption,
investment, and net exports. Alternatively, the country must accept that the
fixed exchange rate is not feasible any more and abandon it.
20. The effects of a fiscal expansion are the same when comparing fixed and flexible
exchange rate, at least within the specific formulation of the IS-LM model
considered here. This is because in our setting, the fiscal expansion generates
no pressure on the exchange rate, hence there is no difference whether we are
in a fixed or a flexible exchange rate regime.
14
21. Can you think outside of the model? Here is one example of what the model
does not explicitly account for, but which could well affect the conclusions
drawn using the model. In this model, does an increase in investments have a
positive effect in the future production possibility of the economy? Not really,
because it is a demand-side model: aggregate supply is simply assumed to
follow demand. Yet, an increase in aggregate demand driven by investments
should also generate a second round effect on the potential level of output.
The model does not formally include this, hence it might underestimate the
positive effects associated with an increase in aggregate investments.
4
Exchange rate regimes
Relevant reading(s) from Blanchard, Macroeconomics, 7th edition: Chapter 20
(only 20-4, “Choosing between exchange rate regimes”)
22. As discussed, adopting a fixed exchange rate regime does not improve the
effectiveness of fiscal policy, and it implies that monetary policy is lost as an
independent tool for economic policy. Then, why should a country agree to a
fixed exchange rate regime? The general consensus is that a flexible exchange
rate regime is better, except for two cases:
(a) if two or more countries are very integrated, a fixed exchange rate (or even
more, a common currency) can lower transaction costs, improve competition across countries, facilitate a stronger political integration. However,
the more dissimilar are the shocks that hit the different countries, the more
costly it will be to have given up on monetary policy as an independent
tool;
(b) if a country struggles to build credibility on how it uses money, then it
can be optimal to tie the hands of the central bank and of the politicians.
This can convince foreign investors to invest in the countries. An extreme
version of the hard peg is the dollarization.
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