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Jump to Revision Questions for chapter 4
Chapter Introduction
In Chapter 3 we looked at some of the fundamental identities for an open economy and considered the possible effect of devaluation on the current account. It was noted that the ultimate impact of a devaluation will in large part be dependent upon the economic policies that accompany the devaluation. In this chapter we shall be examining how both exchange rate changes and macroeconomic policies impact upon an open economy. A fundamental difference between an open economy and a closed economy is that over time a country has to ensure that there is an approximate balance in its current account. This is because no country can continuously build up a stock of net liabilities to the rest of the world by running a continuous current account deficit. Conversely, it does not make sense for a surplus country to continuously build up a stock of net claims on the rest of the world. Eventually it will wish to spend those claims.
The need for economic policy-makers to pay attention to the implications of changes in monetary and fiscal policy on the balance of payments is an important additional dimension for consideration in the formulation of economic policy in an open economy.Ensuring a sustainable balance of payments position over time is an important economic objective to go along with those like high economic growth, low unemployment and low inflation.
One of the additional policy choices that has to be made by the authorities of an open economy is to decide whether to fix the exchange rate, allow it to float, or perhaps choose some arrangement between these two extremes. The choice between these two regimes is the focus of analysis of Chapter 10; in this chapter we concentrate upon how fiscal and monetary policy operate under both regimes.
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