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Chapter Review Chapter 35: Policy in the Open Economy

  1. In the open economy, net exports are a component of aggregate spending. Both imports and exports depend on the real exchange rate. A lower real exchange rate increases exports and reduces imports.
  2. Changes in the real interest rate affect investment, the exchange rate, and net exports. A rise in the real interest rate reduces domestic investment and net exports, leading to a downward shift in aggregate expenditures.
  3. The aggregate demand-inflation (ADI) curve in an open economy has a negative slope-the level of output consistent with equilibrium falls as inflation rises. The ADI curve can shift if incomes abroad fluctuate or if foreign interest rates rise or fall relative to the U.S. interest rate.
  4. Exchange rate movements can have a temporary but direct effect on U.S. inflation. If the dollar depreciates, the prices of imported inputs rise, and firms may pass this increase through in the form of higher prices.
  5. Exchange rate movements can directly affect the consumer price index (CPI) measure of inflation, because the CPI includes the prices of imported goods purchased by households.
  6. Monetary policy is more effective in an open economy-changes in interest rates affect private investment, but they also cause reinforcing changes in net exports through the exchange rate channel.
  7. Fiscal policy is less effective in an open economy-the change in exchange rate causes net exports to offset the initial fiscal action.
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