ABSTRACT
The second half of this book has thus far dealt almost entirely with the balance of payments and with exchange markets. It is now necessary to turn to the effects of international trade and capital flows on the behavior of a domestic macroeconomy, with particular emphasis on business cycles and on the usefulness of monetary and fiscal policies in dealing with them. This chapter will first add international trade to a typical Keynesian national income determination model to see how such trade affects the cyclical behavior of the economy. It turns out that the effects are sizable, particularly for an economy that is relatively open to trade, that is, for a country in which exports and imports play a large role. Macroeconomic shocks that originate within the economy are somewhat milder, because the Keynesian multiplier is smaller, but business cycles are transmitted from one economy to another
By the end of this chapter you should be able to understand:
• the impacts of foreign trade on a standard Keynesian income determination model: exports as a new source of exogenous shocks to demand, and the marginal propensity to import as a new leakage from the multiplier process, thereby making the multiplier smaller; the larger the role of trade in the economy, the larger the reduction in the size of the domestic multiplier;
• the transmission of business cycles through trade flows among countries maintaining fixed exchange rates;
• the S – I/X – M graph as a means of illustrating responses to foreign or domestic shocks in this simple Keynesian world;
• why a fixed exchange rate and an open economy severely limit the ability of a country to use a domestic monetary policy to manage the domestic macroeconomy when that monetary policy differs significantly from that prevailing elsewhere;
• how domestic fiscal policy can be made more effective by a fixed exchange rate if international capital market integration is extensive, but less effective if capital market integration is very limited;
• how the IS/LM/BP graph can be used to clarify the arguments in the two previous items;
• why a monetary policy shift abroad imposes a parallel shift in monetary policy at home when a fixed exchange rate exists.
