ABSTRACT
In the analysis of our simple model with fixed exchange rates, we made two important discoveries. First, expansionary fiscal and monetary policies cause a deterioration of the trade balance. Second, the effectiveness of fiscal and monetary policy in raising output is smaller as compared to the closed economy (or as compared to the open economy with flexible exchange rates). We also found out that exchange rate policy, such as a one-time devaluation can stimulate output. The extensions presented in this chapter include new insights about sterilization (an assumption of the model) and the possibility of using several policies to achieve several goals. Finally we relax the small economy assumption and investigate what happens when two equally sized countries trade. We continue to assume the absence of non-official capital flows.
