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CHAPTER 23 INTERNAL AND EXTERNAL BALANCE WITH FIXED EXCHANGE RATES Objectives of the Chapter Reconciling the policy goals of full employment, price stability, and overall payments balance is a difficult undertaking for a government determined to keep the exchange rate fixed. Starting from some states of disequilibrium, the choice of fiscal and monetary policies that would move the economy toward both internal and external equilibrium (or balance) might be quite easy. Starting from some other disequilibrium states, the choice is less obvious. Chapter 23 analyzes the effects of fiscal and monetary policies on the product market, the money market and the foreign exchange market. A set of recommendations for the proper policy mix is then derived for the case of imperfect capital mobility. Finally, the analysis of the feedback from the balance of payments to the money supply and the case of perfect capital mobility highlights the limitations of discretionary monetary policy under fixed exchange rates. After studying Chapter 23 you should know 1. the connection between official intervention in the foreign exchange market and the domestic money supply. 2. how official intervention affects a country’s balance of payments and macroeconomic performance goals. 3. the reasons for, and methods of, sterilized intervention by monetary authorities. 4. how monetary and fiscal policies affect internal and external balance under fixed exchange rates. 5. the effectiveness of monetary policy and fiscal policy under perfect capital mobility. 6. when aggregate demand policies can and cannot achieve both internal and external balance. 7. how, under imperfect capital mobility, an appropriate mix of monetary and fiscal policies can achieve internal and external balance in the short run. 8. when a country might want to abandon its defense of a fixed exchange rate. 9. how much the trade balance will respond to a change in the exchange rate. Important Concepts Aggregate demand policy Refers to the difficulty of improving the levels of both national dilemma: income and the balance of payments by manipulating only the level of aggregate demand. Assignment rule: A guideline for assigning goals to fiscal and monetary policies. Fiscal policy should aim at achieving internal balance, while
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This note was uploaded on 02/18/2010 for the course ECON 343 taught by Professor Dblack during the Fall '09 term at University of Delaware.

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