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CHAPTER 24 FLOATING EXCHANGE RATES AND INTERNAL BALANCE Objectives of the Chapter From the discussion of stabilization policy under fixed exchange rates, it appears that when the economy finds itself in one of the two cases of aggregate demand-policy dilemma explored in Chapter 23, letting the exchange rate float freely (rather than attempting to juggle monetary and fiscal policies) would solve all our troubles. Since external balance would automatically be assured, we would just have to worry about tuning monetary policy and fiscal policy for internal balance. However, the exchange rate movements that achieve external balance will have a feedback effect on our domestic economy and internal balance. This chapter should come as something of a relief to you monetary types who were dismayed by the apparent loss of monetary policy’s power under the fixed exchange rate regime discussed in the last chapter. In contrast, we find in Chapter 24 that monetary policy becomes very powerful in a world of capital mobility and flexible exchange rates. (The opposite is true for fiscal policy.) But there is also a surprising twist: monetary policy expands aggregate demand and income more through its impact on exchange rates and net exports than through its impact on interest rates and investment spending. We have one more general conclusion from the chapter. If a country is internally stable but exists in an unstable world, a fixed exchange rate regime will prove to be its best bet: it will tend to protect the country from external shocks. On the other hand, if a country is unstable domestically, a fixed exchange rate regime will multiply those problems at home. The unstable country should, instead, opt for a floating exchange rate regime, which tends to “bleed off” some of the impact of domestic instability onto trade partners. (Of course, the country would then have to contend with some very unhappy international neighbors….) After studying Chapter 24 you should know 1. the effectiveness of monetary policy under flexible exchange rates. 2.
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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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