Temporary Changes in Monetary and Fiscal Policy
Now that we have seen how the economy’s short-run equilibrium is determined, we can
study how shifts in government macroeconomic policies affect output and the exchange
rate. Our interest in the effects of macroeconomic policies stems from their usefulness in
counteracting economic disturbances that cause fluctuations in output, employment, and
inflation. In this section we learn how government policies can be used to maintain full
employment in open economies.
We concentrate on two types of government policy, monetary policy, which works
through changes in the money supply, and fiscal policy, which works through changes in
government spending or taxes.7 To avoid the complications that would be introduced by
ongoing inflation, however, we do not look at situations in which the money supply grows
over time. Thus, the only type of monetary policies we will study explicitly are one-shot
increases or decreases in money supplies.8
In this section we examine temporary policy shifts, shifts that the public expects to be
reversed in the near future. The expected future exchange rate, , is now assumed to
equal the long-run exchange rate discussed in Chapter 16, that is, the exchange rate that
prevails once full employment is reached and domestic prices have adjusted fully to past
disturbances in the output and asset markets. In line with this interpretation, a temporary
policy change does not affect the long-run expected exchange rate, .
We assume throughout that events in the economy we are studying do not influence the
foreign interest rate, , or price level, , and that the domestic price level, , is fixed in
the short run.
R* P* P
Ee
Ee
E2 E3
E
7An example of the latter (as noted earlier) would be the tax cut enacted during the 2001–2005 administration
of President George W. Bush. Other policies, such as commercial policies (tariffs, quotas, and so on), have
macroeconomic side effects. Such policies, however, are not used routinely for purposes of macroeconomic stabilization,
so we do not discuss them in this chapter. (A problem at the end of this chapter does ask you to think
about the macroeconomic effects of a tariff.)
8You can extend the results below to a setting with ongoing inflation by thinking of the exchange rate and price
level changes we describe as departures from time paths along which E and P trend upward at constant rates.
438 PART THREE Exchange Rates and Open-Economy Macroeconomics
Monetary Policy
The short-run effect of a temporary increase in the domestic money supply is shown in
Figure 17-10. An increased money supply shifts upward to but does not affect the
position of DD. The upward shift of the asset market equilibrium schedule moves the economy
from point 1, with exchange rate and output , to point 2, with exchange rate
and output . An increase in the money supply causes a depreciation of the domestic
currency, an expansion of output, and therefore an increase in employment.
We can understand the economic forces causing these results by recalling our earlier
discussions of asset market equilibrium and output determination. At the initial output
level and given the fixed price level, an increase in money supply must push down the
home interest rate, . We have been assuming that the monetary change is temporary and
does not affect the expected future exchange rate, , so to preserve interest parity in the
face of a decline in (given that the foreign interest rate, , does not change), the
exchange rate must depreciate immediately to create the expectation that the home currency
will appreciate in the future at a faster rate than was expected before fell. The
immediate depreciation of the domestic currency, however, makes home products cheaper
relative to foreign products. There is therefore an increase in aggregate demand, which
must be matched by an increase in output.
Fiscal Policy
As we saw earlier, expansionary fiscal policy can take the form of an increase in government
spending, a cut in taxes, or some combination of the two that raises aggregate demand.
A temporary fiscal expansion (which does not affect the expected future exchange rate)
therefore shifts the DD schedule to the right but does not move AA.
Figure 17-11 shows how expansionary fiscal policy affects the economy in the short
run. Initially the economy is at point 1, with an exchange rate and output . Suppose
the government decides to spend $15 billion to develop a new space shuttle. This one-time
increase in government purchases moves the economy to point 2, causing the currency to
appreciate to and output to expand to . The economy would respond in a similar way
to a temporary cut in taxes.
E2 Y2
E1 Y1
R
R R*
Ee
R
Y1
Y2
E1 Y1 E2
AA1 AA2
Exchange
rate, E
Output, Y
2
E2
Y2
DD
1
E1
Y1
AA2
AA1
Figure 17-10
Effects of a Temporary Increase in
the Money Supply
By shifting AA1 upward, a temporary
increase in the money supply
causes a currency depreciation
and a rise in output.
CHAPTER 17 Output and the Exchange Rate in the Short Run 439
What economic forces produce the movement from point 1 to point 2? The increase in
output caused by the increase in government spending raises the transactions demand for
real money holdings. Given the fixed price level, this increase in money demand pushes
the interest rate, , upward. Because the expected future exchange rate, , and the foreign
interest rate, , have not changed, the domestic currency must appreciate to create
the expectation of a subsequent depreciation just large enough to offset the higher international
interest rate difference in favor of domestic currency deposits.
Policies to Maintain Full Employment
The analysis of this section can be applied to the problem of maintaining full employment
in open economies. Because temporary monetary expansion and temporary fiscal
expansion both raise output and employment, they can be used to counteract the effects
of temporary disturbances that lead to recession. Similarly, disturbances that lead to
overemployment can be offset through contractionary macroeconomic policies.
Figure 17-12 illustrates this use of macroeconomic policy. Suppose the economy’s
initial equilibrium is at point 1, where output equals its full-employment level, denoted
. Suddenly there is a temporary shift in consumer tastes away from domestic products.
As we saw earlier in this chapter, such a shift is a decrease in aggregate demand
for domestic goods, and it causes the curve to shift leftward, to . At point 2,
the new short-run equilibrium, the currency has depreciated to and output, at , is
below its full-employment level: The economy is in a recession. Because the shift in
preferences is assumed to be temporary, it does not affect , so there is no change in
the position of .
To restore full employment, the government may use monetary or fiscal policy, or both.
A temporary fiscal expansion shifts back to its original position, restoring full employment
and returning the exchange rate to . A temporary money supply increase shifts the
asset market equilibrium curve to and places the economy at point 3, a move that
restores full employment but causes the home currency to depreciate even further.
Another possible cause of recession is a temporary increase in the demand for money,
illustrated in Figure 17-13. An increase in money demand pushes up the domestic interest
rate and appreciates the currency, thereby making domestic goods more expensive and
AA2
E1
DD2
AA1
Ee
E2 Y2
DD1 DD2
Yf
R*
R Ee
Exchange
rate, E
Output, Y
2
E1
Y 2
1
E2
Y1
DD2
DD1
AA
Figure 17-11
Effects of a Temporary Fiscal
Expansion
By shifting DD1 to the right, a
temporary fiscal expansion causes
a currency appreciation and a rise
in output.
440 PART THREE Exchange Rates and Open-Economy Macroeconomics
Y f
Exchange
rate, E
Output, Y
2
E2
E1 1
Y 2
AA1
E 3 3 DD1
DD2
AA2
Figure 17-12
Maintaining Full Employment
After a Temporary Fall in World
Demand for Domestic Products
A temporary fall in world demand
shifts DD1 to DD2, reducing output
from Yf to Y2 and causing the
currency to depreciate from E1 to
E2 (point 2). Temporary fiscal
expansion can restore full employment
(point 1) by shifting the DD
schedule back to its original
position. Temporary monetary
expansion can restore full employment
(point 3) by shifting AA1 to
AA2. The two policies differ in their
exchange rate effects: The fiscal
policy restores the currency to its
previous value (E1), whereas the
monetary policy causes the currency
to depreciate further to E3.
Y f
Exchange
rate, E
Output, Y
2
E2
E3 3
Y 2
AA2
E1 1 DD2
AA1
DD1
Figure 17-13
Policies to Maintain Full
Employment After a Money
Demand Increase
After a temporary money demand
increase (shown by the shift from
AA1 to AA2), either an increase in
the money supply or temporary
fiscal expansion can be used to
maintain full employment. The two
policies have different exchange
rate effects: The monetary policy
restores the exchange rate back to
E1, whereas the fiscal policy leads
to greater appreciation (E3).
causing output to contract. Figure 17-13 shows this asset market disturbance as the downward
shift of to , which moves the economy from its initial, full-employment
equilibrium at point 1 to point 2.
Expansionary macroeconomic policies can again restore full employment. A temporary
money supply increase shifts the AA curve back to AA1 and moves the economy back to its
AA1 AA2
CHAPTER 17 Output and the Exchange Rate in the Short Run 441
initial position at point 1. This temporary increase in money supply completely offsets the
increase in money demand by giving domestic residents the additional money they desire
to hold. Temporary fiscal expansion shifts to and restores full employment at
point 3. But the move to point 3 involves an even greater appreciation of the currency.
Now that we have seen how the economy’s short-run equilibrium is determined, we can
study how shifts in government macroeconomic policies affect output and the exchange
rate. Our interest in the effects of macroeconomic policies stems from their usefulness in
counteracting economic disturbances that cause fluctuations in output, employment, and
inflation. In this section we learn how government policies can be used to maintain full
employment in open economies.
We concentrate on two types of government policy, monetary policy, which works
through changes in the money supply, and fiscal policy, which works through changes in
government spending or taxes.7 To avoid the complications that would be introduced by
ongoing inflation, however, we do not look at situations in which the money supply grows
over time. Thus, the only type of monetary policies we will study explicitly are one-shot
increases or decreases in money supplies.8
In this section we examine temporary policy shifts, shifts that the public expects to be
reversed in the near future. The expected future exchange rate, , is now assumed to
equal the long-run exchange rate discussed in Chapter 16, that is, the exchange rate that
prevails once full employment is reached and domestic prices have adjusted fully to past
disturbances in the output and asset markets. In line with this interpretation, a temporary
policy change does not affect the long-run expected exchange rate, .
We assume throughout that events in the economy we are studying do not influence the
foreign interest rate, , or price level, , and that the domestic price level, , is fixed in
the short run.
R* P* P
Ee
Ee
E2 E3
E
7An example of the latter (as noted earlier) would be the tax cut enacted during the 2001–2005 administration
of President George W. Bush. Other policies, such as commercial policies (tariffs, quotas, and so on), have
macroeconomic side effects. Such policies, however, are not used routinely for purposes of macroeconomic stabilization,
so we do not discuss them in this chapter. (A problem at the end of this chapter does ask you to think
about the macroeconomic effects of a tariff.)
8You can extend the results below to a setting with ongoing inflation by thinking of the exchange rate and price
level changes we describe as departures from time paths along which E and P trend upward at constant rates.
438 PART THREE Exchange Rates and Open-Economy Macroeconomics
Monetary Policy
The short-run effect of a temporary increase in the domestic money supply is shown in
Figure 17-10. An increased money supply shifts upward to but does not affect the
position of DD. The upward shift of the asset market equilibrium schedule moves the economy
from point 1, with exchange rate and output , to point 2, with exchange rate
and output . An increase in the money supply causes a depreciation of the domestic
currency, an expansion of output, and therefore an increase in employment.
We can understand the economic forces causing these results by recalling our earlier
discussions of asset market equilibrium and output determination. At the initial output
level and given the fixed price level, an increase in money supply must push down the
home interest rate, . We have been assuming that the monetary change is temporary and
does not affect the expected future exchange rate, , so to preserve interest parity in the
face of a decline in (given that the foreign interest rate, , does not change), the
exchange rate must depreciate immediately to create the expectation that the home currency
will appreciate in the future at a faster rate than was expected before fell. The
immediate depreciation of the domestic currency, however, makes home products cheaper
relative to foreign products. There is therefore an increase in aggregate demand, which
must be matched by an increase in output.
Fiscal Policy
As we saw earlier, expansionary fiscal policy can take the form of an increase in government
spending, a cut in taxes, or some combination of the two that raises aggregate demand.
A temporary fiscal expansion (which does not affect the expected future exchange rate)
therefore shifts the DD schedule to the right but does not move AA.
Figure 17-11 shows how expansionary fiscal policy affects the economy in the short
run. Initially the economy is at point 1, with an exchange rate and output . Suppose
the government decides to spend $15 billion to develop a new space shuttle. This one-time
increase in government purchases moves the economy to point 2, causing the currency to
appreciate to and output to expand to . The economy would respond in a similar way
to a temporary cut in taxes.
E2 Y2
E1 Y1
R
R R*
Ee
R
Y1
Y2
E1 Y1 E2
AA1 AA2
Exchange
rate, E
Output, Y
2
E2
Y2
DD
1
E1
Y1
AA2
AA1
Figure 17-10
Effects of a Temporary Increase in
the Money Supply
By shifting AA1 upward, a temporary
increase in the money supply
causes a currency depreciation
and a rise in output.
CHAPTER 17 Output and the Exchange Rate in the Short Run 439
What economic forces produce the movement from point 1 to point 2? The increase in
output caused by the increase in government spending raises the transactions demand for
real money holdings. Given the fixed price level, this increase in money demand pushes
the interest rate, , upward. Because the expected future exchange rate, , and the foreign
interest rate, , have not changed, the domestic currency must appreciate to create
the expectation of a subsequent depreciation just large enough to offset the higher international
interest rate difference in favor of domestic currency deposits.
Policies to Maintain Full Employment
The analysis of this section can be applied to the problem of maintaining full employment
in open economies. Because temporary monetary expansion and temporary fiscal
expansion both raise output and employment, they can be used to counteract the effects
of temporary disturbances that lead to recession. Similarly, disturbances that lead to
overemployment can be offset through contractionary macroeconomic policies.
Figure 17-12 illustrates this use of macroeconomic policy. Suppose the economy’s
initial equilibrium is at point 1, where output equals its full-employment level, denoted
. Suddenly there is a temporary shift in consumer tastes away from domestic products.
As we saw earlier in this chapter, such a shift is a decrease in aggregate demand
for domestic goods, and it causes the curve to shift leftward, to . At point 2,
the new short-run equilibrium, the currency has depreciated to and output, at , is
below its full-employment level: The economy is in a recession. Because the shift in
preferences is assumed to be temporary, it does not affect , so there is no change in
the position of .
To restore full employment, the government may use monetary or fiscal policy, or both.
A temporary fiscal expansion shifts back to its original position, restoring full employment
and returning the exchange rate to . A temporary money supply increase shifts the
asset market equilibrium curve to and places the economy at point 3, a move that
restores full employment but causes the home currency to depreciate even further.
Another possible cause of recession is a temporary increase in the demand for money,
illustrated in Figure 17-13. An increase in money demand pushes up the domestic interest
rate and appreciates the currency, thereby making domestic goods more expensive and
AA2
E1
DD2
AA1
Ee
E2 Y2
DD1 DD2
Yf
R*
R Ee
Exchange
rate, E
Output, Y
2
E1
Y 2
1
E2
Y1
DD2
DD1
AA
Figure 17-11
Effects of a Temporary Fiscal
Expansion
By shifting DD1 to the right, a
temporary fiscal expansion causes
a currency appreciation and a rise
in output.
440 PART THREE Exchange Rates and Open-Economy Macroeconomics
Y f
Exchange
rate, E
Output, Y
2
E2
E1 1
Y 2
AA1
E 3 3 DD1
DD2
AA2
Figure 17-12
Maintaining Full Employment
After a Temporary Fall in World
Demand for Domestic Products
A temporary fall in world demand
shifts DD1 to DD2, reducing output
from Yf to Y2 and causing the
currency to depreciate from E1 to
E2 (point 2). Temporary fiscal
expansion can restore full employment
(point 1) by shifting the DD
schedule back to its original
position. Temporary monetary
expansion can restore full employment
(point 3) by shifting AA1 to
AA2. The two policies differ in their
exchange rate effects: The fiscal
policy restores the currency to its
previous value (E1), whereas the
monetary policy causes the currency
to depreciate further to E3.
Y f
Exchange
rate, E
Output, Y
2
E2
E3 3
Y 2
AA2
E1 1 DD2
AA1
DD1
Figure 17-13
Policies to Maintain Full
Employment After a Money
Demand Increase
After a temporary money demand
increase (shown by the shift from
AA1 to AA2), either an increase in
the money supply or temporary
fiscal expansion can be used to
maintain full employment. The two
policies have different exchange
rate effects: The monetary policy
restores the exchange rate back to
E1, whereas the fiscal policy leads
to greater appreciation (E3).
causing output to contract. Figure 17-13 shows this asset market disturbance as the downward
shift of to , which moves the economy from its initial, full-employment
equilibrium at point 1 to point 2.
Expansionary macroeconomic policies can again restore full employment. A temporary
money supply increase shifts the AA curve back to AA1 and moves the economy back to its
AA1 AA2
CHAPTER 17 Output and the Exchange Rate in the Short Run 441
initial position at point 1. This temporary increase in money supply completely offsets the
increase in money demand by giving domestic residents the additional money they desire
to hold. Temporary fiscal expansion shifts to and restores full employment at
point 3. But the move to point 3 involves an even greater appreciation of the currency.
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