Page 482 - Krugmans Economics for AP Text Book_Neat

rate—increases exports and reduces imports, thereby increasing aggregate demand. A
depreciation that results from an interest rate cut has the same effect: it increases ex-
ports and reduces imports, increasing aggregate demand.
In other words, monetary policy under floating rates has effects beyond those we’ve
described in looking at closed economies. In a closed economy, a reduction in the in-
terest rate leads to a rise in aggregate demand because it leads to more investment
spending and consumer spending. In an open economy with a floating exchange rate,
the interest rate reduction leads to increased investment spending and consumer
spending, but it also increases aggregate demand in another way: it leads to a currency
depreciation, which increases exports and reduces imports, further increasing aggre-
gate demand.

International Business Cycles
Up to this point, we have discussed macroeconomics, even in an open economy, as if all
demand changes or shocks originated from the domestic economy. In reality, however,
economies sometimes face shocks coming from abroad. For example, recessions in the
United States have historically led to recessions in Mexico.
The key point is that changes in aggregate demand affect the demand for goods and
services produced abroad as well as at home: other things equal, a recession leads to a
fall in imports and an expansion leads to a rise in imports. And one country’s imports
are another country’s exports. This link between aggregate demand in different na-
tional economies is one reason business cycles in different countries sometimes—but
not always—seem to be synchronized. The prime example is the Great Depression,
which affected countries around the world.
The extent of this link depends, however, on the exchange rate regime. To see why,
think about what happens if a recession abroad reduces the demand for Genovia’s ex-
ports. A reduction in foreign demand for Genovian goods and services is also a reduc-
tion in demand for genos on the foreign exchange market. If Genovia has a fixed
exchange rate, it responds to this decline with exchange market intervention. But if
Genovia has a floating exchange rate, the geno depreciates. Because
Genovian goods and services become cheaper to foreigners when
the demand for exports falls, the quantity of goods and services ex-
ported doesn’t fall by as much as it would under a fixed rate. At the
same time, the fall in the geno makes imports more expensive to
Genovians, leading to a fall in imports. Both effects limit the de-
cline in Genovia’s aggregate demand compared to what it would
have been under a fixed exchange rate regime.
One of the virtues of floating exchange rates, according to their
advocates, is that they help insulate countries from recessions
originating abroad. This theory looked pretty good in the early
2000s: Britain, with a floating exchange rate, managed to stay out
HADJ/SIPA of a recession that affected the rest of Europe, and Canada, which
also has a floating rate, suffered a less severe recession than the
For better or worse, trading partners United States.
tend to import each other’s business cy- In 2008, however, a financial crisis that began in the United States seemed to be pro-
cles in addition to each other’s goods.
ducing a recession in virtually every country. In this case, it appears that the interna-
tional linkages between financial markets were much stronger than any insulation
from overseas disturbances provided by floating exchange rates.

440 section 8 The Open Economy: Inter national Trade and Finance