The Goods Market and Financial Markets in an Open Economy

• Goods Market Equilibrium:
  Output is determined by the demand for domestic goods, which includes consumption, investment, government spending, and net exports (exports minus imports).
• Interest Rates and Exchange Rates:
  The interest rate influences both investment and net exports. A higher domestic interest rate reduces investment and causes the currency to appreciate, making exports less competitive. Conversely, a lower interest rate encourages investment, leading to a depreciation, which boosts exports.

Interest Parity and Exchange Rate Determination

In an open economy, investors seek the highest return, whether from domestic or foreign bonds. The interest parity condition states that the returns on domestic and foreign bonds must be equal when adjusted for exchange rates. This means:

• A rise in the domestic interest rate leads to currency appreciation, as investors prefer domestic assets.
• A rise in the foreign interest rate leads to currency depreciation, as investors shift toward foreign assets.

Impact of Monetary and Fiscal Policies

1. Monetary Policy:
   When the central bank raises interest rates, two effects occur:

• Domestic Demand falls, as borrowing becomes more expensive.
• Exchange Rate Appreciation reduces exports, decreasing net demand for domestic goods. In an open economy, both effects work together, resulting in a significant reduction in output.

1. Fiscal Policy:
   An increase in government spending raises output, boosting consumption and investment. However, higher output increases imports, worsening the trade balance. If the central bank raises interest rates to prevent inflation, the currency appreciates, further reducing exports.

Fixed vs. Flexible Exchange Rates

1. Flexible Exchange Rates:
   The exchange rate adjusts freely based on market conditions. An increase in interest rates leads to currency appreciation, reducing net exports and output.
2. Fixed Exchange Rates:
   The central bank maintains a constant exchange rate by aligning domestic interest rates with foreign rates. In this regime, the central bank loses control over independent monetary policy, limiting its ability to respond to domestic economic conditions.

Conclusion

In an open economy, the interaction between interest rates and exchange rates shapes both domestic output and trade balances. Policymakers must carefully balance fiscal and monetary tools, considering the impact on exchange rates and international competitiveness. Under fixed exchange rate regimes, the trade-offs become more pronounced, as monetary policy is constrained by the need to maintain currency stability.