Aggregate Demand with Fixed Exchange Rate

This chapter begins by explaining the impact of aggregate demand in an open economy, via fixed and flexible exchange rates. In a fixed or pegged exchange rate, the central bank doesn’t allow the value of the national currency to deviate relative to foreign currencies, and will intervene in foreign markets to stabilize price. Professor Sachs explains aggregate demand through fiscal expansion or government spending, and then talks about how currencies operate when they are pegged using the IS-LM model. Monetary policy is highly effective under the floating exchange rate system, and fiscal policy is effective under a fixed exchange rate. Sachs talks about how a currency interacts with other currencies in the international market. In all of these examples, there is an assumption that there is a high degree of capital mobility between the home financial system and the international markets, but there can be capital controls.

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