Note: We have assumed a flexible exchange rate. Suppose we had a fixed exchange rate and an increase in MS.

Everything would be the same as before until we get to the foreign exchange rate. If the bank wants to keep e=e, it must BUY the excess supply of Canadian dollars which implies decrease in MS. This would be contrary to the expansionary monetary police (increase in MS) we started with. The bank of Canada cannot simultaneously choose the size of the money and the value of Canadian dollar. Summary: Monetary Policy Closed economy: works Open economy Flexible exchange rate: works Fixed exchange rate: does not work Review of Monetary Policy In Open Economy and Flexible Exchange rate, An increase in MS- shifts right An decrease in IR means an increase in I which means an increase in AD which means an increase in Y. An increase in Y > an increase in M^demand When r < r^w > sells CAD > an increase in S of CAD > decrease e. A decrease in e > an increase in NX > an increase in AD > an increase in Y. An increase in Y > an increase in M demand until r = r^w. With a fixed exchange rate An increase in MS > shift to the right. A decrease in IR > an increase in I > an increase in AD > an increase in Y. An increase in Y > increase in M demand. When r < r^w > sell CAD > increase in S cad > downward pressure on e, but e= e. Bank of Canada must BUY the excess supply of CAD to prevent the depreciation of exchange rate. Doing so, an increase in MS. Started with an increase in MS.

Closed economy multiplier or simple multiplier o Multiplier = 1/ (1- MPC) o Marginal propensity to consume (MPC) the change in consumption that is due to a given change in income. o MPC= change in consumption/ change in income. o Example: If income increases by $100 and consumption increases by $60, this implies MPC=change in C/ change in Y = 60/100=0.6 o Then, the multiplier is: Multiplier= 1/ (1-MPC) = 1/ (1-0.6)= 2.5 Therefore, if an increase in G implies an increase in Y will be: Change in Y= Change in G times multiplier. = $5 x 2.5 = $12.5 billion o Open Economy multiplier Multiplier = 1/ (1- MPC + MPI) o Marginal propensity to Import (MPI)- the change in imports that is due to a given change in income. MPI = change in imports/ change in income. o Example: If income increases by $100, consumption increases by $60, and imports increase by $20, this implies MPI=change in IM/ change in Y= 20/100= 0.2 Then the multiplier is Multiplier = 1/ (1-MPC+MPI) =1/(1-0.6+0.2) ~1.7 o Therefore, if an increase in G by $5 billion implies an increase in Y will be: o Change in Y= Change in B x multiplier = $ 5 billion x 1.7 = $8.5 billion o Crowding-out Effect: at the same time that the multiplier effect is causing output to increase, the crowding-out effect is limiting expansion. The effects of FISCAL POLICY in a CLOSED ECONOMY. o Multiplier effect o Crowding effect o Result: The decrease in investment spending would offset the expansionary effects of the fiscal policy. When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding out effect is larger. Small open economy assumption:

o Small open economy assumption of perfect capital mobility implies r=r^w Or the domestic interest rate = world intert rate.