If I follow the IS-LM model (or some derivative of it), a small open economy can really only use monetary policy to change GDP in the short term.

According to the model (or one of its spin-offs), if the government wants to temporarily boost GDP, it can expand the money supply. Since the interest rate doesn't change, thru the regular series of knock on effects, the exchange rate goes down and net exports go up.

From the same model, the government can't use government spending because the economy is too small to impact the real interest rate, and the end result is that the import/export sector absorb the changes, increasing the exchange rate, and lowering net exports, offsetting the increase in government spending.

So, if a country exported primarily inferior goods, according to the model, that country may have to decreasing the money supply, increasing the exchange rate, making its goods more expensive to foreign buyers, making them 'more poor' via the income effect, and given the substitution effect and this country's goods' inferiority, cause foreign consumption of their goods to increase, which is of course, an increase in net exports.

I'm aware this model's generalizations are extreme, but it still provokes me to ask the following questions:

  1. Does this make sense?
  2. Are there any countries that have to incorporate this kind of reasoning?

That is all.


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.