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T his chapter examines within a theoretical framework some of the constraints that the openness of the economy impose upon policy making.1 The open economy is linked to the rest of the world primarily through three key linkages: through international trade in goods and services, through international mobility of capital, and through international exchanges of national monies. Macroeconomic policies for open economies differ, in fundamentally important ways, from the corresponding policies for closed economies. The openness of the economy imposes constraints on the effectiveness and proper conduct of macroeconomic policies but it also provides policymakers with information that may be usefully exploited in the design of policy. In order to set the stage for the analysis and in order to illustrate how the degree of integration in world capital markets impacts on the proper policy mix, my next section analyzes the famous “policy assignment problem.” The main message of this analysis—which is carried out within the analytical framework of the Mundell-Fleming model of the 1 960s vintage — is that from some points of view an increased degree of capital market integration may simplify rather than complicate the solution to the policy assignment problem. On the other hand the analysis also demonstrates the severe constraint that a pegged exchange rate system imposes on the conduct of monetary policy. This constraint is illustrated further under Aspects of the Monetary Approach to the Balance of Payments. That framework also serves to illustrate the more fundamental restrictions on the conduct of fiscal and monetary policy—restrictions that stem from the interdependence among the various policy instruments.

International Interdependence and the Constraints on Macroeconomic Policies