INTRODUCTION

The purpose of this chapter is to extend the open-economy version of the IS-LM-AS model beyond its long-run characteristics to situations in which shocks occur, expectations are frustrated, and unemployment exists and to find the appropriate monetary mechanism in this environment. The transition here is very similar to the one between Chapter 2, which presented the structure of the model, and Chapters 3 and 4, which put that model into a policy context, and then Chapter 7, which investigated the optimal monetary mechanism for closed economies. To make that same transition for open economies, stochastic variables must be introduced, the choice of monetary policy instruments must be specified, and then the optimal monetary mechanism can be chosen. The choice will again depend on the types of shocks to which the economy is subjected, and therefore there is no universally optimal mechanism; it all depends on the circumstances. For that reason, most countries have chosen to operate with managed exchange rates instead of either fixed rates or flexible rates. At some times the monetary authorities allow the exchange rate to adjust to market forces, and at other times they resist market pressures strenuously. To understand this system of managed exchange rates we need to analyze the various shocks to which the economy is susceptible and their effect on the economy under alternative monetary mechanisms.