An overview

To study interactions between national economies and between national economic policies, we have first to describe in some detail the structure of a single national economy, then to show how it responds to exogenous disturbances and changes in domestic policies.

This chapter is devoted to the first task. It presents an algebraic model of a small economy that serves as the cornerstone of this book. The remaining chapters of Part II are devoted to the second task. They show how the economy responds instantaneously to disturbances and policy changes, how it adapts dynamically, and how the disturbances and policy changes affect it permanently. They also show how the economy's behavior is affected by the exchange-rate regime, by substitutability between traded and nontraded goods, and by substitutability between domestic and foreign assets. Throughout, we emphasize the roles of asset markets in the determination of a flexible exchange rate and in the determination of the balance of payments when the exchange rate is pegged.

In Part III, we relax some of the assumptions adopted in this chapter to simplify the presentation and solution of the model. We examine alternative specifications of the demand for money and of fiscal policies and the influence of expectations on the behavior of a flexible exchange rate. Finally, in Parts IV and V, the same small-country model is used as an ingredient of a larger model–the one we employ to analyze policy interdependence and economic unions.