6.5 Open economy $AD$ and policy

Achievable AP Macroeconomics

6. Open economy

Our AP Macroeconomics course is currently in development and is a work-in-progress.

Open economy $AD$ and policy

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An open economy adds some extra details to the $A D$ - $A S$ model and the long-run effects of fiscal and monetary policy. Here there is no distinction between a small and large open economy, something that does appear at the college level. At the AP level, you are only responsible for understanding generally what is different for an open economy compared to a closed economy.

Let’s begin with what is added to the $A D$ curve.

Open economy $A D$

When we first presented the $A D$ curve, it was mentioned that it can be thought of as a GDP equation. We only lightly discussed the $N X$ portion, with increases and decreases due to tastes and preferences. With exchange rates outlined, we can explain what is happening behind the scenes.

When we first presented the $A D$ curve we gave three reasons why it is downward sloping. To summarize the first two,

Wealth effect
- As the price level falls, real income rises. Loosely speaking, “people feel richer, so they buy more.”
Interest rate effect
- When the price level falls, interest rates drop. This leads to higher investment and consumer spending.

With exchange rates outlined, we can now explain the third reason in full.

Exchange rate effect
- As the domestic price level falls, interest rates fall and the exchange rate falls (depreciation).

As a consequence exports are relatively cheaper so $X$ increases. Imports also are relatively more expensive, so $M$ decreases. Thus $N X$ increases and so does real GDP.

This also makes the stories behind $N X$ shifts more clear.

Factor Increasing	Change in E	Impact	New open economy $A D$ shift
Foreign income	$E ↑$	$X ↑$	$A D \to$
Foreign tastes and preferences	$E ↑$	$X ↑$	$A D \to$
Domestic tastes and preferences	$E ↑$	$M ↓$	$A D \to$
Domestic income	$E ↓$	$M ↑$	$A D \leftarrow$
Exchange rate (non-PL)	$E ↑$	$N X ↓$	$A D \leftarrow$

What happens in each of the first three cases is that the exchange rate change partially cancels out the direct effect. For example an increase in foreign income or foreign tastes and preferences first increases exports. This increases demand for dollars and lowers the supply of dollars, leading to an appreciation of the dollar. Because of this, imports rise and exports fall. The first change is usually taken to be larger, so $A D$ still shifts right just by less than the initial shift.

When domestic income increases, there is an extra change in an open economy. Higher income leads to higher consumption and part of that includes imports, so imports rise and consumption rises by less than in the closed economy case. In total, this means that while $A D$ still increases overall, it is to the left of the full increase seen in a closed economy.

Our final shifter is non-PL changes in exchange rates. Examples of this include changes in the risk of investing or any change in the demand or supply for investment or goods and services from a specific country. In that case, the exchange rate change is the direct change.

A negative event or an increase in risk would lead to a depreciation, which would lower imports and raise exports. Thus $N X$ rises, there is a gross capital outflow, and the $A D$ curve shifts right.

A positive event or a decrease in risk would lead to an appreciation, lowering exports and increasing imports. Thus $N X$ falls, there is a gross capital inflow, and the $A D$ curve shifts left.

Fiscal policy

Because capital flows impact the loanable funds market, crowding out is experienced differently in an open economy. As the government deficit increases, this shifts the supply of loanable funds to the left. In a closed economy, this would increase the domestic interest rate.

In an open economy, the world interest rate is what “controls” the loanable funds market. An increased government budget deficit still shifts the supply of loanable funds to the left. But now this increases capital inflows instead of the interest rate. Correspondingly, net exports fall as well.

If an economy is running a trade deficit and the government borrows more, all else equal that makes the trade deficit larger.

Why does this happen?

(spoiler)

Answer: Because the domestic currency has appreciated.

This may be described as an international crowding out effect, which makes fiscal policy less effective in an open economy than it is in a closed economy.

Monetary policy

The standard open economy story has free capital flows, central bank control over domestic interest rates and a floating exchange rate. We will consider the fixed exchange rate case at the end of this section.

If the Fed pursues expansionary monetary policy, the domestic interest rate is lowered, which makes US assets less desirable. This leads to capital outflows and a depreciation of the dollar. Net exports rise, and $A D$ increases more than in a closed economy.

So smaller changes in interest rates can achieve the same change in $Y$ in an open economy compared to a closed economy.

Fixed exchange rate fiscal and monetary policy

One final brief consideration is what occurs if a country does not have a floating exchange rate. Consider Denmark, which has a fixed exchange rate with respect to the Euro.

With free capital flows, changing the interest rate puts pressure on the exchange rate. So if they hope to maintain a fixed exchange rate, the Danish central bank, the Danmarks Nationalbank cannot use monetary policy. And if the European Central Bank changes their interest rate, the Danish response must be to match the change.

For monetary policy to be used with a fixed exchange rate, there need to be capital controls. For many years China had a fixed exchange rate versus the dollar and use of capital controls was how they were still able to use monetary policy as a stimulus for their domestic economy. That allows the Chinese interest rate to be different from the world interest rate. Capital wants to flow across borders to seek higher returns, but it is legally prevented from doing so.

Fiscal policy is also different with a fixed exchange rate. New government borrowing puts upward pressure on interest rates and with capital flows that would lead to an increase in demand in the foreign exchange market and a currency appreciation. A central bank aiming to maintain a fixed exchange rate needs to prevent this.

They have a few options to achieve this. They may add supply to the foreign exchange market. This may seem desirable, but can only be done if the central bank has enough foreign reserves or they are willing to print money to intervene in the currency market.

They may cut interest rates, which lowers demand to counteract the increase due to fiscal policy. Finally, they may attempt to use capital controls to prevent the increase in demand.

Trade barriers

A final international element is trade barriers. These are government policies designed to restrict, limit or eliminate certain types of trade. We have already discussed capital controls, limits on transfers of savings and investments. What remains are policies that affect trade in goods and services.

Definitions

Import quota: A government policy that creates a maximum amount that can be imported of a specific good or service
Tariff: A tax on either imports or exports. Primarily used to refer to import taxes in common usage.

Any policy that restricts or lowers demand for imports, leads to substitution to domestic goods. $N X$ rises and this initially leads to a rightward shift in $A D$ .

All of this assumes that no country retaliates with tariffs or trade restrictions of their own. If they do this makes $X$ fall and lowers $N X$ . It is possible the shift from this is large enough to make $A D$ below the initial level even in the short run.

In the long run, our tariffs lead to less efficient domestic production in the market and foreign tariffs would eliminate some firms in export sectors. Overall this lowers competition and increases costs of production, shifting $L R A S$ and $S R A S$ to the left. So the long run effect is stagflation and it should be worse if other countries respond.

Tariffs do raise government revenue. But they act as targeted sales taxes and thus are usually limited in revenue generation compared to income taxes.

Thus a country would only want to use these tools if there are benefits outside of our $A D$ - $A S$ model.

Examples of these include:

Infant industry protection (allowing development of new companies or new technology)
National security reasons (domestic production is more important than lowest cost production)
Retaliation against other countries (response to policy against you)
Addressing negative externalities (to combat pollution or child labor)

For an economist a legitimate use of tariffs should have

A specific problem to address
A time limit
Additional policies (such as domestic investment incentives or retraining of workers in non-competitive firms)

Protectionism in general, policies that favor domestic industries as a whole, is a net negative economically.

Open economy summary

Below is a table that summarizes closed and open policy cases and their anticipated impacts on the $A D$ - $A S$ model.

Policy	Economy type	Change in $P$	Change in $Y$
Monetary policy	Closed economy	$↑$	$↑$
	Open economy	larger $↑$	larger $↑$
Fiscal policy	Closed economy	$↑$	$↑$
	Open economy	smaller $↑$	smaller $↑$
Trade restrictions (no retaliation)	Open economy (SR)	$↑$	$↑$
Trade restrictions (retaliation)	Open economy (SR)	small $↑$ or $↓$	small $↑$ or $↓$
Trade restrictions (no retaliation )	Open economy (LR)	$↑$	$↓$
Trade restrictions (retaliation )	Open economy (LR)	large $↑$	large $↓$

Capital flows act as a headwind for fiscal policy, but they act as a tailwind for monetary policy. Trade restrictions in a vacuum may cause a short run economic boost. If other countries response, that boost is either smaller or may be cancelled out entirely to cause a recession. In the long run trade restrictions show up in the $A D$ - $A S$ model as stagflation, with larger leftward shifts if there is retaliation.

Open economy AD and the exchange rate effect

Exchange rate effect completes the downward-sloping $A D$ story: $P ↓$ → interest rates $↓$ → exchange rate depreciates → exports cheaper, imports pricier → $N X ↑$ → $Y ↑$
Other shifters partially offset via exchange rate feedback:
- Foreign income/tastes $↑$ → $X ↑$ → appreciation → dampens but still $A D$ shifts right
- Domestic tastes $↑$ for foreign goods → $M ↑$ → depreciation → dampens but $A D$ still shifts left
- Domestic income $↑$ → $M ↑$ → depreciation → $A D$ rises less than in closed economy
Non-PL exchange rate changes (risk, investment demand shifts) directly drive $N X$ and $A D$ :
- Depreciation (negative event/risk) → $N X ↑$ , capital outflow, $A D$ shifts right
- Appreciation (positive event/lower risk) → $N X ↓$ , capital inflow, $A D$ shifts left

Fiscal policy in an open economy

Government deficit shifts loanable funds supply left; world interest rate (not domestic) governs the market
Result: capital inflows rise instead of interest rate rising sharply; dollar appreciates, $N X$ falls
Called international crowding out — makes fiscal policy less effective (smaller $A D$ shift) than in closed economy
Worsens existing trade deficits when government borrows more

Monetary policy in an open economy

Expansionary policy lowers domestic interest rate → capital outflows → dollar depreciates → $N X$ rises
This adds to the usual domestic effect, making $A D$ increase more than in a closed economy
Smaller interest rate changes needed to achieve same $Y$ change vs. closed economy

Fixed exchange rate policy constraints

With free capital flows + fixed exchange rate, central bank loses independent monetary policy (must match anchor country’s rate, e.g., Denmark/Euro)
Capital controls allow independent monetary policy despite fixed rate (e.g., China’s past peg to USD)
Fiscal policy under fixed rates: deficit spending raises rates → currency appreciation pressure; central bank must counteract via:
- Supplying more currency (needs reserves or money printing)
- Cutting interest rates
- Imposing capital controls

Trade barriers

Import quota: caps quantity of imports allowed
Tariff: tax on imports (or exports)
Short run (no retaliation): restricting imports boosts $N X$ → $A D$ shifts right
With retaliation: foreign tariffs lower $X$ , can offset or reverse the initial $A D$ gain
Long run: reduced efficiency/competition shifts $S R A S$ and $L R A S$ left → stagflation (worse with retaliation)
Tariffs raise revenue like targeted sales taxes (limited compared to income tax)
Legitimate economic justifications: infant industry protection, national security, retaliation, correcting externalities
Proper tariff use requires: specific problem, time limit, supplementary policies (e.g., retraining, investment incentives)
General protectionism (favoring domestic industry broadly) is a net economic negative

Summary comparison (closed vs. open economy policy effects)

Monetary policy: larger $P ↑$ and $Y ↑$ in open economy (tailwind from capital flows)
Fiscal policy: smaller $P ↑$ and $Y ↑$ in open economy (headwind from international crowding out)
Trade restrictions: short-run boost to $P$ and $Y$ (less/reversed with retaliation); long-run stagflation ( $P ↑$ , $Y ↓$ ), intensified by retaliation

Practice exams

Open economy $AD$ and policy

Let’s begin with what is added to the $A D$ curve.

Open economy $A D$

When we first presented the $A D$ curve we gave three reasons why it is downward sloping. To summarize the first two,

Wealth effect
- As the price level falls, real income rises. Loosely speaking, “people feel richer, so they buy more.”
Interest rate effect
- When the price level falls, interest rates drop. This leads to higher investment and consumer spending.

With exchange rates outlined, we can now explain the third reason in full.

Exchange rate effect
- As the domestic price level falls, interest rates fall and the exchange rate falls (depreciation).

As a consequence exports are relatively cheaper so $X$ increases. Imports also are relatively more expensive, so $M$ decreases. Thus $N X$ increases and so does real GDP.

This also makes the stories behind $N X$ shifts more clear.

Factor Increasing	Change in E	Impact	New open economy $A D$ shift
Foreign income	$E ↑$	$X ↑$	$A D \to$
Foreign tastes and preferences	$E ↑$	$X ↑$	$A D \to$
Domestic tastes and preferences	$E ↑$	$M ↓$	$A D \to$
Domestic income	$E ↓$	$M ↑$	$A D \leftarrow$
Exchange rate (non-PL)	$E ↑$	$N X ↓$	$A D \leftarrow$

A positive event or a decrease in risk would lead to an appreciation, lowering exports and increasing imports. Thus $N X$ falls, there is a gross capital inflow, and the $A D$ curve shifts left.

Fiscal policy

If an economy is running a trade deficit and the government borrows more, all else equal that makes the trade deficit larger.

Why does this happen?

(spoiler)

Answer: Because the domestic currency has appreciated.

This may be described as an international crowding out effect, which makes fiscal policy less effective in an open economy than it is in a closed economy.

Monetary policy

So smaller changes in interest rates can achieve the same change in $Y$ in an open economy compared to a closed economy.

Fixed exchange rate fiscal and monetary policy

One final brief consideration is what occurs if a country does not have a floating exchange rate. Consider Denmark, which has a fixed exchange rate with respect to the Euro.

They may cut interest rates, which lowers demand to counteract the increase due to fiscal policy. Finally, they may attempt to use capital controls to prevent the increase in demand.

Trade barriers

Definitions

Import quota: A government policy that creates a maximum amount that can be imported of a specific good or service
Tariff: A tax on either imports or exports. Primarily used to refer to import taxes in common usage.

Any policy that restricts or lowers demand for imports, leads to substitution to domestic goods. $N X$ rises and this initially leads to a rightward shift in $A D$ .

Tariffs do raise government revenue. But they act as targeted sales taxes and thus are usually limited in revenue generation compared to income taxes.

Thus a country would only want to use these tools if there are benefits outside of our $A D$ - $A S$ model.

Examples of these include:

Infant industry protection (allowing development of new companies or new technology)
National security reasons (domestic production is more important than lowest cost production)
Retaliation against other countries (response to policy against you)
Addressing negative externalities (to combat pollution or child labor)

For an economist a legitimate use of tariffs should have

A specific problem to address
A time limit
Additional policies (such as domestic investment incentives or retraining of workers in non-competitive firms)

Protectionism in general, policies that favor domestic industries as a whole, is a net negative economically.

Open economy summary

Below is a table that summarizes closed and open policy cases and their anticipated impacts on the $A D$ - $A S$ model.

Policy	Economy type	Change in $P$	Change in $Y$
Monetary policy	Closed economy	$↑$	$↑$
	Open economy	larger $↑$	larger $↑$
Fiscal policy	Closed economy	$↑$	$↑$
	Open economy	smaller $↑$	smaller $↑$
Trade restrictions (no retaliation)	Open economy (SR)	$↑$	$↑$
Trade restrictions (retaliation)	Open economy (SR)	small $↑$ or $↓$	small $↑$ or $↓$
Trade restrictions (no retaliation )	Open economy (LR)	$↑$	$↓$
Trade restrictions (retaliation )	Open economy (LR)	large $↑$	large $↓$

Achievable AP Macroeconomics

6. Open economy

Our AP Macroeconomics course is currently in development and is a work-in-progress.

Open economy $AD$ and policy

9 min read

Font

Discuss

Feedback

Let’s begin with what is added to the $A D$ curve.

Open economy $A D$

When we first presented the $A D$ curve we gave three reasons why it is downward sloping. To summarize the first two,

Wealth effect
- As the price level falls, real income rises. Loosely speaking, “people feel richer, so they buy more.”
Interest rate effect
- When the price level falls, interest rates drop. This leads to higher investment and consumer spending.

With exchange rates outlined, we can now explain the third reason in full.

Exchange rate effect
- As the domestic price level falls, interest rates fall and the exchange rate falls (depreciation).

As a consequence exports are relatively cheaper so $X$ increases. Imports also are relatively more expensive, so $M$ decreases. Thus $N X$ increases and so does real GDP.

This also makes the stories behind $N X$ shifts more clear.

Factor Increasing	Change in E	Impact	New open economy $A D$ shift
Foreign income	$E ↑$	$X ↑$	$A D \to$
Foreign tastes and preferences	$E ↑$	$X ↑$	$A D \to$
Domestic tastes and preferences	$E ↑$	$M ↓$	$A D \to$
Domestic income	$E ↓$	$M ↑$	$A D \leftarrow$
Exchange rate (non-PL)	$E ↑$	$N X ↓$	$A D \leftarrow$

A positive event or a decrease in risk would lead to an appreciation, lowering exports and increasing imports. Thus $N X$ falls, there is a gross capital inflow, and the $A D$ curve shifts left.

Fiscal policy

If an economy is running a trade deficit and the government borrows more, all else equal that makes the trade deficit larger.

Why does this happen?

(spoiler)

Answer: Because the domestic currency has appreciated.

This may be described as an international crowding out effect, which makes fiscal policy less effective in an open economy than it is in a closed economy.

Monetary policy

So smaller changes in interest rates can achieve the same change in $Y$ in an open economy compared to a closed economy.

Fixed exchange rate fiscal and monetary policy

One final brief consideration is what occurs if a country does not have a floating exchange rate. Consider Denmark, which has a fixed exchange rate with respect to the Euro.

They may cut interest rates, which lowers demand to counteract the increase due to fiscal policy. Finally, they may attempt to use capital controls to prevent the increase in demand.

Trade barriers

Definitions

Import quota: A government policy that creates a maximum amount that can be imported of a specific good or service
Tariff: A tax on either imports or exports. Primarily used to refer to import taxes in common usage.

Any policy that restricts or lowers demand for imports, leads to substitution to domestic goods. $N X$ rises and this initially leads to a rightward shift in $A D$ .

Tariffs do raise government revenue. But they act as targeted sales taxes and thus are usually limited in revenue generation compared to income taxes.

Thus a country would only want to use these tools if there are benefits outside of our $A D$ - $A S$ model.

Examples of these include:

Infant industry protection (allowing development of new companies or new technology)
National security reasons (domestic production is more important than lowest cost production)
Retaliation against other countries (response to policy against you)
Addressing negative externalities (to combat pollution or child labor)

For an economist a legitimate use of tariffs should have

A specific problem to address
A time limit
Additional policies (such as domestic investment incentives or retraining of workers in non-competitive firms)

Protectionism in general, policies that favor domestic industries as a whole, is a net negative economically.

Open economy summary

Below is a table that summarizes closed and open policy cases and their anticipated impacts on the $A D$ - $A S$ model.

Policy	Economy type	Change in $P$	Change in $Y$
Monetary policy	Closed economy	$↑$	$↑$
	Open economy	larger $↑$	larger $↑$
Fiscal policy	Closed economy	$↑$	$↑$
	Open economy	smaller $↑$	smaller $↑$
Trade restrictions (no retaliation)	Open economy (SR)	$↑$	$↑$
Trade restrictions (retaliation)	Open economy (SR)	small $↑$ or $↓$	small $↑$ or $↓$
Trade restrictions (no retaliation )	Open economy (LR)	$↑$	$↓$
Trade restrictions (retaliation )	Open economy (LR)	large $↑$	large $↓$

Open economy AD and the exchange rate effect

Exchange rate effect completes the downward-sloping $A D$ story: $P ↓$ → interest rates $↓$ → exchange rate depreciates → exports cheaper, imports pricier → $N X ↑$ → $Y ↑$
Other shifters partially offset via exchange rate feedback:
- Foreign income/tastes $↑$ → $X ↑$ → appreciation → dampens but still $A D$ shifts right
- Domestic tastes $↑$ for foreign goods → $M ↑$ → depreciation → dampens but $A D$ still shifts left
- Domestic income $↑$ → $M ↑$ → depreciation → $A D$ rises less than in closed economy
Non-PL exchange rate changes (risk, investment demand shifts) directly drive $N X$ and $A D$ :
- Depreciation (negative event/risk) → $N X ↑$ , capital outflow, $A D$ shifts right
- Appreciation (positive event/lower risk) → $N X ↓$ , capital inflow, $A D$ shifts left

Fiscal policy in an open economy

Government deficit shifts loanable funds supply left; world interest rate (not domestic) governs the market
Result: capital inflows rise instead of interest rate rising sharply; dollar appreciates, $N X$ falls
Called international crowding out — makes fiscal policy less effective (smaller $A D$ shift) than in closed economy
Worsens existing trade deficits when government borrows more

Monetary policy in an open economy

Expansionary policy lowers domestic interest rate → capital outflows → dollar depreciates → $N X$ rises
This adds to the usual domestic effect, making $A D$ increase more than in a closed economy
Smaller interest rate changes needed to achieve same $Y$ change vs. closed economy

Fixed exchange rate policy constraints

With free capital flows + fixed exchange rate, central bank loses independent monetary policy (must match anchor country’s rate, e.g., Denmark/Euro)
Capital controls allow independent monetary policy despite fixed rate (e.g., China’s past peg to USD)
Fiscal policy under fixed rates: deficit spending raises rates → currency appreciation pressure; central bank must counteract via:
- Supplying more currency (needs reserves or money printing)
- Cutting interest rates
- Imposing capital controls

Trade barriers

Import quota: caps quantity of imports allowed
Tariff: tax on imports (or exports)
Short run (no retaliation): restricting imports boosts $N X$ → $A D$ shifts right
With retaliation: foreign tariffs lower $X$ , can offset or reverse the initial $A D$ gain
Long run: reduced efficiency/competition shifts $S R A S$ and $L R A S$ left → stagflation (worse with retaliation)
Tariffs raise revenue like targeted sales taxes (limited compared to income tax)
Legitimate economic justifications: infant industry protection, national security, retaliation, correcting externalities
Proper tariff use requires: specific problem, time limit, supplementary policies (e.g., retraining, investment incentives)
General protectionism (favoring domestic industry broadly) is a net economic negative

Summary comparison (closed vs. open economy policy effects)

Monetary policy: larger $P ↑$ and $Y ↑$ in open economy (tailwind from capital flows)
Fiscal policy: smaller $P ↑$ and $Y ↑$ in open economy (headwind from international crowding out)
Trade restrictions: short-run boost to $P$ and $Y$ (less/reversed with retaliation); long-run stagflation ( $P ↑$ , $Y ↓$ ), intensified by retaliation

Practice exams

Open economy $AD$ and policy

Let’s begin with what is added to the $A D$ curve.

Open economy $A D$

When we first presented the $A D$ curve we gave three reasons why it is downward sloping. To summarize the first two,

Wealth effect
- As the price level falls, real income rises. Loosely speaking, “people feel richer, so they buy more.”
Interest rate effect
- When the price level falls, interest rates drop. This leads to higher investment and consumer spending.

With exchange rates outlined, we can now explain the third reason in full.

Exchange rate effect
- As the domestic price level falls, interest rates fall and the exchange rate falls (depreciation).

As a consequence exports are relatively cheaper so $X$ increases. Imports also are relatively more expensive, so $M$ decreases. Thus $N X$ increases and so does real GDP.

This also makes the stories behind $N X$ shifts more clear.

Factor Increasing	Change in E	Impact	New open economy $A D$ shift
Foreign income	$E ↑$	$X ↑$	$A D \to$
Foreign tastes and preferences	$E ↑$	$X ↑$	$A D \to$
Domestic tastes and preferences	$E ↑$	$M ↓$	$A D \to$
Domestic income	$E ↓$	$M ↑$	$A D \leftarrow$
Exchange rate (non-PL)	$E ↑$	$N X ↓$	$A D \leftarrow$

A positive event or a decrease in risk would lead to an appreciation, lowering exports and increasing imports. Thus $N X$ falls, there is a gross capital inflow, and the $A D$ curve shifts left.

Fiscal policy

If an economy is running a trade deficit and the government borrows more, all else equal that makes the trade deficit larger.

Why does this happen?

(spoiler)

Answer: Because the domestic currency has appreciated.

This may be described as an international crowding out effect, which makes fiscal policy less effective in an open economy than it is in a closed economy.

Monetary policy

So smaller changes in interest rates can achieve the same change in $Y$ in an open economy compared to a closed economy.

Fixed exchange rate fiscal and monetary policy

One final brief consideration is what occurs if a country does not have a floating exchange rate. Consider Denmark, which has a fixed exchange rate with respect to the Euro.

They may cut interest rates, which lowers demand to counteract the increase due to fiscal policy. Finally, they may attempt to use capital controls to prevent the increase in demand.

Trade barriers

Definitions

Import quota: A government policy that creates a maximum amount that can be imported of a specific good or service
Tariff: A tax on either imports or exports. Primarily used to refer to import taxes in common usage.

Any policy that restricts or lowers demand for imports, leads to substitution to domestic goods. $N X$ rises and this initially leads to a rightward shift in $A D$ .

Tariffs do raise government revenue. But they act as targeted sales taxes and thus are usually limited in revenue generation compared to income taxes.

Thus a country would only want to use these tools if there are benefits outside of our $A D$ - $A S$ model.

Examples of these include:

Infant industry protection (allowing development of new companies or new technology)
National security reasons (domestic production is more important than lowest cost production)
Retaliation against other countries (response to policy against you)
Addressing negative externalities (to combat pollution or child labor)

For an economist a legitimate use of tariffs should have

A specific problem to address
A time limit
Additional policies (such as domestic investment incentives or retraining of workers in non-competitive firms)

Protectionism in general, policies that favor domestic industries as a whole, is a net negative economically.

Open economy summary

Below is a table that summarizes closed and open policy cases and their anticipated impacts on the $A D$ - $A S$ model.

Policy	Economy type	Change in $P$	Change in $Y$
Monetary policy	Closed economy	$↑$	$↑$
	Open economy	larger $↑$	larger $↑$
Fiscal policy	Closed economy	$↑$	$↑$
	Open economy	smaller $↑$	smaller $↑$
Trade restrictions (no retaliation)	Open economy (SR)	$↑$	$↑$
Trade restrictions (retaliation)	Open economy (SR)	small $↑$ or $↓$	small $↑$ or $↓$
Trade restrictions (no retaliation )	Open economy (LR)	$↑$	$↓$
Trade restrictions (retaliation )	Open economy (LR)	large $↑$	large $↓$

Key points

Open economy AD and the exchange rate effect

Exchange rate effect completes the downward-sloping $A D$ story: $P ↓$ → interest rates $↓$ → exchange rate depreciates → exports cheaper, imports pricier → $N X ↑$ → $Y ↑$
Other shifters partially offset via exchange rate feedback:
- Foreign income/tastes $↑$ → $X ↑$ → appreciation → dampens but still $A D$ shifts right
- Domestic tastes $↑$ for foreign goods → $M ↑$ → depreciation → dampens but $A D$ still shifts left
- Domestic income $↑$ → $M ↑$ → depreciation → $A D$ rises less than in closed economy
Non-PL exchange rate changes (risk, investment demand shifts) directly drive $N X$ and $A D$ :
- Depreciation (negative event/risk) → $N X ↑$ , capital outflow, $A D$ shifts right
- Appreciation (positive event/lower risk) → $N X ↓$ , capital inflow, $A D$ shifts left

Fiscal policy in an open economy

Government deficit shifts loanable funds supply left; world interest rate (not domestic) governs the market
Result: capital inflows rise instead of interest rate rising sharply; dollar appreciates, $N X$ falls
Called international crowding out — makes fiscal policy less effective (smaller $A D$ shift) than in closed economy
Worsens existing trade deficits when government borrows more

Monetary policy in an open economy

Expansionary policy lowers domestic interest rate → capital outflows → dollar depreciates → $N X$ rises
This adds to the usual domestic effect, making $A D$ increase more than in a closed economy
Smaller interest rate changes needed to achieve same $Y$ change vs. closed economy

Fixed exchange rate policy constraints

With free capital flows + fixed exchange rate, central bank loses independent monetary policy (must match anchor country’s rate, e.g., Denmark/Euro)
Capital controls allow independent monetary policy despite fixed rate (e.g., China’s past peg to USD)
Fiscal policy under fixed rates: deficit spending raises rates → currency appreciation pressure; central bank must counteract via:
- Supplying more currency (needs reserves or money printing)
- Cutting interest rates
- Imposing capital controls

Trade barriers

Import quota: caps quantity of imports allowed
Tariff: tax on imports (or exports)
Short run (no retaliation): restricting imports boosts $N X$ → $A D$ shifts right
With retaliation: foreign tariffs lower $X$ , can offset or reverse the initial $A D$ gain
Long run: reduced efficiency/competition shifts $S R A S$ and $L R A S$ left → stagflation (worse with retaliation)
Tariffs raise revenue like targeted sales taxes (limited compared to income tax)
Legitimate economic justifications: infant industry protection, national security, retaliation, correcting externalities
Proper tariff use requires: specific problem, time limit, supplementary policies (e.g., retraining, investment incentives)
General protectionism (favoring domestic industry broadly) is a net economic negative

Summary comparison (closed vs. open economy policy effects)

Monetary policy: larger $P ↑$ and $Y ↑$ in open economy (tailwind from capital flows)
Fiscal policy: smaller $P ↑$ and $Y ↑$ in open economy (headwind from international crowding out)
Trade restrictions: short-run boost to $P$ and $Y$ (less/reversed with retaliation); long-run stagflation ( $P ↑$ , $Y ↓$ ), intensified by retaliation