This model, often described as “the dominant policy paradigm for studying open-economy monetary and fiscal policy,” makes oneimportant and extreme assumption: the economy being studied is a
small open economy
and there is
perfect capital mobility
, meaningthat it can borrow or lend as much as it wants in world financialmarkets, and therefore, the economy’s interest rate is controlled bythe world interest rate, mathematically denoted as
r = r*.
One key lesson about this model is that the behavior of an economydepends on the exchange rate regime it adopts—floating or fixed.This model will help answer the question of which exchange rateregime should a nation adopt?