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This chapter marks the first step toward the construction of the ISLM/ADAS model which will power macroeconomic analyses in the chapters to come. At this stage we have completed an intuitive overview of the broad links between global capital flows, fiscal, and trade imbalances, and their effects on interest rates and exchange rates.

This chapter introduces the role of intertemporal expectations into our analysis. Effects of current and expected inflation on long-term interest rates will be the focus of the first half of this chapter. This will be followed by a discussion of the ultimate macroeconomic meltdown—hyperinflation.

By the early 1980s, the macroeconomic landscape had changed significantly for the United States and several other Western European economies. Once-successful Keynesian discretionary demand-side stabilization policies appeared to be ineffective. The output-inflation tradeoff seemed to be no longer in evidence—expansionary fiscal and monetary stimuli only yielded additional inflation with no accompanying increase in GDP growth or employment. The Phillips curve, for all intents and purposes, appeared to be dead.

While most advanced Western countries allow the free movement of overseas capital in and out of their economies, many countries, particularly in the developing world, impose restrictions. In fact, the current dominance of freely floating rates is a relatively new historical development. Significant restrictions on capital mobility have been the norm until the globalization era which began in the 1980s. We apply the BOP equilibrium for Imperfectly Mobile Capital to the ISLM-BOP and examine how the results differ from those attained under Perfectly Mobile Capital. Here we see the applicability of the Keynesian multiplier. We move on to discuss fiscal budget sustainability and the Dornbusch model, which leads us into the history and evolution of the Euro. The current state and future of the Euro are discussed here. We discuss speculative currency attacks and their related phenomena of overshooting. We ask: how are private actors able to drive markets in the fact of powerful central banks? We explore the sources and limits of a central bank’s power.

After analyzing monetary policy in both Keynesian and rational expectations paradigms, and across emerging and developed economies, the time has finally come to explore the exact mechanism by which central banks enact monetary growth.

In the previous chapter, we examined the possibility of a shift in the goods market equilibrium from E0 to a higher equilibrium E1, which equated to an equivalent rightward shift in the AD curve. This chapter continues the analysis with a discussion of the specific fiscal and monetary policies by which the aggregate demand (AD) curve can be shifted to enact demand-side stabilization. This will be followed by an in-depth description of overheating, soft-landings, and hard-landings.

In this chapter, changes in the rate of inflation are finally incorporated into the ISLM-ADAS analysis. This raises the overall level of sophistication of our analysis from Chapter 7 by incorporating a “real world” aggregate supply curve into the ISLM analysis. The stage is also set for an explanation of paradigm shifts between Keynesian and supply-sider models.