The domestic economy and the rest of the world

So far in this book, the economy has only been considered in isolation. In this chapter, it is opened to the rest of the world. International flows of trade and finance as well as the exchange rate are added to the analysis. Neoclassical explanations of exchange rate determination are discussed, showing that they rely on erroneous assumptions. An alternative explanation is given with reference to quantum macroeconomics and several important classical elements. The investigation shows that once the economy is considered as embedded in the rest of the world, neither monetary policy nor public investment are effective. They rather cause exchange rate volatility, balance-of-payment deficits and the accumulation of external debt. This is the so-called Thirlwall’s law. It is also discussed how conventional instruments such as exchange rate pegging and capital controls try to stabilize the economy but are, at most, partially effective. Moreover, any active policy intervention tends to be punished by capital flight, thus causing macroeconomic instability before policies are even implemented. The argument of the external constraint’s fundamental importance is supported by another extension and simulation of the stock-flow consistent model.