Q. Imagine a world with two large countries, Home and Foreign. Evaluate how Home's macroeconomic policies affect Foreign. Compare the small and the large country cases; consider both permanent monetary and fiscal policies.
Answer: Note that while the two countries are large neither country is able to be thought of any longer as facing a fixed external interest rate or else a fixed level of foreign export demand. Consider merely permanent shifts.
A permanent monetary expansion via Home in the small country's case would cause currency depreciation and increase in output interest rates as well falling. When the Home wealth is large the alike would happen however now the rest of the world is affected too. For the reason that Home is facing real currency depreciation Foreign should be experiencing a real currency appreciation. This makes foreign goods comparatively expensive and therefore reduces its output. Though this increases Home's output since Home's imports will go up. Therefore it isn't clear what will happen to foreign output. Note that the Foreign output can go up only if the foreign nominal interest rate rises as well as and it is able to fall only if Foreign nominal interest rate falls. This is for the reason that the foreign market equilibrium is:
M*/P* = L(R*, Y*) for the reason that in this exercise M* is not changing and P* is sticky by assumption and thus fixed in the short run.
Now regard as a permanent expansionary fiscal policy in Home.
In the small country case a permanent monetary expansion would makes a real currency appreciation and a current account deterioration that would fully abolish any positive effect on aggregate demand. Effectively the expansionary impact of the Home fiscal effortlessness would leak entirely abroad. This is for the reason that the counterpart of Home's lower current account balance must be a higher current account balance abroad.
In the large country case foreign output still go up for the reason that Foreign's exports turns into relatively cheaper when Home's currency appreciates. Additionally now some of Foreign's improved spending increases Home exports therefore Home's output actually increases along with the output of Foreign. Home's nominal interest rate should go up and Foreign's interest rate increases at the same time as well.