The Open Economy

Extension to an Open Economy Model

We now extend the IS/LM model to an open economy. The equilibrium condition in the goods market is now rewritten as

where X denotes trade surplus, which is exports EX minus imports IM(X = EX — IM), and e denotes exchange rate (for example, 1 dollar = e yen). An increase in e means a depreciation of the home currency, the yen, stimulating exports and depressing imports. Thus, an increase in e raises net exports X. In addition, an increase in income stimulates imports and reduces net exports. Imports increase with income. The marginal propensity to import,

m = AM/AY = — AX/AY, is between 0 and 1. For simplicity, we do not consider changes in taxes here.

The equilibrium condition in the money market is the same as in the closed economy and given as before.

I

When the world capital market is perfect, because of the arbitrage behavior of capital movement, the rate of interest in the home country r is equal to the world rate of interest, r*.

From this point on, we consider the small open country situation where the home country cannot manipulate the world rate of interest.

 
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