Unit 5: Open Economy Models

1. Open Economy Version of IS-LM

In an open economy, the goods market equilibrium (IS curve) must account for exports (X) and imports (M).

Open Economy IS Formula: Y = C + I + G + (X - M)

• Net Exports (NX): NX = X - M. Exports depend on foreign income and the real exchange rate, while imports depend on domestic income and the real exchange rate.
• Interest Rates: The LM curve remains largely the same, but the overall equilibrium is now constrained by the balance of payments.

2. Derivation of the BOP Schedule

The Balance of Payments (BOP) schedule (or BP curve) represents combinations of interest rates (r) and income (Y) that result in a zero balance in the overall balance of payments.

• Slope: Usually upward sloping. As income (Y) rises, imports increase, creating a trade deficit. To maintain a zero BOP balance, interest rates must rise to attract capital inflows.
• Capital Mobility:
  • Perfect Capital Mobility: The BP curve is horizontal at the world interest rate (r*).
  • Imperfect Capital Mobility: The BP curve is upward sloping.

3. Mundell-Fleming Model

The Mundell-Fleming model is the standard framework for analyzing monetary and fiscal policy in an open economy under different exchange rate regimes.

Policy Effectiveness:

4. Monetary Approach to BOP

The monetary approach views the Balance of Payments primarily as a monetary phenomenon.

• It emphasizes that any disequilibrium in the BOP reflects a disequilibrium in the domestic money market.
• A surplus in the BOP represents an excess demand for money, while a deficit represents an excess supply of money.

5. International Financial Markets

This refers to the global network of institutions that facilitate the exchange of currencies and the flow of capital between countries.

• Foreign Exchange Market: Where currencies are traded and exchange rates are determined.
• Capital Flows: The movement of financial assets across borders in search of higher returns or diversification.