The Open Economy IS-LM Model – A (Basic) Summary Sheet
In a closed economy, the formula for the IS curve is derived from the GDP identity .
In an open economy, the GDP identity is , so the IS curve is derived from this. . We also refer to as the current account.
The Current Account depends on the real exchange rate , domestic GDP (because the higher domestic income is, the more we consume and import), and world GDP (because the higher world income is the more is the demand for our goods). We are mainly concerned with how it depends on the real exchange rate, which is the ratio of price of domestic goods to the price of foreign goods when expressed in the same currency.
If the real exchange rate appreciates, the current account decreases (or worsens) and the IS curve shifts left, since domestic goods now have become relatively more expensive when compared to foreign goods. If the real exchange depreciates, the current account increases (or improves) and the IS curve shifts right.
The real exchange rate where is the nominal exchange rate, is the domestic price level and are world prices. In the short run, we treat and as fixed, so the real exchange rate only depends on the nominal exchange rate .
Through the UIP condition, however, interest rates affect the nominal exchange rate . This is the key to understanding the open economy IS-LM model. From the UIP condition, if domestic interest rates are bigger than world interest rates , it then becomes more attractive to invest in domestic assets, so the domestic currency appreciates, i.e. the nominal exchange rate goes up. This causes the real exchange rate to appreciate, so the current account worsens and the IS curve shifts left. If then depreciates and the IS curve shifts right.
The equilibrium is where the IS and LM curves intersect as usual. But also in equilibrium we will have so the IS and LM curves will cross on the line. Either the IS or LM curve will move to ensure this....
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