The Open Economy Is-Lm Model

The Open Economy IS-LM Model – A (Basic) Summary Sheet

In a closed economy, Y=C+I+G

In an open economy, Y=C+I+G+NX, where NX= net exports = X-Z. We also refer to NX as the current account.

The Current Account depends on the real exchange rate ?, domestic GDP Y (because the higher domestic income is, the more we consume and import), and world GDP Y* (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.

In the open economy IS-LM model, we have to incorporate the current account into the IS curve. If the real exchange rate appreciates, the current account decreases (or worsens) and the IS curve shifts left, in just the same way that it would do if we decreased government spending. If the real exchange depreciates, the current account increases (or improves) and the IS curve shifts right.

The real exchange rate ?=SP/P* where S is the nominal exchange rate, P is the domestic price level and P* are world prices. In the short run, we treat P and P* as fixed, so the real exchange rate only depends on the nominal exchange rate S.

Through the UIP condition, however, interest rates i affect the nominal exchange rate S. This is the key to understanding the open economy IS-LM model.

If domestic interest rates i are bigger than world interest rates i*, then S appreciates. The current account worsens and the IS curve shifts left. If i<i* then S depreciates and the IS curve shifts right.

Fixed Exchange Rates

Suppose we are in a fixed exchange rate regime. S cannot be allowed to appreciate or depreciate, so we must have i=i* always. In practice fiscal policy works with lags and though it influences interest rates, it does not do so in a precise and predictable way. With fixed exchange rates, a noticeable departure from i=i* for a day or even for an hour could lead to huge capital flows. It is the responsibility of monetary policy to ensure i=i* by making the LM curve always intersect the IS curve on the i=i* line. So monetary policy is ineffective.

However fiscal policy is effective. Since S