Open Economy Macroeconomics: The IS-LM-BP Model
When we open the economy to international transactions we have to take into account the effects of trade in goods and services (i.e. items in the current account) as well as trade in assets (i.e. items in the capital account). Opening the economy to international trade in goods and services means that we have to take into account the increased demand for our goods by foreigners (our exports), as well as the decreased demand for our goods that occurs because we purchase foreign goods (i.e. our imports). Total expenditures in an open economy are C + I + G + NX, where NX -- net exports -- is equal to the level of exports (X) less the level of imports (V). Thus, our exports (X) represent spending by foreigners on domestic goods so they increase the level of domestic output. Imports (V), on the other hand, represent spending by domestic residents on foreign goods, so they decrease the level of (domestic) production. To analyze the effect of exports and imports on the equilibrium level of output, it is important to understand the various factors which determine the levels of exports and imports. Exports represent foreign demand for our goods and services. Foreign purchases of goods and services depend, among other things, on foreign income levels (just as our purchases of goods and services depend on our income levels). We assume that foreign income levels are constant, thus, foreigners demand a constant amount of our goods. Whether foreigners buy our goods, or some other country's goods, or their own goods, depends on the relative prices of those goods. The lower our relative price, the more of our goods they will purchase. The exchange rate is an indicator of the relative price of our goods to foreigners. We will use "e" as the domestic price of foreign currency (i.e. how many dollars must be given up to receive 1 unit of foreign currency). Let's say that e is initially 1. 5. If e ↓ , then a domestic resident will have to give up fewer dollars to get an additional unit of foreign currency (e1 < e0 ); foreigners, on the other hand, will need to give more of their currency to receive $1. A decrease in e, also called a revaluation under fixed exchange rates or an appreciation under flexible exchange rates, allows domestic residents to buy the same amount of foreign goods using less domestic currency. If e↑ , domestic residents will need to give more currency to receive one unit of foreign currency. An increase in e, also called a devaluation under fixed exchange rates or a depreciation under flexible exchange rates, means domestic residents must give up more currency to buy the same amount of foreign goods. If e increases (i.e. our currency devalues -- it is worth less), foreigners don't have to give up as much of their currency to purchase the same quantity of our goods, therefore, the relative price of our goods to foreigners has fallen: they purchase more of our goods. Thus, an increase in e causes exports to increase. An increase in e causes imports to fall (because foreign goods are relatively more expensive). To sum up, exports are determined by foreign income levels (which we assume to be constant) and the exchange rate. An increase in e causes X to increase. A decrease in e
causes X to fall. If e is unchanged, X is constant. Imports (V) are domestic purchases of foreign goods. Imports represent expenditures on foreign goods instead of domestic goods. Thus, the level of domestic production does not have to be as high when-we import goods and services. The domestic demand for goods and services is determined by the domestic level of income: a higher level of income means a higher level of consumption -- consumption of both domestic and foreign goods. Thus, an increase in (domestic) income increases the level of imports. Similar to the case of exports, whether we purchase domestic goods or foreign goods depends on the relative prices of the goods. The exchange rate is an...
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