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Is-LM Open Economy

Is-LM Open Economy

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Published by: Appan Kandala Vasudevachary on Mar 21, 2014
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03/21/2014

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IS
– 
 LM Model in Open Economy
It is time to relax the closed economy assumption and understand the impact & design of Macro economic policy in an open economy.
 
We first introduce the foreign balance constraint into IS-LM framework and then consider the design of optimal policies under fixed and flexible exchange rates.
 
Foreign Balance & IS-LM analysis:
 
With an open economy, the notion of Macro economic equilibrium has to be reinterpreted.
 
In the IS-LM frame work, full macro economic equilibrium is established when there is simulateneous equilibrium in the BOP accounts and the Goods & Money Markets.
 
 
We write the Goods Market equilibrium as ( IS Equation): I (r)+G+X = S (y) + T + Z
 
Where I = investment, G= exogeneous Govt Expenditure, X= exports, S=Savings, T=Taxes and Z= Imports.
 
As par as I,G,S,T we has a detailed discussion but regarding X & Z we should know:
 
Exports depend on the real exchange rate = ep*/p i.e., X = f (ep*/p)
 
P= domestic price level and p*= foreign price level.
 
Imports are a function of real income and the real exchange rate, so that
 
Z = f (Y, ep*/p)
 
BOP Equilinrium itself occurs when the net surplus on the current and capital accounts sum to zero. i.e., X-Z+K =O, K = Net inflow of capital.
 

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