Macroeconomics 12: Short Run Macroeconomics of the Large Open Economy

Question 1

Describe & explain the equations and models for the large open economy in the short run

Answer 1

The equations describing a large open economy in the short run are:
- Y= a+b(Y-T) + I(r) +G + NX(ε)
- M/P=L(r,Y)
- NX(ε)=CF(r)
We can take this third identity and replace NX(epsilon) with CF(r). Hence, the first 2 equations can be converted to IS-LM
The last equation can be substituted into the first equation to give the IS curve
Y= a+ b(Y-T) + I(r) + G + CF(r) OR Y= (a+G−bT)/(1−b) + (I(r)+CF(r))/(1−b)
The IS/LM equilibrium sets output and interest rate; CF (=NX) then depends on the domestic interest rate; the real exchange rate (ε) will be determined by the NX equation. Since we assume prices are fixed in the short run then we can use e (the nominal exchange rate) rather than ε

Model

*3 graphs. First one, “(a) The IS-LM model”, has “Income, output, Y” x-axis and “Real interest rate, r” y-axis…