W3P4 - Open Economy ISLM Flashcards
How is the IS schedule modified to extend the ISLM model to include the open economy?
The IS schedule in the open economy now also depends on net exports: NX = X - Z
i.e. it also depends positively on foreign income Y* and negatively on the real exchange rate σ. As we are assuming that prices are fixed in this model, there is a one to one relationship between the nominal
exchange rate S and the real exchange rate σ.
How is the LM schedule modified to extend the ISLM model to include the open economy?
The LM schedule is the same in the open economy and the closed economy. Remember the LM schedule can be written as M/P=L(Y,i)
And hence it does not depend directly on foreign variables or the exchange rate.
How do interest rates affect nominal and real exchange rates when the ISLM model is extended to include the open economy?
When domestic interest rates are above foreign interest rates, we will see an appreciation of the nominal exchange rate S. Since we assume that prices are fixed, a change in the nominal exchange rate S will
translate directly into a change in the real exchange rate σ. Note that the real exchange rate σ is simply:
σ = S.P/P*
What must happen for exchange rates to be fixed?
When exchange rates are fixed, then we require that domestic interest
rates are equal to foreign interest rates:
i=i*
If that was not the case, then we would see pressure on the exchange rate to either appreciate or depreciate
If exchange rates are floating, how does a change in exchange rates affects the IS schedule?
When exchange rates are flexible, an appreciation of the exchange rate leads to a decrease in exports and an increase in imports and hence net exports are decreasing. When the IS schedule is derived, we were
treating the exchange rate as constant i.e. we derived the IS schedule for a certain amount of net exports. Now an appreciation of the exchange rate and hence a decrease in net exports will shift the IS schedule to the left. Similarly, a depreciation of the exchange rate will increase net exports and for any given interest rate we will have higher output, hence the IS schedule shifts to the right.
Explain what happens to the IS schedule if exchange
rates are floating and i > i. What if i < i?
When domestic interest rates are above foreign interest rates i > I*
We will see an appreciation of the exchange rate and hence a decrease
in net exports. The IS schedule will shift to the left.
When domestic interest rates are below foreign interest rates i < i*
We will see a depreciation of the exchange rate and hence an increase in net exports. The IS schedule will shift to the left.
