Economic Modelling

Lecture 17
Small Open Economy

Determinants of Output in an Open Economy

Aggregate demand depends on consumption, investment, government spending and

net exports.

Consumption depends on disposable income.

Investment on the real interest rate.
Tax revenues on national income.
Exports on foreign income and the real exchange rates.
Imports on domestic income and the real exchange rate.

The real exchange rate is determined by domestic and foreign price levels and the
nominal exchange rates.

Nominal interest rate is determined in the money market.

Capital inflow/outflow depends on the difference in the domestic and foreign real
interest rates.

Aggregate supply depends on capital stock and labour force.

Mundell-Fleming Small Open Economy Model

Notations in the Above Open Economy Model

An Example of an Open Economy Model

Consumption
Investment
Tax and Spending

C 200 0.8 Y T
I 50 200 i

T =100 G = 100

NX 10 0.3Y f 0.1Y 20

Net exports
Real exchange rate
Financial integration
Demand for Money
Parameters

Y C Y T I i G NX Y , Y f ,

National Income

Y 500
f

EP *

i i 5%
*

M
200 50i 0.5Y
P

0.02

P 2 P2
*

A Solution of the Model

Y 1280

C 1144

I 44
Private Saving:

NX 8
S = Y-T-C = 1280 - 100-1144= 36

Equilibrium Condition:

Y C Y T I i G NX Y , Y f ,

=1144 + 44 +100-8=1280
Model Closure:

T G S I NX 100 100 36 44 8
6

Three GAPs: Investment-Saving, Budget and Trade Gaps

SI

S(Y)

Trade Surplus

S I T G X M

NX 0 NX Cap Flow
K-outflow

T G 0
i

Private saving +public saving

= net export

SI
0

I(r)
Trade deficit
K-inflow NX 0
Saving and Investment

Re call : Y C S T M C I G X rK wL Tr
7

Keynesian Open Economy Model

How an Expansion in Income causes Trade Deficit?
AD

*
eP
f
e
Y C (Y T ) I (Y , i ) G NX (Y , Y , )
P
0
Y

M=M(Y)

Trade
balance

X=X0

+
Surplus
0
-

Deficit

NX=X-M

Derivation of Net Exports and Investment Saving in an Open Economy

Note:
AD
(a) Shows reduction in AD
following an increase in ER
(b) Shows investment saving
balance in an open economy
(c) Shows net export as
a function of the exchange
rate
(c)

AD

(a)

NX

Y1
(b)

e2

e2

Y2 Y

e1

e1
NX (e)
NX2

NX1

IS*(e)
y1

Y2
9

IS-LM Model in an Open Economy: Mundell-Fleming Model

Exchange
Rate

LM (y, i)
Assumption:
Money supply does not
depend on exchange rate

e*

IS*
o

Output

10

Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
Flexible Exchange Rate System

Fixed Exchange Rate System

LM

LM1

LM2

e2
IS*

e1

IS*
IS*

IS*
Y
No Impact of Fiscal Policy

Y1

Y2

Full Impact of Fiscal Policy

11

Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
Flexible Exchange Rate System

Fixed Exchange Rate System

LM

LM1

LM2

e2
IS*

e1
IS*

IS*
Y1
Y2
Full Impact of Monetary Policy

Y1

Y2

No Impact of Monetary Policy

12

Open Economy Fixed Exchange Rate

Effectiveness of Fiscal Policy and Ineffectiveness of Monetary Policy
LM0
LM1

i1
i=i*

BOP=X-M=0

IS0
0

y1

IS1

y2
13

IS-LM and Uncovered Interest Parity Model

LM
2
1

IS
0

Y0

Y1

E0

E1
Appreciation
Exchange rate
14

J-Curve Hypothesis: Impact of Devaluation on Net Exports

Export creation and
Import substitution or
demand switching takes time
Net
Exports

Time
15

Determinants of Net Export

16

Marshall-Lerner condition

17

Numerical Example of the Marshall-Lerner Condition

18

References

Blanchard (18) Mankiw (2) M&S (20)

Bhattarai (2002) Welfare Gains to the UK from a Global Free Trade, European
Research Studies, vol. IV, Issue 3-4, 2001, pp55-72. pp. 1161-1176.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit
and Banking, 11, Aug.
Krugman P. and L. Taylor (1978) Contractionary Effects of Devaluation Journal of
International Economics, 445-56.
Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic
Dynamics and Control, July-Oct. 1990, v. 14, iss. 3-4, pp. 553-69
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible
exchange rates, Canadian Journal of Economic and Political Science, 29, 475-85.
Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and
Statistics, vol. 68, 3, 501-508.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic
Literature, March, vol 33, No. 1, pp. 13-47.
Whalley (1985) Trade Liberalisation among Major World Trading Areas , MIT Press
for developments on trade arrangement among various trading regions.

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