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Equilibrium in Open Economy

goods market equilibrium


  • Y = C(Y-T) + I(Y,r) + G – IM(Y,e)/e + X(Y*,e)
  • NX = X(Y*,e) – IM(Y,e)/e
  • Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*,e)
    • increase in real interest rate >> decrease in investment >> decrease in output

financial market equilibrium – same in closed and open economy


  • M/P = Y L(i)
  • demand for domestic money mostly among domestic residents
    • foreign residents would have to exchange money to use domestic money >> no point in them having a demand for domestic money (better off holding domestic bonds)
  • interest parity condition >> it = i*t - (Et+1-Et)/Et
    • E = Ee (1+i) / (1+i*)
    • increase domestic interest rate >> decrease exchange rate >> appreciation of domestic currency

IS/LM model – combines financial/goods market equilibria and interest-parity


  • IS: Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, Ee(1+i)/(1+i*))
    • interest rate increase >> decrease in investment, net exports >> decrease in output, demand
  • LM: M/P = Y L(i)
  • equilibrium interest rate determines equilibrium exchange rate


Subject X2: 

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