Module 11 · Chapters 6, 7, 8

Open Economy I: Trade & Goods Market

Nominal & real exchange rates, net exports, and the open-economy IS curve.

“Where macro stops being closed.”

~35 min· 4 sub-skills·5 exercisesExam frequency · high0% mastered

An open economy adds two new variables: the exchange rate E (price of foreign currency in domestic) and the real exchange rate ε (relative price of domestic to foreign goods). Imports and exports adjust to ε; the open IS curve has a smaller multiplier because some demand leaks abroad.
Real exchange rate
$\varepsilon \;=\; \frac{E \cdot P^*}{P}$
$E$
nominal FX (€ per $)
$P^*$
foreign price level
$P$
domestic price level
ε measures how expensive foreign goods are relative to domestic. ε rises (depreciation) → exports up, imports down.
Net exports
$NX \;=\; X(\varepsilon, Y^*) - \varepsilon\,IM(\varepsilon, Y)$
$X$
exports — depend on ε and foreign income Y*
$IM$
imports — depend on ε and domestic income Y
Marshall-Lerner: NX rises with depreciation only if export and import elasticities sum > 1. Empirically true at horizons > a year (J-curve).
Tip·J-curve
Right after a depreciation, NX often worsens (existing import contracts cost more in local currency, exports take time to ramp up). After 6-12 months, NX improves and overshoots. This is the J-curve.
Open-economy IS
$Y \;=\; C(Y - T) + I(Y, i) + G + NX(\varepsilon, Y, Y^*)$
Adding NX makes IS less responsive to fiscal shocks: a fraction of the demand spills into imports.
Open economy multiplier
$k_{open} \;=\; \frac{1}{1 - c_1 + m_1}$
$m_1$
marginal propensity to import (ΔIM/ΔY)
Higher m₁ → smaller multiplier. EU member states have high m₁ → fiscal multipliers smaller than US.
Figure · Real FX dynamics
Dornbusch (1976): sticky prices + flexible FX → initial overshoot.
Higher ε → exports up, imports down → NX rises (after the J-curve dips).
Exercise · numerical · +12 XP
Real FX from nominal
E = 1.10 €/$, P = 102 (domestic), P* = 100 (foreign). Compute ε.
Your answer
Exercise · true false · +8 XP
Depreciation vs appreciation
Quoting E as € per $: a rise in E means the euro has depreciated against the dollar.
"Quoting E as € per $: a rise in E means the euro has depreciated against the dollar."
Exercise · multiple choice · +12 XP
Marshall-Lerner
Marshall-Lerner says depreciation improves NX if:
Exercise · numerical · +14 XP
Open-economy multiplier
c₁ = 0.6, m₁ = 0.2. Compute the open-economy multiplier.
Your answer
Exercise · multi step · +18 XP
Compare closed vs open multiplier
c₁ = 0.6, m₁ = 0.25. Compare the closed and open multipliers.
Context: A high marginal propensity to import shrinks the multiplier because demand leaks abroad. EU economies typically have m₁ ~ 0.25-0.40.
(a)Closed-economy multiplier:
(b)Open-economy multiplier:
(c)ΔY from ΔG = +100 in open economy:

Mastery check

5 questions · pass with 80%

Answer all five to confirm you've internalised the module. A passing run unlocks the next module.

Q1
"Two countries with identical inflation: a 5% nominal depreciation equals a 5% real depreciation."
Q2
Right after a depreciation, NX often:
Q3
Why is the open-economy multiplier smaller than the closed-economy one?
Q4
E rises 10% with P, P* unchanged. ε change?
Q5
"Higher foreign income Y* raises domestic exports."

0 / 5 answered

Exam pitfalls

Confusing rises in E (depreciation) with appreciation. Convention varies — always check.
Forgetting that ε = E·P*/P; ignoring price levels gives wrong real-FX comparative statics.
Using closed-economy multiplier in EU questions. Open-economy m₁ is significant.
Ignoring the J-curve when interpreting short-horizon NX data.