The Open Economy Bridge

Open-Economy IS-LM-PC

coreExam · medium

Integrates open-economy NX into the IS-LM-PC framework. Open-economy IS: Y = C(Y−T) + I(Y, r+x) + G + NX(Y, Y*, ε). With flat LM at i=iᵀ. Phillips curve: π − π₋₁ = (α/L)(Y − Yn). Medium-run equilibrium: Y = Yn, Δπ = 0, r = rn, BUT now NX matters — persistent deficits accumulate foreign debt.

Derivation

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The Open-Economy IS

Y = C(Y - T) + I(Y, r + x) + G + NX(Y, Y^*, \varepsilon)

Three new ingredients compared to closed-economy IS:

$NX$ : depends on domestic $Y$ (imports), foreign $Y^*$ (exports), and real exchange rate $\varepsilon$ .
$\varepsilon = E \cdot P / P^*$ : real exchange rate.
Marshall–Lerner condition governs whether depreciation improves $NX$ .

Policy Effects

| Policy | Y | NX | CA | |--------|---|-----|-----| | $\uparrow G$ (fiscal) | $\uparrow$ | $\downarrow$ | $\downarrow$ (twin deficits) | | $\downarrow i^T$ (monetary, floating) | $\uparrow$ | $\uparrow$ (via $\downarrow E$ ) | $\uparrow$ |

Fiscal and monetary policy both raise Y but have opposite effects on the current account. This is why countries with CA deficits should prefer monetary easing as stimulus; fiscal expansion makes the imbalance worse.

Medium-Run Equilibrium

Y = Y_n, \quad \Delta\pi = 0, \quad r = r_n

But unlike the closed-economy case, $NX$ need not equal zero. The country can be a persistent net debtor or creditor — as long as capital inflows finance any CA deficit.

Real-Appreciation Slow-Burn

Under fixed FX, if domestic inflation runs persistently above partner inflation:

\pi > \pi^* \quad \text{with} \quad E = \bar{E} \Rightarrow \uparrow \varepsilon \Rightarrow \downarrow NX

Competitiveness erodes slowly. This was the EMS pattern — high-inflation countries needed periodic devaluations or structural reform.

Worked Example

Open economy. Closed-economy IS had Y = 825 − 1250r. Add NX = 100 − 0.1Y − 200ε. ε = 1.0. Yn = 800.

Open IS: Y = 825 − 1250r + (100 − 0.1Y − 200·1.0) = 925 − 1250r − 0.1Y − 200.
Y(1 + 0.1) = 725 − 1250r → Y = (725 − 1250r)/1.1 ≈ 659 − 1136r.
Find rn: 800 = 659 − 1136rn → rn = (659 − 800)/1136 = −0.124 ≈ −12%. Deep recession territory.
Monetary easing (↓iᵀ) would cut r AND depreciate ε, boosting Y and NX.

Open-economy Y = 659 − 1136r. rn ≈ −12% (ZLB binds). Combined monetary+fiscal stimulus or exchange-rate depreciation needed.

Common Mistakes

—Forgetting that NX enters IS — in open economy, ↑G raises Y less than closed-economy multiplier.
—Confusing nominal (E) and real (ε) exchange rates in the IS equation.
—Assuming medium-run NX = 0 — it doesn't have to; persistent CA deficits are sustainable if financeable.
—Ignoring the domestic-vs-foreign inflation differential for ε dynamics.

Exam Cues

→Open IS adds NX(Y, Y*, ε) to closed-economy aggregate demand.
→Fiscal expansion: ↑Y, ↓NX (twin deficits). Monetary easing: ↑Y, ↑NX (via depreciation).
→Medium run: Y = Yn, Δπ = 0, r = rn. NX need not equal zero.
→Inflation differential: π > π* with fixed E → real appreciation → NX deteriorates.