The is–lm model in an open economy

dimensions:
Openness in goods markets. Free trade restrictions include tariffs and quotas.
Openness in financial markets. Capital controls place restrictions on the ownership of foreign assets.
Openness in factor markets. The ability of firms to choose where to locate production, and workers to choose where to work.

composed of tradable goods—or goods that compete with foreign goods in either domestic or foreign markets.

Exports and imports

6.1 Openness in Goods Markets (Continued)

country size:
Distance from other markets.
Size also matters: The smaller the country, the more it must specialize in producing and exporting only a few products and rely on imports for other products.

Exports and imports

Table 6.1 Ratios of exports to GDP (%) for selected OECD countries, 2010 Source: Eurostat.

6.1 Openness in Goods Markets (Continued)

value of their GDP because exports and imports may include exports and imports of intermediate goods.
In 2007, the ratio of exports to GDP in Singapore was 229%!

how much to consume and save but also whether to buy domestic goods or foreign goods.
Central to the second decision is the price of domestic goods relative to foreign goods, or the real exchange rate.

The choice between domestic goods and foreign goods

6.1 Openness in Goods Markets (Continued)

of two ways:
As the price of the domestic currency in terms of the foreign currency.
As the price of the foreign currency in terms of the domestic currency.

6.1 Openness in Goods Markets (Continued)

Nominal exchange rates

in terms of the domestic currency.
An appreciation of the domestic currency is a decrease in the price of the foreign currency in terms of the domestic currency, which corresponds to a decrease in the exchange rate.
A depreciation of the domestic currency is an increase in the price of the foreign currency in terms of the domestic currency, or a increase in the exchange rate.

6.1 Openness in Goods Markets (Continued)

Nominal exchange rates

constant exchange rate between them, two other terms used are:
Revaluations, rather than appreciations, which are decreases in the exchange rate, and
Devaluations, rather than depreciations, which are increases in the exchange rate.

Nominal exchange rates

6.1 Openness in Goods Markets (Continued)

the euro since 1999
Source: European Central Bank.

6.1 Openness in Goods Markets (Continued)

Nominal exchange rates

the exchange rate—there was a depreciation of the pound vis-à-vis the euro over the period.
The large fluctuations in the exchange rate—there was a very large appreciation of the pound at the end of the 1990s, followed by a large depreciation in the following decade.

6.1 Openness in Goods Markets (Continued)

Nominal exchange rates

European goods in euros

From nominal to real exchange rates

Figure 6.3 The construction of the real exchange rate

6.1 Openness in Goods Markets (Continued)

the price of a Ford in USA is $50,000 and dollar is worth 350 tenge, then the price of a Ford in tenge is $50,000 X 350 = KZT17.5 millions.
If the price of a Chevrolet in the Kazakhstan is KZT 5 millions, then the price of a Ford in terms of Chevrolet would be KZT 17.5 millions/KZT5 millions = 3.5.
To generalize this example to all of the goods in the economy, we use a price index for the economy, or the GDP deflator.

From nominal to real exchange rates

6.1 Openness in Goods Markets (Continued)

that real exchange rate is price of foreign good in terms of domestic good:
An decrease in the relative price of foreign goods in terms of domestic goods is called a real appreciation, which corresponds to a decrease in the real exchange rate, ε.
A increase in the relative price of foreign goods in terms of domestic goods is called a real depreciation, which corresponds to an increase in the real exchange rate, ε.

From nominal to real exchange rates

6.1 Openness in Goods Markets (Continued)

rates in the UK since 1999
The nominal and the real exchange rates in the UK have moved largely together since 1999.
Source: ECB, Eurostat, Bank of England.

6.1 Openness in Goods Markets (Continued)

Figure 6.4:
The large nominal and real appreciation of the pound at the end of the 1990s and the collapse of the pound in 2008–2009.
The large fluctuations in the nominal exchange rate also show up in the real exchange rate.

6.1 Openness in Goods Markets (Continued)

rates are exchange rates between several countries.
For example, to measure the average price of UK goods relative to the average price of goods of UK trading partners, we use the UK share of import and export trade with each country as the weight for that country, or the multilateral real UK exchange rate.

From bilateral to multilateral exchange rates

6.1 Openness in Goods Markets (Continued)

goods are:
The real multilateral Kazakhstan exchange rate.
The Kazakhstan trade-weighted real exchange rate.
The Kazakhstan effective real exchange rate.

From bilateral to multilateral exchange rates

6.1 Openness in Goods Markets (Continued)

foreign currency—sometimes called foreign exchange.
Openness in financial markets allows:
Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate movements.
Allows countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.

6.2 Openness in Financial Markets

rest of the world.
It consists of current account and capital account.
The current account balance and the capital account balance should be equal, but because of data gathering errors they aren’t. For this reason, the account shows a statistical discrepancy.

The balance of payments

6.2 Openness in Financial Markets (Continued)

called current account transactions:
The first two lines record the exports and imports of goods and services.
UK residents receive investment income on their holdings of foreign assets and vice versa.
Countries give and receive foreign aid; the net value is recorded as net transfers received.

The current account

The balance of payments

6.2 Openness in Financial Markets (Continued)

be positive, in which case the country has a current account surplus, or negative—a current account deficit.
A positive current account balance indicates that the nation is a net lender to the rest of the world, while a negative current account balance indicates that it is a net borrower from the rest of the world.

The current account

The balance of payments

6.2 Openness in Financial Markets (Continued)

nation.
The capital account balance, also known as net capital flows, can be positive (negative) if foreign holdings of US assets are greater (less) than US holdings of foreign assets, in which case there is a capital account surplus (deficit). Negative net capital flows are called a capital account deficit.
The numbers for current and capital account transactions are constructed using different sources; although they should give the same answers, they typically do not. The difference between the two is called the statistical discrepancy.

The balance of payments

The capital account

6.2 Openness in Financial Markets (Continued)

not only on interest rate differences but also on your expectation of what will happen to the nominal exchange rate.

The choice between domestic and foreign assets

Figure 6.6 Expected returns from holding one-year UK bonds or one-year US bonds

6.2 Openness in Financial Markets (Continued)

they must have the same expected rate of return, so that the following arbitrage relation must hold:

Rearranging the equation, we obtain the uncovered interest parity relation, or interest parity condition:

The choice between domestic and foreign assets

6.2 Openness in Financial Markets (Continued)

the highest expected rate of return is obviously too strong, for two reasons:
It ignores transaction costs.
It ignores risk.

The choice between domestic and foreign assets

6.2 Openness in Financial Markets (Continued)

interest rate and the expected rate of depreciation of the domestic currency is stated as:

A good approximation of the equation above is given by:

Interest rates and exchange rates

6.2 Openness in Financial Markets (Continued)

domestic interest rate must be (approximately) equal to the foreign interest rate plus the expected depreciation rate of the domestic currency.
If , then

Interest rates and exchange rates

6.2 Openness in Financial Markets (Continued)

the USA and in the UK since 1970
UK and US nominal interest rates have largely moved together over the past 40 years.

6.2 Openness in Financial Markets (Continued)

expect the pound to depreciate vis-á-vis the dollar over the coming year.
If you expect the pound to depreciate by more than 3.0%, then investing in UK bonds is less attractive than investing in US bonds.
If you expect the pound to depreciate by less than 3.0% or even to appreciate, then the reverse holds, and UK bonds are more attractive than US bonds.

Interest rates and exchange rates

6.2 Openness in Financial Markets (Continued)

the measure that corresponds to value added products, domestically. Gross national product (GNP) corresponds to the value added products by domestically owned factors of production.

Table 6.4 GDP, GNP and net factor income in Ireland, 2002–2008 Source: Central Statistics Office Ireland.

of 36.9%?
What rate of depreciation of the cruzeiro should you expect over the coming month? A reasonable assumption is to expect the rate of depreciation during the coming month to be equal to the rate of depreciation during last month.
The expected rate of return in dollars from holding Brazilian bonds is only (1.017 – 1) = 1.7% per month.
Think of the risk and the transaction costs—all the elements we ignored when we wrote the arbitrage condition. When these are taken into account, you may well decide to keep your funds out of Brazil.

Buying Brazilian bonds

6.3 The IS Relation in an Open Economy

relation between the interest rate and exchange rate implied by interest parity
A higher domestic interest rate leads to a higher exchange rate – an appreciation

In an open economy, the demand for money is given by :