A Technical Note on the Open Economy IS/LM Model

7 Pages Posted: 9 Jun 2009

See all articles by Francis E. Warnock

Francis E. Warnock

University of Virginia - Darden Business School; National Bureau of Economic Research (NBER)

Abstract

This technical note introduces the basic structure of what we call the Three-Paned Model. The model is essentially just an “opening up” of the closed-economy IS/LM Model, with the main pane being the IS/LM Model (modified only slightly to allow for international trade) and two additional panes that determine the amount of capital inflows, net exports, and the exchange rate. This note is not a substitute for the more in-depth presentation of these models found in textbooks, but should be used to complement each textbook's richer treatment of the theoretical and technical aspects of these models.

Excerpt

UVA-BP-0528

A Technical Note on the Open-Economy IS/LM Model

Making reasoned judgments about the effects of global events or policy shocks on the economy is important for firms but is fraught with opportunities for logical missteps. The IS/LM Model is a tool for explaining key relationships in the economy while avoiding the missteps that often arise in macroeconomic analysis. The challenge of macroeconomic analysis is to coherently explain the interrelationships among a multitude of markets while respecting the complexity of those interrelationships and the behaviors that produce them. Microeconomics focuses on variables such as price and quantity in individual markets, while closed-economy macroeconomics seeks to explain movements in and relationships among aggregate variables such as national income, the real interest rate, and the level of unemployment and the rate of inflation. Open-economy macroeconomics adds to this by incorporating analysis of capital flows, international trade, and the most important international price, the exchange rate.

This technical note introduces the basic structure of what we will call the Three-Paned Model. The model is essentially just an “opening up” of the closed-economy IS/LM Model, with the main pane being the IS/LM Model (modified only slightly to allow for international trade) and two additional panes that determine the amount of capital inflows, net exports, and the exchange rate.

This note is not a substitute for the more in-depth presentation of these models found in textbooks, but should be used to complement each textbook's richer treatment of the theoretical and technical aspects of these models.

. . .

Keywords: Capital inflows, net exports, exchange rate

Suggested Citation

Warnock, Francis E., A Technical Note on the Open Economy IS/LM Model. Darden Case No. UVA-BP-0528, Available at SSRN: https://ssrn.com/abstract=1416558

Francis E. Warnock (Contact Author)

University of Virginia - Darden Business School ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-6076 (Phone)

HOME PAGE: http://faculty.darden.virginia.edu/warnockf/index.htm

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138-5398

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