Question

Consider an open economy with flexible exchange rates. Let IS stand for the product market equilibrium condition, LM for the financial market equilibrium condition, and IP for the interest parity condition. a.Write done the equations for IS, LM and IP curve

Answer 1

In an open economy model with flexible exchange rates, the relevant equations are -

Product market equilibrium (IS) -

Y = C(Yd) + I (i) + G + NX (Y, Y*, q)

Where Y is total domestic output, Yd is disposable income (Y-T), I is the investment that is dependent upon interest rate, G is government expenditure and NX is net export that is dependent upon domestic output (Y), foreign output (Y*) and real exchange rate (q).

The financial market equilibrium (LM) -

M/P = L(i,Y)

where M is nominal money supply, P is the price, L is money demand that is a function of interest rate and domestic output.

Interest rate parity equation -

i = if

Where the domestic interest rate is equal to the world interest rate (if).