Chapter 3. Open Economy Macroeconomics Aggregate Demand: IS – LM Models Aggregate Supply: Fixed Prices, Flexible Prices and Sticky Prices

Derivation of IS Curve for AD Y = C + I + G + NX   Where; Y = real national income C = expenditure on consumption I = expenditure on investment G = net government purchases of goods and services NX = net exports (exports minus imports) If we subtract C, I, and NX from both sides, we get: S – I – NX = G

Real Exchange Rate by + zr = G0 + hQ0 Components of AD: by + zr – hQ = G0 by + zr = G0 + hQ0 by0 + zr0 = G0 + hQ0

The IS Curve

The LM Curve Definitions of Money M1 = currency in circulation + checkable deposits M2 = M1 + noncheckable savings deposits + MMDA + small time deposits + MMMFs M3 = M2 + large time deposits   MMDA = money market deposit accounts MMMF = money market mutual funds Near monies: M2 and M3 Small time deposits: less than 100,000 US$ in USA Large time deposits: 100,000 US$ or more in USA

Demand For Money Md = kY k > 0 Y = Py Md = k Py

Government Budget Constraint G – T = the budget deficit = total government spending G – T = MB + BS

Money Supply in an Open Economy FX + DC = (MB – MBb) + D FX + DC = MBp + D FX + DC = MS   Where: FX = gold and foreign currency reserves DC = domestic credit (L + LG) L: loans advanced to personal and corporate sector by commercial banks LG: lending to government by central bank MB = currency issued (monetary base) MBb = currency plus deposits with central bank MBp = currency in circulation D = deposits by public MS = money supply FX + DC = MS

The LM Curve

The LM Curve

Aggregate Demand IS curve : by + zr = G0 + hQ0 LM curve : k,l > 0

AD Curve

AS: Flexible Prices

AS: Fixed Prices

AS: Sticky Prices