Model of a Large Open Economy

Abstract

The theoretical construct presented in this chapter contains the five domestic decision-making units analyzed in Chapters 7–12 plus a foreign sector. Four of the five domestic sectors interact with the foreign sector through the product and financial markets. The domestic household and government sectors purchase not only domestically-produced consumption and capital goods but also foreign-produced commodities. The private nonfinancial business sector also imports commodities from the foreign sector. Domestic private depository institutions, domestic nonfinancial businesses and the domestic government sector carry out transactions involving foreign exchange. They also hold deposits denominated in foreign exchange at foreign depository institutions. The “rest-of-the-world” or foreign sector holds checkable deposits denominated in the domestic currency at domestic private depositiory institutions. The foreign sector also holds bonds issued by domestic borrowers and buys goods produced by domestic firms. Domestic private depository institutions hold both domestic and foreign bonds. The only domestic decision-making unit not engaging in transactions with the foreign sector is the central bank. It continues to deal only with domestic private depository institutions. Furthermore, no foreign firm or worker attempts to buy or sell labor in the domestic economy and no domestic firm or national enters the foreign labor market. Foreign commodity prices, foreign bond prices and interest rates on checkable deposits at foreign banks are treated as exogenous.