Open-Economy National Income Accounting and the IS/LM Model

Abstract

When we introduce macroeconomic models, we assume that goods and services are exchanged within a single country but not across countries. This assumption is useful for understanding some of the primary determinants of output, inflation, and interest rates. In reality, however, economies trade with each other, and the presence of international markets has implications for national economies. In this note, we incorporate international markets to understand how changes in one country can affect other countries. Excerpt UVA-GEM-0128 Rev. Dec. 3, 2018 Open-Economy National Income Accounting and the IS/LM Model When we introduced macroeconomic models, we assumed that goods and services were exchanged within a single country but not across countries (i.e., net exports were assumed to be zero). This assumption is useful for understanding some of the primary determinants of output, inflation, and interest rates. In reality, however, economies trade with each other, and the presence of international markets has implications for national economies. This shows up most directly in the open-economy National Income Accounting Identity (Equation 1): where net exports (NX) are exports minus imports, or net sales of goods and services to foreigners. With more exports to other countries and fewer imports, GDP increases. In this note, we incorporate international markets to understand how changes in one country can affect other countries. Relative to closed-economy models, we expand the notion of GDP to account for net exports. But net exports depend on the exchange rate, which depends on international capital flows, which in turn depend on the interest rate, so adding net exports requires a somewhat more complicated model, the Three-Paned Model. . . .