The IS Curve for an Open economy

The IS Curve for an Open economy

In introduction to Economics, we covered the open economy.
We saw that in an open economy, planned expenditure is now
C + I + G + X –M. (X-M) or net exports (NX) is affected by the
domestic country’s income (Y), income in the foreign country (Y*)
as well as the real exchange rate (EP*/P).

When plotted against income, the NX curve is negatively sloped. Why?

Fixed exchange rate system

In a fixed exchange rate system, as long as the central bank has the necessary reserves, it can continue to intervene in the foreign exchange market. Persistent BOP deficit means that the central bank will run dry of foreign currency reserves but before reaching such a point the central bank will have to decide that it can no longer maintain the exchange rate and it will have to devalue its currency.

Fixed exchange rate system

In a fixed exchange rate system, however, the central bank intervenes in the foreign exchange market to buy and sell foreign currency as it is committed to maintaining the country’s exchange rate at a particular level. A balance of payment surplus (an of excess supply of foreign currency) will see the central bankintervening and buying foreign currency.

As domestic currency is exchanged for foreign currency, there is now more currency in circulation hence increasing the money supply in the country. On the other hand, a balance of payment deficit (an excess demand for foreign currency) will see the central bank selling foreign currency in exchange for domestic currency. This reduces the amount of money in circulation and therefore the money supply in the country

Exchange Rate Systems

The two types of foreign exchange system we are looking
at are the fixed and the flexible exchange rate system. The nominal
exchange rate is the price of the domestic currency against the
foreign currency.

In a flexible exchange rate system, the exchange rate is allowed to
adjust to equate the demand for and supply of foreign currency.
Market forces therefore determine the exchange rate. In a clean
float, the exchange rate will adjust to make the current and capital
account sum up to zero. A BOP surplus will result in an
appreciation of the domestic currency i.e. a decrease in the nominal
exchange rate E, while a BOP deficit will result in a depreciation of
the domestic currency i.e. an increase in the nominal exchange rate,
E.

Capital Account

Note: The capital account is divided into two parts (i) the transactions of the private sector; and (ii) official reserves transactions, which corresponds to the central bank’s activities. Hence, a current account deficit can be financed by the private sector selling off their assets abroad or by borrowing abroad.

If this is insufficient, the current account deficit can also be financed by a rundown of the government’s foreign exchange reserves; and vice versa. A country having an overall BOP surplus will see an increase in its official reserves while a country having a BOP deficit will see a rundown of its official reserves.

Balance of Payment

The BOP is a systematic record of the transactions between
the residents of the country with the rest of the world. The two
main accounts in the BOP are the current account and the capital
account. The current account records international transactions in
goods and services, including transfers while the capital account
record international transactions in real and financial assets.

A nation, like individuals and firms must pay for what they buy
from abroad. Hence, if the current account is in deficit this needs to
be financed by selling assets or by borrowing abroad. Therefore
any deficit in the current account is financed by an offsetting
capital inflow or a surplus in the capital account, and vice versa i.e

Current Account + Capital Account = 0

Insight

Insight

When we look at the open economy we will need to look at not only trade in goods and services but also assets. These international transactions between the domestic country and the rest of the world are recorded in the balance of payments.

We therefore need to take a brief look at the balance of payments. In addition, since we are looking at international transactions we will also need to take a look at the exchange rate system a country is on.