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The Open Economy Extending the basic Keynesian model to the open economy involves modelin o kinds of international connections. I We must brin exports (exports minus imports) into aggregate demand. I We must take account of international flows of borrowing and lending. Both the flow of goods and the flow of capital between economies are often constrained. For simplicity, consider the rest of the world as a single country. e is nominal exchange rate. ε = eP∗ , the real exchange rate, the price of foreign goods in units of P domestic goods The higher is the real exchange rate, the more expensive foreign goods are relative to domestic ones, so the more lined both foreign and domestic buyers are to buy domestic goods. Goods Market: Y = E (Y, r, G, T, ε), Eε 0 Money Market: MP curve is unaffected. We had one more market: foreign-exchange market. Different Assumptions Exchange-rate regime: floating or fixed Capital mobility: perfect or imperfect Exchange-rate expectation: static or rational Foreign-Exchange Market I Investors are risk-neutral and there is no barriers to capital mobility. I Investors do not expect the real exchange rate to change. I Both types of assets must be held by someone. These three assumptions imply that r = r ∗ Goods Market: Y = E (Y, r, G, T, ε) Money Market: r = r (Y, π) Foreign-Exchange Market: r = r ∗ MP* curve is vertical, output for a given inflation rate, or the position of the AD curve, is determined entirely by m ary . Suppose G rise, IS* shifts to the right, which leads to the appreciation of the exchange rate ⇒has not effect on output in (Y, ε) Let’sthink about it in (Y, r ) space. r MP r’