A Brief Note on Open Economy ISLM Model (Three-Paned Model)
Utility for Business Managers: Firms resort to macroeconomic analysis to make rational judgments about the effects of global events or policy shocks on the economy and thereby on the business environment. But such analysis is often laden with possibilities for logical missteps. The Three- Pane model (open economy IS/LM model) is discussed here as a tool for explaining key relationships in the economy while avoiding the missteps encountered in macroeconomic analysis. What is open economy macroeconomics?
Macroeconomic analysis helps firms to explore the interrelationships among a whole host of markets, while microeconomics focuses on variables like price and quantity, & cost and revenue in individual markets. Macroeconomic analysis can be closed-economy or open -economy. Closed-economy macroeconomics deals with movements in and relationships among aggregate variables such as National Income, rate of interest, the aggregate price level, rate of inflation etc. Open economy macroeconomics makes the analysis complete by adding analysis of capital flows, international trade and exchange rate. The objective of this note is to introduce the Three-paned or Open-economy IS/LM model. As we will see, this model is an extension of the simple closed-economy IS/LM model.
A Little Bit of History: The IS/LM closed economy model was introduced by the British Economist, Sir John Hicks in 1937. The IS/LM model denotes the simultaneous equilibrium of the two key markets in a market economy, product (real) market and the money market. IS represents real/product market equilibrium and LM, money market equilibrium. IS refers to the fundamental relationship between Investment (I) and Saving(S). LM represents the relationship between L, the demand for money, and M, the supply of money. The open economy version of IS/LM is credited to two economists, Robert Mundell & Marcus Fleming and hence called the Mundell-Fleming model. The three-paned model we are discussing here is pretty close to the Mundell-Fleming model. This model is best suited for discussing short-to-medium term changes in the economy, i.e., changes over a few years. The Three-Paned Model [Large Open Economy IS/LM Model].
The model as presented in the below diagram has three panes with one graph in each pane. (1) Pane I depicts the IS/LM model [product & money market]. Point ‘e’ in the first graph represents the equilibrium rate of interest and the corresponding level of output/income at which, both the product and money markets are in simultaneous equilibrium. (2) Pane II [capital outflow schedule] shows Net Capital Outflow as a function of the rate of interest. Net Capital Outflow (CF) is defined as the difference between Capital Outflows and Capital Inflows. (3) In Pane III, we have the foreign exchange market, where the exchange rate, E is determined by the capital outflow schedule in Pane two and net export schedule ( NX). NX is the difference between Exports and Imports.
PANE I PANE II
PANE III Diagram showing the Three-Paned Open-Economy IS/LM Model
Explaining the working of the Three-paned Model:
Now let us see how the three-paned model works. We begin from point ‘e’, the initial equilibrium, in the ISLM model. Point e represents the simultaneous equilibrium of the product and money markets at an equilibrium rate of interest, ’ r’, and ‘ Y ‘ level of income/output. To determine the equilibrium in the capital outflow schedule, the equilibrium rate of interest, r, is brought over from the first pane to determine the equilibrium amount of net capital outflows. When the rate of interest is r, equilibrium CF in the economy is given by CFo. Suppose the RBI hikes the rate of interest from r to r1. If r* remains...
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