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# IS relation in an open economy (Textbook: Macroeconomics by Olivier Blanchard)

Wed 12 Mar, 2014 04:26 pm
Hello everyone!
I am newbie here and I am not sure if I am writing in Macroeconomics forum! I have a question regarding Macroeconomics concept! Here it is!

In the textbook of Macroeconomics by Olivier Blanchard, in the chapter relating to The Goods Market in An Open Economy, it introduce the extended version of IS relation which is Y = Z = C(Y-T)+I(Y,r)+G-IM/e+X
Everything is clear but I cannot understand why imports (IM) should be divided by "REAL EXCHANGE RATE (e)" instead of "Nominal Exchange Rate (E)"?
Don't we want to derive the value of the GDP from this formula? If so, don't we want to have our value in terms of domestic currency? And again if it is the case, why we just don't multiply the imported goods with their foreign price and then divide it by the nominal exchange rate which is the currencies exchange rate? How dividing the value of the total imported goods by the real exchange rate is going to help us??

I am totally confused here and within a week I have to do the exam! I can simply accept this fact as given and have my mark but I really want to understand the implication here. I would be more than appreciate for your help!

Behnam
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Thomas

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Wed 12 Mar, 2014 04:53 pm
@Behnam,
In Blanchard's terminology, how do the real exchange rate and the nominal exchange rate relate to one another? My guess is that Blanchard's Y, T, etc, are all "real" figures in the sense that they're corrected for inflation. If so, it would make sense for e to be the exchange rate, corrected for the "inflation" of domestic currency relative to foreign currency, i.e., for changes in the exchange rate. Does that make sense?
Behnam

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Wed 12 Mar, 2014 05:04 pm
@Thomas,
First of all, many thanks for the reply.

Actually the only variable in this relation which is corrected for inflation is "r" which is within the investment function "I". All the other variables are nominal. In Blanchard's terminology the "nominal exchange rate" or "E" is the relative price of domestic currency in terms of foreign currency, which is the common exchange rate which all of us are familiar with. Instead, the "real exchange rate" or "e" (epsilon in greek alphabet), is the relative price of domestic goods in terms of foreign goods and it's formula is: e = EP/P*
Where:
e = real exchange rate
E = nominal exchange rate
P = domestic price level (domestic GDP deflator)
p* = foreign price level (foreign GDP deflator)
Thomas

1
Wed 12 Mar, 2014 06:56 pm
@Behnam,
But that makes sense, too. Overall, GDP measures the value of goods consumed by domestic buyers, measured in domestic currency. The imports component, ie, the value of foreign goods consumed by domestic buyers, then, has to be the amount of foreign currency purchased by domestic buyers, times the value of foreign goods per unit of foreign currency. (Multiply the two. The amount of foreign currency cancels out, and you'll see the identity.)
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