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

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    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!

    Thanks in advance!
    Behnam
  • Liberal Democrat
    Democrat
    Colorado Springs, CO
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    We don't have many macroeconomic experts on this website, although you'll find some people that will give you a best opinion. However, we do have an expert, Carlitos Bam Bam, on one facet of macroeconomics, Modern Monetary Theory, and if he is reading your post, I'm sure he will comment.
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    Many thanks for getting back to me. I am looking forward and appreciate any comment...
  • Liberal Democrat
    Democrat
    Colorado Springs, CO
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    Again, I'm not qualified to comment, but I did do some browsing. I'll extract a paragraph from this Economic Times article:

    The Economic Times, January 27, 2003: What exactly are nominal & real exchange rates?

    "To incorporate the purchasing power and competitiveness aspect and, therefore, make the measure more meaningful, real exchange rates are used. The real exchange rates are nothing but the nominal exchange rates multiplied by the price indices of the two countries. This means the market price level of goods and services, given by indices of inflation. So if the price level in the US is higher than the price level in India, then the real exchange rate of the rupee versus the dollar will be greater than the nominal exchange rate. Suppose the nominal exchange rate is Rs 50 and US prices are greater than Indian prices, a dollar will buy more in India than what Rs 50 will buy in the US. So the real rupee-dollar exchange rate is greater than the nominal rate. If the real exchange rate is calculated using the price levels of common traded goods, then it gives a measure of export competitiveness. For example, if both the US and India manufacture the same (or highly comparable) pharmaceutical drug, and Indian drug prices are lower than US prices, then the exchange rate in terms of drugs is favourable to India. This can be generalized to all the goods manufactured by the two economies that compete in the export market. If the real rupee-dollar exchange rate based on export-competing goods depreciates, then Indian exports enjoy an enhanced pricing advantage over US goods. The converse is true for a real appreciation."
  • Strongly Liberal Democrat
    Democrat
    Dallas, TX
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    I think you answered it Schmidt. To put it very simply, using GDP is like an alternative way of constructing the Investment-Savings (IS) curve in an "open economy." There's a lot I don't know about the history of how and why they came to these conclusions.

    By dividing imports by the real exchange rate, they are saying that a rise in the real exchange rate means more net-exports.

    But I would suggest caution with anything the model implies, as it observably gets it wrong and the very person who came up with the IS/LM equation repudiated it.

    "IS/LM: an Explanation" by John Hicks

    you can download the pdf from this page here.
  • Center Left
    Independent
    Central, FL
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    Schmidt and Carlitos,
    It was very cool that you attempted to help the kid. Hopefully it puts him onto the right path of understanding. I would have thought he should have asked a professor or teachers aide. The professor earns a pay check for that. Your knowledge is an asset for this site.