Although there are only three variables, these three variables as will
be shown when we go over the data, are essentially variables that are
determining level of Croatian GDP. Import as a value is inversely
correlated with the nominal and real exchange rate and positively cor-
related with the GDP. Thus as the currency is appreciating (the ex-
change rate is going up, for one Kuna we can get more of the foreign
currency) the level of imports will rise. Although the nominal ex-
change rate is stable in Croatia, the real exchange rate has been appre-
ciating considerable, thus causing constant increase in the level of im-
ports. The third variable, GDP, has standard explanation. As the level
of GDP is increasing, the purchasing power of the average citizen is
rising and so is the demand for imports.
IM= È(y) + im°(E/P) ± æ(CM, E/P)
È(y) is the consumption of imports that depends on the current
level of real GDP, there is also an autonomous level of imports
im°. im° depends on the medium and the long run oscilations in
the real exchange rate. This part exists because our small econ-
omy is not self-sufficient and it depends on the long term
changes in the real exchange rate. The last part will be equal to 0
for the equilibrium IS-LM-CM. It will be positive when r
d
> r
w
the reason for this is the artificial boom caused by the influx of
investments and it will be negative when r
d
< r
w.
In this case an
outflow of capital will cause recession.
2.5 EXPORT FUNCTION
The export function follows standard Keynesian principles and it is
dependent on the nominal, real exchange rates and the level of foreign
demand for Croatian exports.
EX (E, E/P, A*)
Where A* is the level of foreign demand for the Croatian goods. Al-
though A* is a very significant and interesting variable for the model
and for the study of a small open economy, in this particular case I
will not take it into consideration and will assume that A* is constant
in the medium run. The reason for that is that in the time period that I
am studying (1995-2001) the level of foreign demand did not change
much. In general, this time period has been very prosperous periods in
the history of the world. Both USA and Europe (where most of the
Croatian exports and going) enjoyed very high levels of prosperity
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and stability due to the supply shock caused by the technological im-
provements. Due to these facts, I will assume that the level of foreign
demand has been constant and high through the period for which I am
going analyze the data.
There might be some objections to these assumptions. They may arise
from the fact that Croatia was in war and the some of the business re-
lations have been lost due to the change in the political and economi-
cal climate in Croatia. Alas that is not an excuse that after the war was
completely over in 1995 the new business connections were not made
or that some positive effects from the above mentioned technological
supply shock were not used and spilled over as a benefit for a Cro-
atian producers.
The function for the exports looks just like the function for imports
EX= A*(y*) + ex°(E/P) ± æ(CM, E/P)
2.6 IS-LM RELATIONSHIP
The derivation of the IS and LM curves will be based on their stan-
dard derivations that can be used to derive the curves for a closed
economy.
In a closed economy the goods produced are separated between three
sectors
(1)
y = c + g + s
So the agents can use their income in three ways. They can consume
it, pay taxes and let government spent it and save it.
As for the expenditures, we can denote expenditure function in the
following way
(2)
e= c + g + i
In a closed economy, the agents will have three sources for expendi-
ture. They can consume the goods they have produced. The govern-
ment will spent all of t that it has collected from the consumers and
the rest of the income can be invested in capital accumulation. In a
closed economy, the equations (1) and (2) have to be equal because
there is no influx or outflow of the goods and/or services. In the open
economy, this does not hold. The formula for the aggregate expendi-
ture and aggregate production will look like this
(1’) y = c + s + g + (ex-im)
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NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
We have to augument the equation (1) for the open market. Same has
to be done with the equation (2) which will give us
(2’) e= c + g + i + f – d
The equation (2’) has been augmented and now we have that the
agents in the economy can spend goods, give it to government, invest
it domestically or invest it into foreign assets (f), but at the same time
the foreigners can come in and invest in domestic assets (d)
If we combine the equations (1) and (2) we get that i=s. This relation-
ship can be used to combine (1’) and (2’), so that we get
(a) ex – im = f – d
The result is very interesting. When the economy is running a current
account surplus, it is effectively investing abroad into the foreign as-
sets. On the other hand, if the economy is running a current account
deficit it is effectively borrowing from abroad. The equation a is a
medium and long run equilibrium, but in the short run the equation a
can be in a disequilibrium while the capital inflow or outflow adjust
to the IS-LM-CM equilibrium.
We shall assume that the government spending is always in equilib-
rium, which is g = t + v, where t is the amount of taxes collected and v
is the variable government deficit or surplus. We shall denote auton-
omous government spending as g°. The issues of changes in govern-
ment spending shall be discussed latter.
Here is the quick review of the model so far
(3) y= c + s + g + (ex – im)
(4) e = c + I + g + (f – d)
(5) c = c°(-r,y) + A + c(y,- r, -E/P, W/P)
A= z + (y, E/P)
(6) I = i(-r)° + i(CM) – iA*(CM, E/P) = i° + p
(7) im = c(y) + im° ±æ(CM, E/P) = im° + m
(8) ex = ex°(E/P) + A*(y*) ± æ (CM, E/P) = ex° + x
(9) g= g°
we can combine the equations (3) and (5-9). We plug equations
(5)-(9) into the equation (3) and we get
(10) y= c°(-r,y) + c(y,-r, -E/P, W/P) + i°(-r) + g° + im° + ex° + [ A + p
+ m + x]
400
NEVEN VIDAKOVIÆ: Application of the Mundell-Fleming on Small Open Economy
EKONOMIJA / ECONOMICS, 11 (3) str. 392 - 423 (2005)
www.rifin.com
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