Simple open economy macro with comprehensive accounting: a two country model

Abstract

This paper presents a stock flow model of two economies (together comprising the whole world) which trade goods and financial assets with one another. The accounting framework, though comprehensive in its own terms, is very much simplified so as to reach the main conclusions as simply and easily as possible. The first part of the paper describes a single-economy on a fixed exchange rate, with no private capital flows, in order to obtain simple analytic solutions which display the basic constraints and forces at work. The second part describes a flexible exchange rate model, with two economies trading financial assets as well as merchandise. A final section adapts the two country model to describe a fixed exchange rate regime. In all models interest rates are exogenous and the money supply is (found to be) endogenous.