The Traditional IS-LM Model Of The Open Economy

In the closed economy, the output is engaged in the domestic country and total expenditure is divided into three parts; consumption (C) investment (I) and government expenditure (G). In a simple notation,
Y=C+I+G (1)
Traditional IS-LM model explains the “General Theory of Keynes” in neo-classical terms considering economy under autarky or closed economy in the short term. The IS-LM model explains a combination of equilibrium in goods market and money market. Equilibrium in goods market is achieved when investment (I) equals saving (S) and is termed as IS.
IS = I+S (2)
On the other side, equilibrium in money market is achieved when demand for liquidity (L) equals the supply of money (M).
LM= L+M (3)
Two variables, output (Y) and interest rate (i) determines the equilibrium in these market. The basic assumptions of the IS-LM model are that all prices including wages in the economy are fixed and there is excess production capacity in the economy. In the short run, economy moves for the interaction of IS and

Robert Mundell and Marcus Fleming gave a model of open economy with an extension to the traditional IS-LM model Mundell-Fleming model basically deals with the output and the nominal exchange rate, while in traditional IS-LM model, relationship between rate of interest and output has been portrayed. According to Mundell-Flemming model, an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This problem is termed as “the Unholy Trinity” or “Impossible Trinity”. The balance of Payments (BOP) curve has been added to traditional IS-LM model and this model became IS-LM-BOP model. The BOP curve includes current account surplus (CA) and capital surplus (KA), hence the BOP is denoted