Our next task is to develop an analytical framework – a model – that we can use to think about macroeconomic issues in emerging and developing economies. That will be our objective in Part 2, consisting of this chapter and the four that follow. We will use this model to identify the types of shocks that tend to disrupt short-run macroeconomic stability in those economies, to analyze how such shocks affect a broad range of macroeconomic variables, and to examine the set of instruments that policy makers can potentially deploy to ameliorate the effects of such shocks. We begin that task in this chapter and the next by developing a benchmark version of our model, that is, a simple version to which we will add bells and whistles later on. This chapter and the three that follow build a “short-run” version of this model, in the sense that it holds constant certain important macroeconomic variables that in the real world tend to change very slowly over time. We extend the model to a medium-run setting in Chapter 8 by studying how some of these slowly changing variables evolve over time.

The economy that we will begin describing in this chapter has certain features that are worth calling attention to at the outset. First, it is an open economy in the sense that it trades both goods and services as well as financial assets with the rest of the world.