Download The Demand for Domestic Goods and Net Exports

CHAPTER 19
CHAPTER19
The Goods Market
in an Open
Economy
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
Chapter 19: The Goods Market in an
Open Economy
19-1
The IS Relation in
the Open Economy
Now we must be able to distinguish between the
domestic demand for goods and the demand for
domestic goods.
Some domestic demand falls on foreign goods,
and some of the demand for domestic goods
comes from foreigners.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Demand for Domestic Goods
In an open economy, the demand for domestic
goods is given by:
Z C I  G IM/ X
Until now, we have only looked at C + I + G. But
now we have to make two adjustments:
 First, we must subtract imports.
 Second, we must add imports.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Determinants of C, I, and G
Domestic Demand:
C  I  G  C(Y  T )  I (Y , r )  G
( )
(  , )
The real exchange rate affects the composition
of consumption and investment, but not the
overall level of these aggregates.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Determinants of Imports
A higher real exchange rate leads to higher
imports, thus:
IM  IM (Y ,  )
(  , )
 An increase in domestic income, Y, leads to
an increase in imports.
 An increase in the real exchange rate, ,
leads to an increase in imports, IM.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Determinants of Exports
Let Y* denote foreign income, thus for exports
we write:
X  X (Y * ,  )
(  , )
 An increase in foreign income, Y*, leads to an
increase in exports.
 An increase in the real exchange rate, ,
leads to a decrease in exports.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Putting the Components Together
Figure 19 - 1
The Demand for
Domestic Goods and
Net Exports
The domestic demand
for goods is an
increasing function of
income (output). (Panel
a) The demand for
domestic goods is
obtained by subtracting
the value of imports from
domestic demand, and
then adding exports.
(Panel b)
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Demand for Domestic Goods
Figure 19 - 1
The Demand for
Domestic Goods and
Net Exports
The demand for
domestic goods is
obtained by subtracting
the value of imports from
domestic demand, and
then adding exports.
(Panel c) The trade
balance is a decreasing
function of output.
(Panel d)
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The Demand for Domestic Goods
We can establish two facts about line AA, which
will be useful later in the chapter:
 AA is flatter than DD. As income increases,
the domestic demand for domestic goods
increases less than total domestic demand.
 As long as some of the additional demand
falls on domestic goods, AA has a positive
slope.
YTB is the value of output that corresponds to a
trade balance.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
19-2
Equilibrium Output
and the Trade Balance
The goods market is in equilibrium when
domestic output equals the demand – both
domestic and foreign – for domestic goods:
Y Z
Collecting the relations we derived for the
components of the demand for domestic goods,
Z, we get:
Y  C(Y  T )  I (Y , r )  G  M (Y ,  )  X (Y ,  )
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Chapter 19: The Goods Market in an
Open Economy
Equilibrium Output
and the Trade Balance
Figure 19 - 2
Equilibrium Output and
Net Exports
The goods market is in
equilibrium when
domestic output is equal
to the demand for
domestic goods. At the
equilibrium level of
output, the trade balance
may show a deficit or a
surplus.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
19-3
Increases in Demand,
Domestic or Foreign
Figure 19 - 3
The Effects of an
Increase in Government
Spending
An increase in
government spending
leads to an increase in
output and to a trade
deficit.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Increases in Demand,
Domestic or Foreign
There are two important difference you should
note between open and closed economies:
 There is now an effect on the trade balance.
The increase in output from Y to Y’ leads to a
trade deficit equal to BC. Imports go up, and
exports do not change.
 Government spending on output is smaller
than it would be in a closed economy. This
means the multiplier is smaller in the open
economy.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Increases in Foreign Demand
Figure 19 - 4
The Effects of an
Increase in Foreign
Demand
An increase in foreign
demand leads to an
increase in output and to
a trade surplus.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Increases in Foreign Demand
The direct effect of the increase in foreign output
is an increase in U.S. exports by some amount,
which we shall denote by  X :
 For a given level of output, this increase in
exports leads to an increase in the demand
for U.S. goods by  X , so the line shifts by  X
from ZZ to ZZ’.
 For a given level of output, net exports go up
by  X . So the line showing net exports as a
function of output in Panel (b) also shifts up
by  X , from NX to NX’.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Fiscal Policy Revisited
We have derived two basic results so far:
 An increase in domestic demand leads to an
increase in domestic output, but leads also to
a deterioration of the trade balance.
 An increase in foreign demand leads to an
increase in domestic output and an
improvement in the trade balance.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Fiscal Policy Revisited
The so-called G-7 – the seven major countries of
the world – meet regularly to discuss their
economic situation; the communiqué at the end
of the meeting rarely fails to mention
coordination. The fact is that there is very
limited macro-coordination among countries.
Here’s why:
 Some countries might have to do more
than others and may not want to do so.
 Countries have a strong incentive to
promise to coordinate, and then not
deliver on that promise.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
19-4
Depreciation, the Trade
Balance, and Output
Recall that the real exchange rate is given by :
EP
 *
P
In words:
The real exchange rate,
, is equal to the
nominal exchange rate, E, times the domestic
price level, P, divided by the foreign price level,
P*.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Depreciation and the Trade Balance:
The Marshall-Lerner Condition
NX  X (Y  , ) IM (Y , )/

As the real exchange rate enters the right side
of the equation in three places, this makes it clear
that the real depreciation affects the trade
balance through three separate channels:
 Exports, X, increase.
 Imports, IM, decrease
 The relative price of foreign goods in terms of
domestic goods, 1/ , increases.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Depreciation and the Trade Balance:
The Marshall-Lerner Condition
The Marshall-Lerner condition is the condition
under which a real depreciation (an increase in )
leads to an increase in net exports.
The French Socialist Expansion:
1981-1983
Table 1
Table 1 summarizes the
macroeconomic results of the
policy of the Socialist party in
the early 1980s geared at
improving the economy.
© 2006 Prentice Hall Business Publishing
Macroeconomic Aggregates,
France: 1980-1983
1980
1981
1982
1983
GDP growth (%)
1.6
1.2
2.5
0.7
EU growth (%)
1.4
0.2
0.7
1.6
Budget Surplus
0.0
-1.9
-2.8
-3.2
Current Account
Surplus
-0.6
-0.8
-2.2
-0.9
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Chapter 19: The Goods Market in an
Open Economy
The Effects of a Depreciation
Figure 19 – 4 again
Let’s summarize: The
depreciation leads to a
shift in demand, both
foreign and domestic,
toward domestic
goods. This shift in
demand leads, in turn,
to both an increase in
domestic output and
an improvement in the
trade balance.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Combining Exchange-Rate
and Fiscal Policies
Figure 19 - 5
Reducing the Trade
Deficit Without Changing
Output
To reduce the trade deficit
without changing output,
the government must both
achieve a depreciation and
decrease government
spending.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Combining Exchange-Rate
and Fiscal Policies
If the government wants to eliminate the trade
deficit without changing output, it must do two
things:
 It must achieve a depreciation sufficient to
eliminate the trade deficit at the initial level of
output.
 The government must reduce government
spending.
Table 19-1
Exchange-Rate and
Fiscal Policy
Combinations
Initial Conditions
Trade
Surplus
Low output
?G
 G?
High output
G?
?G
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Trade Deficit
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
19-5
Looking at Dynamics:
The J-Curve
A depreciation may lead to an initial deterioration
of the trade balance;  increases, but neither X
nor M adjusts very much initially.
   ( X   IM ) 
Eventually, exports and imports respond, and
depreciation leads to an improvement of the
trade balance.
( X  , IM  ,   )  ( X  IM ) 
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Looking at Dynamics:
The J-Curve
Figure 19 - 6
The J-Curve
A real depreciation leads
initially to a deterioration,
then to an improvement
of the trade balance.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The U.S. Trade Deficit:
Origins and Implications
Figure 1
U.S. Exports and
Imports as Ratios to
U.S. GDP since 1990
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The U.S. Trade Deficit:
Origins and Implications
Table 1
Average Annual Growth Rates in the United States, Japan,
the European Union, and the World, 1991-2003 (percent per
Year)
1991-1995
1996-2000
2001-2003
United States
2.5
4.1
2.9
Japan
1.5
1.5
0.9
European Union
2.1
2.6
1.9
World (excluding U.S.)
3.2
2.8
1.5
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
The U.S. Trade Deficit:
Origins and Implications
Figure 2
The Multilateral Real
Exchange Rate since
1990
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Looking at Dynamics:
The J-Curve
Figure 19 - 7
The Real Exchange Rate
and the Ratio of Net
Exports to GDP: United
States, 1980-1990
The real appreciation and
the depreciation of the
dollar in the 1980s were
reflected in increasing,
then decreasing trade
deficits. There were,
however, substantial lags
in the effects of the real
exchange rate on the
trade balance.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
19-6
Saving, Investment,
and the Trade Balance
The alternative way of looking at equilibrium from
the condition that investment equals saving has
an important meaning:
Y C I  G IM/ X
S  Y  C T
S I  G T IM/ X
NX  X  IM/
NX  S (T G) I
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Saving, Investment,
and the Trade Balance
NX  S (T G) I
From the equation above, we conclude:
 An increase in investment must be reflected
in either an increase in private saving or
public saving, or in a deterioration of the trade
balance.
 An increase in the budget deficit must be
reflected in an increase in either private
saving, or a decrease in investment, or a
deterioration of the trade balance.
 A country with a high saving rate must have
either a high investment rate or a large trade
surplus.
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Olivier Blanchard
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Chapter 19: The Goods Market in an
Open Economy
Key Terms
 demand for domestic goods
 domestic demand for goods
 coordination, G-7
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 Marshall-Lerner condition
 J-curve
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