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19-1 The IS Relation in an Open Economy
Chapter 19: The Goods Market in an 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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19-1 The IS Relation in an Open Economy
The Demand for Domestic Goods
In an open economy, the demand for domestic goods is given
by:
Chapter 19: The Goods Market in an Open Economy
Z  C  I  G  IM /   X
The first three terms—consumption, C, investment, I, and
government spending, G—constitute the domestic demand for
goods.
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 exports.
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19-1 The IS Relation in an Open Economy
The Determinants of C, I, and G
Chapter 19: The Goods Market in an Open Economy
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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19-1 The IS Relation in an Open Economy
The Determinants of Imports
Chapter 19: The Goods Market in an Open Economy
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,
increase in imports, IM.
 , leads to an
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19-1 The IS Relation in an Open Economy
The Determinants of Exports
Chapter 19: The Goods Market in an Open Economy
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,
decrease in exports.
 , leads to a
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19-1 The IS Relation in an Open Economy
Putting the Components Together
Chapter 19: The Goods Market in an Open Economy
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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19-1 The IS Relation in an Open Economy
Putting the Components Together
Chapter 19: The Goods Market in an Open Economy
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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19-1 The IS Relation in an Open Economy
Putting the Components Together
Chapter 19: The Goods Market in an Open Economy
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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19-2 Equilibrium Output and the
Trade Balance
Chapter 19: The Goods Market in an Open Economy
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  IM Y ,   /   X Y *,  
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19-2 Equilibrium Output and the
Trade Balance
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Increases in Domestic Demand
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Increases in Domestic Demand
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Increases in Foreign Demand
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Increases in Foreign Demand
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Fiscal Policy Revisited
Chapter 19: The Goods Market in an Open Economy
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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19-3 Increases in Demand, Domestic
or Foreign
Chapter 19: The Goods Market in an Open Economy
Fiscal Policy Revisited
The so-called G7 – 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 macrocoordination 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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19-4 Depreciation, the Trade Balance,
and Output
Chapter 19: The Goods Market in an Open Economy
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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19-4 Depreciation, the Trade Balance,
and Output
Depreciation and the Trade Balance:
The Marshall–Lerner Condition
NX  X (Y ,  )  IM (Y ,  ) / 
Chapter 19: The Goods Market in an Open Economy

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/e, increases.
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19-4 Depreciation, the Trade Balance,
and Output
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 (a decrease in )
leads to an increase in net exports.
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19-4 Depreciation, the Trade Balance,
and Output
Chapter 19: The Goods Market in an Open Economy
The Effects of a Depreciation
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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19-4 Depreciation, the Trade Balance,
and Output
Combining Exchange Rate and Fiscal Policies
Chapter 19: The Goods Market in an Open Economy
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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19-4 Depreciation, the Trade Balance,
and Output
Combining Exchange Rate and Fiscal Policies
Chapter 19: The Goods Market in an Open Economy
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
Initial Conditions
Exchange-Rate and Fiscal Policy
Combinations
Trade Surplus
Trade Deficit
Low output
?G
 G?
High output
G?
?G
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19-5 Looking at Dynamics: The J-Curve
Chapter 19: The Goods Market in an Open Economy
A depreciation may lead to an initial deterioration of
the trade balance;  increases, but neither X nor IM
adjusts very much initially.
Eventually, exports and imports respond, and
depreciation leads to an improvement of the trade
balance.
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19-5 Looking at Dynamics: The J-Curve
Figure 19 – 6
Chapter 19: The Goods Market in an Open Economy
The J-Curve
A real depreciation leads
initially to a deterioration and
then to an improvement of the
trade balance.
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19-5 Looking at Dynamics: The J-Curve
Chapter 19: The Goods Market in an Open Economy
Figure 19 – 7
The Real Exchange Rate
and the Ratio of the
Trade Deficit to GDP:
United States, 1980 to
1990
The real appreciation and
depreciation of the dollar in
the 1980s were reflected in
increasing and 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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Chapter 19: The Goods Market in an Open Economy
19-5 Looking at Dynamics: The J-Curve
Figure 19-7 plots the U.S. trade deficit against the
U.S. real exchange rate in the 1980s. Turning to the
trade deficit, which is expressed as a ratio to GDP,
two facts are clear:
1. Movements in the real exchange rate were
reflected in parallel movements in net
exports.
2. There were substantial lags in the response
of the trade balance to changes in the real
exchange rate.
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19-6 Saving, Investment, and the Trade
Balance
Chapter 19: The Goods Market in an Open Economy
The alternative way of looking at equilibrium from the
condition that investment equals saving has an important
meaning:
Y  C  I  G  IM /   X
Subtract C + T from both sides and use the fact that
private saving is given by S = Y – C – T to get
S  I  G  T  IM /   X
Use the definition of net exports, NX  X  IM/ , and
reorganize, to get:
NX  S  (T  G)  I
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19-6 Saving, Investment, and the Trade
Balance
NX  S  (T  G)  I
Chapter 19: The Goods Market in an Open Economy
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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The U.S. Trade Deficit: Origins and Implications
Chapter 19: The Goods Market in an Open Economy
Table 1
Average Annual Growth Rates in the United States,
the European Union, and Japan since 1991
(percent per year)
1991 to 1995
1996 to 2000
2001 to 2003
United States
2.5
4.1
3.4
European Union
2.1
2.6
1.6
Japan
1.5
1.5
1.6
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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. Net Saving and Net Investment since 1996 (percent of GDP)
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The U.S. Trade Deficit: Origins and Implications
Chapter 19: The Goods Market in an Open Economy
What Happens Next?
There are three implications:
 The U.S. trade and current account deficits will
decline in the future.
 This decline is unlikely to happen without a real
depreciation.
 Most likely, this depreciation will take place when
foreign investors become reluctant to lend to the
United States at the rate of $800 billion or so per
year.
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Key Terms
 demand for domestic goods
Chapter 19: The Goods Market in an Open Economy
 domestic demand for goods
 coordination, G-7
 Marshall-Lerner condition
 J-curve
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