Download The Goods Market in an Open Economy

The Goods Market
in an Open Economy
The IS Relation - 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
The Demand for Domestic Goods
The Determinants of C, I, and G
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.
The Demand for Domestic Goods
The Determinants of Imports
IM = IM(Y ,ε )
(  , )
 A higher real exchange rate makes foreign
goods relatively cheaper, leading to an
increase in the quantity of imports.
The Demand for Domestic Goods
The Determinants of Exports
X = X(Y ,ε )
*
(  , )
 An increase in Y*, or foreign output, leads to
higher U.S. exports. An increase in , the
value of domestic goods in terms of foreign
goods, also leads to an decrease in exports.
The Demand for Domestic Goods
The Demand for
Domestic Goods
and Net Exports
The Demand for Domestic Goods
Adding the amount of
exports to the domestic
demand for domestic
goods, AA, we obtain the
demand for domestic
goods, ZZ. The trade
balance is a decreasing
function of output.
YTB is the value of
output that corresponds
to a trade balance.
Equilibrium Output and the Trade Balance
The goods market is in
equilibrium when
production is equal to
the demand for
domestic goods. At
the equilibrium level of
output, the trade
balance may show a
deficit or a surplus.
Equilibrium
Y C I  G IM/ X
Increases in Domestic Demand
An increase in
government spending
leads to an increase in
output and to a trade
deficit.
The effect of government
spending in the open
economy is smaller—the
multiplier is smaller—than
it would be in a closed
economy.
Increases in Foreign Demand
An increase in foreign
demand leads to an
increase in output and to a
trade surplus.
The trade balance
improves because the
increase in imports does
not offset the increase in
exports.
Comparison between Foreign and
Domestic Increases in Demand


Increases in demand, both foreign and
domestic, lead to an increase in output.
However, they have opposite impacts on the
trade situation of the country.
An increase in foreign demand is preferred to
an increase in domestic demand because it
leads to an improvement in the trade
balance.
‘Games’ between Countries:
The Case of Fiscal Co-ordination


In times of recession, countries with
high trade deficits may wait for foreign
demand to stimulate the economy.
Coordination among countries, such
as among the G7, is an attempt to
adopt compatible macroeconomic
policies.
Depreciation and Trade Balance

The Marshall-Lerner condition is the
condition under which a real
depreciation (a decrease in ) leads to
an increase in net exports.
NX  X (Y , ) IM (Y , )/

EP
 *
P
Depreciation and Trade Balance
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 domestic goods in terms of
foreign goods decreases.

NX  X (Y , ) IM (Y , )/
Dynamics: The J-Curve


A depreciation may lead to an initial
deterioration of the trade balance; 
decreases, but neither X nor M adjusts very
much initially.
Eventually, exports and imports respond, and
depreciation leads to an improvement of the
trade balance.
Dynamics: The J-Curve
The J-Curve
A real depreciation
leads initially to a
deterioration, then to
an improvement of
the trade balance.
The Effects of a Depreciation
The Effects of a
Depreciation
A real depreciation leads
to an increase in output
and an improvement in
the trade balance.
A depreciation works by
making foreign goods
relatively more expensive.
Combining Exchange-Rate and
Fiscal Policies
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.
A depreciation will increase
output, while reduced
government spending will
decrease output.
The RER and the Trade Balance (U.S.)
Saving, Investment,
and the Trade Balance

The alternative way of looking at
equilibrium from the condition that
investment equals saving has an
important meaning:
NX  S  (T  G)  I
Saving in the U.S.
Saving, Investment, and the Trade Balance
NX  S  (T  G)  I



A trade surplus must correspond to an
excess of saving over investment, and vice
versa.
If saving remains constant, an increase in
investment results in a deterioration of the
trade balance.
An increase in the budget deficit leads to a
deterioration of the trade balance.