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Chapter Fourteen The Market for Goods and Services in an Open Economy © 2003 South-Western/Thomson Learning Chapter Fourteen Outline 1. Introduction 2. What’s in the Balance-of-Payments Accounts? 3. What Are the Balance-of-Payments Surpluses and Deficits? 4. What’s the Connection? The Balance-ofPayments and Foreign Exchange Market 2 Introduction • Our continuing examination of the international macroeconomy will focus on three key markets: 1. That for domestically produced goods and services (the subject of this chapter); 2. Money markets (to be discussed in Chapter 15); and 3. The foreign exchange markets (Chapter 15). 3 How Do We Measure a Country’s Output? • Gross National Product (GNP) and Gross Domestic Product (GDP): – Both measure the sum of the market values of all final goods and services produced by the economy in a given period (typically a year, although the government reports figures quarterly). • GNP refers to output produced by a country’s factors of production – regardless of where in the world the production takes place. • GDP refers to output produced within a country’s geographical boundaries – regardless of the resources’ nationality. 4 How Do We Measure a Country’s Output? • Several features of these definitions deserve note: – GNP and GDP exclude most goods and services not transacted through markets. 1. Both fail to reflect items such as home-grown food and housekeeping by family members. 2. Calculation of GNP and GDP involves adding the values of all goods and services produced in the economy, evaluated at market prices. 3. GNP and GDP include only production of final goods and services, not intermediate ones. 4. GNP and GDP refer to production within a specified period. 5 What Determines Output and income in an Open Economy? • National income – Equal to GDP – Sum of the total income of households in a country’s economy. • Consumption expenditure (C) – Spending by a country’s individuals on goods and services. • Depends on income; represented by C(Y+), where the plus sign indicates the positive relationship between consumption and income. • Investment expenditure (I) – Those goods and services retained by a country’s firms to use to produce next year’s output. • Examples: machine tools or computers. 6 What Determines Output and income in an Open Economy? • Government purchases (G) – Spending by local, state, and federal governments on goods and services. • Exclude government spending that simply transfers income between groups within the economy (like public assistance benefits) • Export expenditures (X) – Spending by foreigners on the domestic economy’s output. • Import expenditures (imp) – Purchases of foreign-produced goods. 7 What Determines Output and income in an Open Economy? • Total expenditures (E) E = C + I + G + X - imp Also, GDP = Y = C + I + G + X – imp • Marginal propensity to consume (mpc) – Share of the increase in income consumed, a fraction between 0 and 1. • Relative price (R), also known as real exchange rate, of domestically produced goods and services in terms of the domestic price level (P) and foreign-currency price (P*) is: R = P/eP* 8 What Determines Output and income in an Open Economy? • Marginal propensity to import (mpi) – Share of any rise in income that goes to increased imports. • Figure 14.1 graphically depicts the relationship between national income and total expenditure on the economy’s output of goods and services. – Total expenditure includes consumption, investment, government purchases, and the current account or net exports. • Income affects consumption and imports by the marginal propensity to consume and import, respectively. 9 Figure 14.1a, b: Expenditure on Domestically Produced Goods & Services Depends on Income C Slope = C/ Y + = mpc C(Y) I I(i) 0 Y (a) Consumption Expenditure 0 Y (b) Investment Expenditure 10 Figure 14.1c, d: Expenditure on Domestically Produced Goods & Services Depends on Income G X _ + X (Y*, R) G O Y (c) Government Purchases O Y (d) Expenditure on Exports 11 Figure 14.1e, f: Expenditure on Domestically Produced Goods & Services Depends on Income E E = C + I + G + X – imp imp Slope = mpc– mpi Slope = imp / Y = mpi + + imp(Y, R) O Y (e) Expenditure on Imports O Y (f) Total Expenditure 12 What Determines Output and income in an Open Economy? • Figure 14.2 shows that equilibrium in the market for domestically-produced goods and services requires that national income (GDP) equal total expenditures. – The market for goods and services is in equilibrium at Y0. • At incomes below Y0, expenditure exceeds income, inventories decline, production increases, and income rises. • At incomes above Y0, income exceeds expenditure, inventories accumulate, production decreases, and income falls. See Figure 14.2 13 Figure 14.2: Equilibrium in the Market for Domestically Produced Goods and Services E Y>E E=C+I+G + X – imp Y<E 45o 0 Y1 Y0 Y2 Y 14 How Does International Trade Affect the Market for Goods and Services? • The relationship between national income and the current account is an interactive one. – This interaction is seen in Figure 14.3. • The net effect of an increase in exports (caused in Fig. 14.3 by an increase in foreign income) on the current account is smaller than the original increase in exports. – Domestic income rises, producing a partially offsetting increase in imports. See Figure 14.3 15 Figure 14.3: The Current Account and National Income X, imp imp(Y, R) Current-account deficit * X(Y , R) Currentaccount surplus 0 Yca Y 16 How Does International Trade Affect the Market for Goods and Services? • Figure 14.4 depicts the interaction between changes in the current account and changes in income. – The net effect of an increase in exports (caused in Fig. 14.3 by an increase in foreign income) on the current account is smaller than the original increase in exports. • Domestic income rises, producing a partially offsetting increase in imports. See Figure 14.4 17 Figure 14.4a: Interaction Between Changes in the Current-Account Balance & Changes in Income E (Y*1 > Y*0) E=C+I+G + X (Y *1) – imp E=C+I+G + X (Y *0) – imp 45o 0 Y0 Y1 Y (a) Equilibrium Income 18 Figure 14.4b: Interaction Between Changes in the Current-Account Balance & Changes in Income X, imp Increase in imports due to rise in income Surplus imp(Y, R) X(Y*1, R) X(Y*0, R) 0 Y0 Y1 (b) Current-Account Balance Y 19 What Causes Changes in the Market for Goods and Services? • Fiscal policy – Policy that uses changes in government spending or taxation to affect the macroeconomy's performance. • Example: change in government purchases of goods and services. • Magnitude of fiscal policy’s effect on income depends on the spending multiplier. – A $1 increase in government purchases generates an income increase of $1 times the spending multiplier. • Value of multiplier equal 1/(1 - mpc + mpi) 20 What Causes Changes in the Market for Goods and Services? • Figure 14.5 indicates that a rise in government purchases raises equilibrium income and moves the current account toward a deficit. – The amount of the increase in income per unit increase in government expenditure is known as the spending multiplier. See Figure 14.5 21 Figure 14.5a: A Rise in Government Purchases Raises Equilibrium Income E E = C + I + G1 + X – imp E = C + I + G0 + X – imp G1– G0 = G 45o 0 Y0 Y1 (a) Equilibrium Income Y 22 Figure 14.5b: and Moves the Currency Account toward a Deficit X, imp Y1 – Y 0 Y 1 = = G 1 – G 0 G 1 – mpc + mpi Deficit imp(Y, R) Surplus X(Y*, R) 0 Y0 Y1 (b) Current-Account Balance Y 23 The Real Exchange Rate • Changes in the relative price of domestic and foreign goods or real exchange rate, R, also alter equilibrium income and the current account. – The domestic real appreciation shown in Figure 14.6 reduces income and moves the current account toward a deficit. • In other words, if domestic goods become relatively more expensive, demand shifts to imports, and income falls. See Figure 14.6 24 Figure 14.6a: A Domestic Real Appreciation Reduces Income… E E=C+I+G + X (R)0 – imp(R0) (R1> R0) E=C+I+G + X (R)1 – imp(R1) 45o 0 Y1 Y0 (a) Equilibrium Income Y 25 Figure 14.6b: …and Moves the Current Account Toward a Deficit X, imp imp(R1) Deficit 0 imp(R0) X(R0) X(R1) Y1 Y0 (b) Current-Account Balance Y 26 The Real Exchange Rate • The effect of the exchange rate on relative prices historically has played an important role in global economic policy making. – During the Depression of the 1930s, countries desperately tried to increase export markets for their goods as a means of combating unemployment. • Many countries devalued their currencies in order to achieve a comparative advantage at the expense of their neighbors. – These competitive devaluations are known as beggar-thyneighbor policies. 27 The Real Exchange Rate • A caveat: J-curve effects – The distinction between the short-run and longrun effects of a real depreciation or devaluation is called the J-curve phenomenon. • In Figure 14.7, policy makers devalue the domestic currency at time t0. This immediately raises the domestic-currency price of imports. See Figure 14.7 – The quantity of imports and exports do not adjust right away, so the current-account deficit grows in the short-run. As time passes, the quantity of imports falls and exports rise. – Eventually, the current account moves toward a surplus (along a curved pattern similar to the letter “J”). 28 Figure 14.7: The J Curve Current Account Surplus 0 t0 Time Deficit 29 Interest Rates • Changes in interest rates alter equilibrium income by changing investment expenditure. – Figure 14.8 indicates that a rise in the interest rate discourages investment, reduces income, and moves the current account toward a surplus. • The interest rate rise increases the opportunity cost of funds for investment. • The fall in income reduces imports. See Figure 14.8 30 Figure 14.8a: A Rise in the Interest Rate Reduces Income… E E = C + I(i0) + G + X – imp E = C + I(i1) + G + X – imp (i1> i0) 45o 0 Y1 Y0 (a) Equilibrium Income Y 31 Figure 14.8b: …and Moves the Current Account Toward Surplus X, imp Surplus imp(Y, R) X(Y,* R) 0 Y1 Y0 (b) Current-Account Balance Y 32 Summary of Effects on Income and the Current Account • Changes in variables that increase total expenditure on domestically produced goods and services increase the income consistent with equilibrium in the market. – Increases in government purchases and decreases in interest rates move the current account toward a deficit. – Increases in foreign income or decreases in the relative price of domestic goods and services move the current account toward a surplus. 33 Interdependence: Protectionism, Income, and the Current Account • Reasons against protectionism: 1. Protectionism by one country reduces foreign incomes. – This reduces foreign demand for exports. – Due to interdependent linkages among economies, artificial reductions in imports result in reductions in exports. 2. Unrestricted global trade allows the world’s scarce resources to produce the maximum quantity of goods and services. – Protectionism and its barriers to trade reduce the world economy’s ability to produce goods and services. – Result: higher prices and fewer goods for consumption. 34 The “Twin” Deficits • Term refers to combination of a government budget deficit and a current-account deficit, both of which grew substantially during the 1980s in the United States. 35 The IS Curve • An IS curve (shown in Fig. 14.9) summarizes the relationship between income and the interest rate that must hold for the market for goods and services to be in equilibrium. – An increase in interest rates raises the opportunity cost of funds for investment, discourages investments, and lowers total expenditure. • IS curve in panel (b) is negatively sloped – a rise in the interest rate lowers investment expenditure and the equilibrium level of income. See Figure 14.9 36 Figure 14.9a: The IS Curve (a) Equilibrium Income E E = C + I(i0 ) + G + X – imp E = C + I(i1 ) + G + X – imp (i1 > i0) 45o 0 Q1 Q0 Q 37 Figure 14.9b: The IS Curve i (b) Current-Account Balance i1 i0 IS 0 Q Q0 Q 38 The IS Curve • Figure 14.10 points out that variables that shift the total expenditure line also shift the IS curve. – Changes that increase total expenditure (for example, an increase in G) shift the IS curve to the right. – Changes that decrease the total expenditure (for example, a decrease in G) shift the IS curve to the left. See Figure 14.10 39 Figure 14.10: Variable that Shift the Total Expenditure Line Also Shift the IS Curve i Decrease in G or X Increase in imp at given Q Increase in G or X Decrease in imp at given Q IS" IS IS' 0 Q 40 Case One: GDP: What’s in There? • Government Statistics break GDP down into: – – – – – C: Consumption I: Investment G: Government Purchases X: Exports imp: Imports • Figure 14.11 in the text shows each of these categories in greater detail. 41 Note for Case Two: The Peso and Mexico-US Trade • Figure 14.12 compares the peso-dollar exchange rate and the Mexican-U.S. trade balance for the period 1992-99. – The large peso depreciation against the dollar in December 1994 lowered the relative price of Mexican goods and services and moved Mexico’s bilateral trade balance with the U.S. from a small deficit to a large surplus. 42 Figure 14.12a: Peso-Dollar Exchange Rate, 1992-1999 43 Figure 14.12b: Mexican-U.S. Trade Balance, 1992-1999 44 Key Terms in Chapter 14 • Gross national product (GNP) • Gross domestic product (GDP) • National income • Consumption expenditure (C) • Investment expenditure (I) • Government purchases (G) • Export expenditure (X) 45 Key Terms in Chapter 14 • • • • • • • • Import expenditure (imp) Marginal propensity to consume (MPC) real exchange rate Marginal propensity to import (MPI) Fiscal policy Spending multiplier Round-by-round effect Expenditure-switching policy 46 Key Terms in Chapter 14 • Competitive devaluation • Beggar-thy-neighbor policy • J curve • Twin deficits • IS curve 47