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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