The Goods Marketin 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 The real exchange rate affects the composition of consumption and investment, composition of consumption and investment, but not the overall level of these aggregates.but not the overall level of these aggregates.

The Demand for Domestic Goods

The Determinants of Imports

A higher real exchange rate makes foreign A higher real exchange rate makes foreign goods relatively cheaper, leading to an goods relatively cheaper, leading to an increase in the quantity of imports.increase in the quantity of imports.

εIM IM(Y , )=( , )

The Demand for Domestic Goods

The Determinants of Exports

An increase in An increase in YY*, or foreign output, leads to *, or foreign output, leads to higher U.S. exports. An increase in higher U.S. exports. An increase in , the , the value of domestic goods in terms of foreign value of domestic goods in terms of foreign goods, also leads to an decrease in exports.goods, also leads to an decrease in exports.

ε*X X(Y , )=( , )

The Demand for Domestic GoodsThe Demand for Domestic Goods and Net Exports

The Demand for Domestic GoodsAdding 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 DemandAn 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 DemandAn 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.

E P

P *

N X X Y IM Y ( , ) ( , ) /

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.

N X X Y IM Y ( , ) ( , ) /

Depreciation and Trade Balance

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-CurveThe 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:

N X S T G I ( )

Saving in the U.S.

Saving, Investment, and the Trade Balance

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.

N X S T G I ( )