The Goods Market of an Open Economy - univie.ac.athomepage.univie.ac.at/christina.zauner/Open Economy Goods...The Goods Market of an Open Economy Christina Zauner Introduction The

The Goods Marketof an OpenEconomy

Christina Zauner

Introduction

The Demand forDomestic Goods

Equilibrium

Fiscal Policy

Increase in ForeignDemand

Depreciation

AlternativeEquilibriumCondition

The Goods Market of an Open Economy

Christina Zauner

Department of Economics, University of Vienna

June 8th, 2011


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Introduction

I In the final chapter we analyse the equilibrium in thegoods market in an open economy

I Changes in domestic as well as foreign demand or theexchange rate affect the equilibrium in the domesticgoods market and the trade balance of an economy

I Furthermore, there exists an important relation betweensaving and investment on the one hand and the tradebalance on the other hand in an open economy


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Demand for Domestic Goods

I In an open economy we have to distinguish betweendomestic demand for goods and the demand fordomestic goods

I Reason: some domestic demand falls on foreign goodswhile some demand for domestic goods comes fromforeigners

I The demand for domestic goods Z in an open economyis defined as

Z ≡ C + I + G − IM/ε+ X

I C + I + G constitutes the domestic demand for goods(both domestic and foreign goods)


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Demand for Domestic GoodsThe Special Case of Imports

I From the domestic demand for goods we have tosubtract the value of imports IM/ε and add exports Xin order to get the demand for domestic goods Z

I Note that imports IM are measured in terms of foreigngoods; since all other aggregates are expressed indomestic goods we first have to express imports interms of domestic goods

I 1/ε is the price of foreign goods in terms of domesticgoods and thus IM/ε is the value of imports in terms ofdomestic goods


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


The Determinants of C , I and G

I In an open economy the determinants of consumptionC , investment I and government spending G do notchange

I Though the real exchange rate affects the compositionof consumption, there is no reason why it should affectthe overall level of consumption

I The same is true for investment: the real exchange ratemay affect whether firms buy at home or abroad butnot total investment

I Finally, we still assume that government spending isexogenously given

⇒ Domestic demand: C (Y − T ) + I (Y , r) + G


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


The Determinants of Imports

I Imports, which are domestic demand that falls onforeign goods, depend on domestic income and the realexchange rate

I Higher domestic income increases the demand for bothdomestic and foreign goods

I Besides, the more expensive domestic goods are relativeto foreign goods (i.e. the higher ε), the higher will bethe domestic demand for foreign goods

I Thus, imports depend positively on domestic income Yand the real exchange rate ε:

⇒ Imports: IM(Y , ε)

with ∂IM∂Y > 0 and ∂IM

∂ε > 0


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


The Determinants of Exports

I Exports, which are foreign demand that falls ondomestic goods, depend on foreign income and the realexchange rate

I Higher foreign income means higher foreign demand forboth foreign and domestic goods

I In addition, the higher the real exchange rate, i.e. thehigher the price of domestic goods in terms of foreigngoods, the lower will be foreign demand for domesticgoods

I Thus, exports depend positively on foreign income Y ∗

and negatively on the real exchange rate ε:

⇒ Exports: X (Y ∗, ε)

with ∂X∂Y ∗ > 0 and ∂X

∂ε < 0


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Demand for Domestic Goods and Net Exports

I From domestic demand(DD line) we subtract thevalue of imports (IM/ε)

I The AA line is thedomestic demand fordomestic goods

I The distance between theDD and the AA lineequals IM/ε

I Because IM increases withincome/output Y , thisdistance increases with Y


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Demand for Domestic Goods and Net Exports

I To domestic demand fordomestic goods (AA line)we add exports X

I The resulting ZZ line isthe demand for domesticgoods

I From panel (c) we candeduce net exportsX − IM/ε as a function ofoutput

I At output Y exports areequal to the distance ACwhile imports are equal toAB

I Net exports BC arepositive ⇒ trade surplus


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Output and the Trade Balance

I Net exports are a decreasing function of output; thisfunction is represented by the NX line in panel (d) onthe previous slide

I Reason: as output/income Y increases, importsincrease while exports stay the same

I At the output level YTB – the subscript stands for tradebalance – net exports are equal to zero, i.e. exportsequal imports

I Output levels above YTB lead to a trade deficit whilelevels below YTB lead to a trade surplus


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Equilibrium Output and the Trade Balance

I An equilibrium in the goods market requires thatdomestic output Y equals the demand (domestic andforeign) for domestic goods Z

I The equilibrium condition is therefore given by

Y = C (Y − T ) + I (Y , r) + G − IM(Y , ε)/ε+ X (Y ∗, ε)

I The exogenous variables are taxes T , governmentspending G , foreign output/income Y ∗ and the realexchange rate ε


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Equilibrium Output and the Trade BalanceGraphical Illustration

I The demand for domesticgoods Z is given by theZZ line

I The condition Y = Z isrepresented by the45-degree line

I Equilibrium output isdetermined by theintersection of these lines

I There is no reason whyequilibrium output shouldbe equal to the level ofoutput where trade isbalanced


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Demand Z

I In the following we analyse the effects that changes inone of the exogenous variables have on the equilibrium

I We start our investigation by analysing an increase ingovernment spending (G ↑), i.e. an increase in domesticdemand

I As we can see from panel (a) on the next slide, we startfrom an equilibrium at point A

I We assume that in this equilibrium trade is balanced,i.e. net exports are zero and equilibrium output equalsYTB


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Government SpendingGraphical Illustration

I G ↑ ⇒ demand at anylevel of output increases,i.e. ZZ shifts up

I The equilibrium moves toA

′and output increases to

Y′

I The increase in Y is largerthan the increase in G(multiplier effect)

I We move along the NXline as output increases

I The increase in Yincreases imports whileexports are not affected ⇒trade deficit


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Government Spending

I An increase in government spending not only results ina trade deficit but its positive effect on output issmaller than in a closed economy

I Reason: the smaller the slope of the demand curve, thesmaller the multiplier; since the slope of the demandcurve in an open economy (ZZ line) is smaller than theslope of the demand curve in a closed economy (DDline), we have a smaller multiplier

I Intuition: in an open economy an increase in demandnot only falls on domestic goods, but is split overdomestic and foreign goods


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Foreign Demand

I Next consider an increase in foreign output (Y ∗ ↑), i.e.an increase in foreign demand

I As before, we start from an equilibrium at point A (seepanel (a) on the next slide)

I Again we assume that in this equilibrium trade isbalanced, i.e. net exports are zero and equilibriumoutput equals YTB

I The ZZ line represents demand for domestic goodswhile the DD line is domestic demand for goods

I The difference between both lines corresponds to netexports NX ⇒ since trade is balanced the lines intersectat the equilibrium


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Foreign DemandGraphical Illustration

I Higher foreign outputleads to an increase inexports

I Thus, at any level ofoutput we get a higherdemand for domesticgoods ⇒ ZZ shifts up

I Further, at any level ofoutput net exports arehigher ⇒ NX line shifts up

I The equilibrium moves toA

′and output increases to

Y′


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Increase in Foreign Demand

I The increase in foreign demand leads to an increase indomestic output

I Complication: while exports of domestic goods increase,higher domestic output also implies an increase inimports; could the trade balance deteriorate?

I Answer: no, the trade balance will improve since theincrease in exports offsets the increase in imports

I Thus, an increase in foreign output increases domesticoutput and improves the trade balance


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Fiscal Policy Revisited

I Our results imply that a demand shock (e.g. a fiscalexpansion) in one country affects output and the tradebalance in all other countries

I The stronger the (trade) links between countries, thestronger will these effects and the interdependence ofcountries be

I Dilemma: governments do not want to run trade deficitsconsistently because of the debt accumulation ⇒ theyprefer increases in foreign demand (higher output andimproved trade balance in the domestic country)

I As a result, governments could be reluctant to increasedomestic demand (worsening trade balance) and waituntil foreign demand increases ⇒ governments shouldcoordinate their actions


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Depreciation and the Trade Balance

I In the following we analyse a change in the (real)exchange rate and how this affects the equilibrium inthe goods market

I Assume that the nominal exchange rate decreases(nominal depreciation) and that the domestic and theforeign price level remain unchanged (short run)

I Therefore the real exchange rate ε ≡ EP/P∗ decreases(real depreciation), i.e. the price of domestic goods interms of foreign goods decreases (domestic goodsbecome relatively cheaper)

I How is this real depreciation going to affect the tradebalance?


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Depreciation and the Trade BalanceTransmission Channels

I Recall that the trade balance (or net exports) is given by

NX = X (Y ∗, ε)− IM(Y , ε)/ε

I Thus, a real depreciation affects the trade balancethrough three separate channels:

1. exports X increase because domestic goods arerelatively cheaper than foreign goods

2. imports IM decrease because foreign goods becomerelatively more expensive than domestic goods

3. the price of foreign goods in terms of domestic goods,i.e. 1/ε, increases; thus the same quantity of importsnow costs more (in terms of domestic goods)

I Therefore, the effect of a real depreciation on the valueof imports is hard to determine


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Depreciation and the Trade BalanceMarshall-Lerner Condition

I A real depreciation leads to an improvement in thetrade balance only if the effect on X is larger than theeffect on IM/ε

I The condition under which a real depreciation actuallyleads to an increase in net exports is known asMarshall-Lerner condition (MLC)

I Since there is empirical evidence that the MLC actuallyholds, we will always assume that a decrease in ε leadsto an increase in NX


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Depreciation and Output

I A real depreciation not only affects the NX line but alsothe ZZ line.

I Like an increase in Y ∗, it shifts the ZZ and the NX lineup ⇒ the equilibrium moves to A

′and domestic output

increases to Y′

I In summary: the depreciation shifts demand towardsdomestic goods; this leads to both an increase indomestic output and an improved trade balance


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Dynamics: the J-Curve

I Consider again the effects of a change in the (real)exchange rate on the trade balance

I If the Marshall-Lerner condition holds then a realdepreciation leads to an improvement in the tradebalance

I This improvement, however, will not occur over nightbut will take some time ⇒ dynamic process

I Recall that a real depreciation, i.e. ε ↓, affects the tradebalance via three channels:

1. it leads to an increase in exports X

2. it leads to a decrease in imports IM

3. it leads to an increase in the value of imports IM/ε


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Dynamics: the J-Curve

I Initially the effect of the depreciation is likely to bereflected more in the value of imports than in thequantities of exports and imports

I Reason: while the price of imports (exports) goes up(down) immediately, traded quantities are likely tochange much slower because consumers first have torealise that prices have changed

I Thus, the third channel will dominate in the beginning,leading to a deterioration in the trade balance (εdecreases while neither X nor IM adjust initially and soX − IM/ε goes down)

I As time goes by, the effects of the depreciation ontraded quantities become stronger


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Dynamics: the J-CurveGraphical Representation

I Eventually domesticconsumers switch torelatively cheaper domesticgoods (IM ↓) and

I Foreign consumersincrease their demand fordomestic goods (X ↑)

I The Marshall-Lernercondition guarantees thatin the end the tradebalance improves

I This dynamic adjustmentprocess is captured by theJ-curve


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Case Study: Combining Exchange Rate andFiscal Policies

I Assume an economy is running a large trade deficit, i.e.NX < 0, while output is at the natural level

I Can the government reduce the trade deficit withoutchanging the level of output?

I A (real) depreciation alone reduces the trade deficit butincreases output

I A fiscal contraction (e.g. G ↓, T ↑) not only leads to areduction in the trade deficit but also to lower output

I Solution: the government should use a combination ofboth


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Case Study: Combining Exchange Rate andFiscal PoliciesGraphical Illustration

I The real depreciation mustbe such that the NX linein panel (b) shifts to NX’

I The increase in netexports shifts the ZZ lineup to ZZ’

I To offset this shift a fiscalcontraction is needed toshift ZZ’ back to ZZ

I This combinationeliminates the trade deficitwhile output remains atthe natural level


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Saving, Investment, and the Trade Balance

I In a closed economy, the equilibrium condition for thegoods market is equivalent to the condition thatinvestment equals saving (private and public)

I There is a corresponding condition for the openeconomy; recall that the equilibrium condition for thegoods market is given by

Y = C + I + G − IM/ε+ X

I Rewriting this equilibrium condition yields

NX = S + (T − G )− I (1)

I Thus, in equilibrium the trade balance NX is equal toprivate saving S plus public saving (T − G ) minusinvestment I


Christina Zauner

Introduction


Equilibrium

Fiscal Policy


Depreciation


Saving, Investment, and the Trade Balance

I In other words, a trade surplus (NX > 0) correspondsto an excess of saving over investment while a tradedeficit (NX < 0) corresponds to an excess ofinvestment over saving

I From the balance of payments we know that a tradedeficit implies that a country has to borrow from therest of the world

I Thus, an excess of investment over saving,corresponding to a trade deficit, has to be financed bythe rest of the world

I Condition (1) has a number of other importantimplications:

I I ↑ ⇒ either S ↑ or (T − G ) ↑ or NX ↓I (T − G ) ↓ ⇒ either S ↑ or I ↓ or NX ↓I S + (T − G ) relatively high ⇒ either I or NX high

Documents

The Goods Market of an Open Economy - univie.ac.athomepage.univie.ac.at/christina.zauner/Open Economy Goods...The Goods Market of an Open Economy Christina Zauner Introduction The