Equilibrium Output and the Trade Balance

1
Equilibrium Output and the Trade Balance

• The goods market is in equilibrium when domestic
  output equals the demand both domestic and
  foreign for domestic goods
• Collecting the relations we derived for the
  components of the demand for domestic goods, Z,
  we get

2
Equilibrium Output and the Trade Balance
Equilibrium Output and Net Exports
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.
3
Increases in Demand, Domestic or Foreign
The Effects of an Increase in Government Spending
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 smallerthe multiplier is smallerthan
it would be in a closed economy.
4
Increases in Demand, Domestic and Foreign

• There are two important differences you should
  note between open and closed economies
• There is now an effect on the trade balance. The
  increase in output from Y to Y leads to a trade
  deficit equal to BC. Imports go up, and exports
  do not change.
• Government spending on output is smaller than it
  would be in a closed economy. This means the
  multiplier is smaller in the open economy.

5
Increases in Foreign Demand

• The Effects of an Increase 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.
6
Games That Countries Play

• In times of recession, countries with high trade
  deficits may wait for foreign demand to stimulate
  the economy.
• Coordination among countries, for example among
  the group of seven major countries of the world,
  or G7, is an attempt to adopt compatible
  macroeconomic policies.

7
Depreciation, the Trade Balance, and Output

• Recall the real exchange rate

• A real depreciation apparently has an ambiguous
  effect on net exports.

• The Marshall-Lerner condition is the condition
  under which a real depreciation (a decrease in ?)
  leads to an increase in net exports.

8
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.
9
Combining Exchange-Rateand 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.
10
Looking at 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.

11
Looking at Dynamics The J-Curve
The J-Curve
A real depreciation leads initially to a
deterioration, then to an improvement of the
trade balance.
12
Looking at Dynamics The J-Curve
The Real Exchange Rate and the Ratio of Net
Exports to GDP United States, 1980-1990
The real appreciation and the depreciation of the
dollar in the 1980s were reflected in increasing,
then decreasing trade deficits. There were,
however, substantial lags in the effects of the
real exchange rate on the trade balance.
13
Saving, Investment, and the Trade Balance

• The alternative way of looking at equilibrium
  from the condition that investment equals saving
  has an important meaning

14
Saving, Investment, and the Trade Balance

• From the equation above, we conclude that 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, all else the
  same, leads to a deterioration of the trade
  balance.