The Goods Market in an Open Economy

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The Goods Marketin an Open Economy
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The IS Relation - Open Economy

• The Demand for Domestic Goods
• In an open economy, the demand for domestic goods
  is given by

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The Demand for Domestic Goods

• The Determinants of C, I, and G

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

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The Demand for Domestic Goods

• The Determinants of Imports

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

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The Demand for Domestic Goods

• The Determinants of Exports

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

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The Demand for Domestic Goods

• The Demand for Domestic Goods and Net Exports

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The Demand for Domestic Goods
Adding 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.
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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.
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Equilibrium
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Increases in Domestic Demand
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.
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Increases 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.
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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.

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Games between CountriesThe 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.

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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.

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Depreciation and Trade Balance

• 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.

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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.

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Dynamics The J-Curve

• The J-Curve

A real depreciation leads initially to a
deterioration, then to an improvement of the
trade balance.
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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.
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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.
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The RER and the Trade Balance (U.S.)
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Saving, Investment,and the Trade Balance

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

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Saving in the U.S.
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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.