The Goods Market in an Open Economy Chapter 19

19-1 The IS Relation in the Open Economy In a closed economy, no need to distinguish between domestic demand for goods and demand for domestic goods. In an open economy, some domestic demand falls on foreign goods (imports), and some of the demand comes from abroad (exports).

The demand for domestic goods Z is the demand for domestic goods. The first three terms of equation (19.1), C+I+G, constitute the domestic demand for goods, both foreign and domestic. Two adjustments: Subtract imports:IM is the quantity of imports and 1/ε is the price of foreign goods in terms of domestic goods. So IM/ε is the value of imports in terms of domestic goods. Add exports:

The determinants of exports and imports A higher ε (the more expensive the domestic goods relative to the foreign goods) leads to higher imports. An increase in income leads to an increase in imports. An increase in foreign income, Y* leads to an increase in exports.

19-1 The IS Relation in the Open Economy Figure 19-1 The Demand for Domestic Goods and Net Exports

Putting the components together The line DD plots domestic demand against output. Subtracting imports will give the line AA, the domestic demand for domestic goods. Because imports increase with income, the distance between the two lines increases with income. Two facts about the line AA: It is flatter than DD. It has a positive slope.

Putting the components together Adding exports will give the line ZZ, total demand for goods. Because exports do not depend on income, the distance between the two lines is constant. Nex exports (NX) are a decreasing function of the output. Ytb is the level of output at which NX=0. Levels of output above (below) it lead to higher (lower) imports and to a trade deficit (surplus).

19-2 Equilibrium Output and the Trade Balance Equilibrium in the goods market requires that domestic output be equal to domestic demand –both domestic and foreign- for domestic goods. The equilibrium condition determines output as a function of all variables we take as given, from taxes to foreign output to the exchange rate.

19-2 Equilibrium Output and the Trade Balance Figure 19-2 Equilibrium Output and Net Exports

19-3 Increases in Domestic Demand Figure 19-3 The Effects of an Increase in Government Spending The story looks the same as the one for a closed economy in Chapter 3. Two things: There is an effect on the trade balance. The multiplier is smaller. The smaller the slope of the demand relation, the smaller the multiplier.

19-3 Increases in Domestic Demand Two implications for an open economy An increase in domestic demand has a smaller effect on output than in a closed economy. It has an adverse affect on the trade balance. Therefore, the more open the economy, the smaller the effect on output and larger the adverse effect on the trade balance.

19-3 Increases in Foreign Demand Figure 19-4 The Effects of an Increase in Foreign Demand An increase in foreign demand leads to an increase in exports and an increase in the demand for domestic goods, shifting the line ZZ up. Net exports also go up.

The basic results so far An increase in domestic demand leads to an increase in domestic output but leads also to a deterioration of the trade balance. An increase in foreign demand leads to an increase in domestic output and an improvement in the trade balance. Implications Shocks to demand in one country affect all other countries. The interactions between countries complicate the task of policymakers, especially fiscal policy.

19-4 Depreciation, the Trade Balance, and Output A depreciation of the dollar: A decrease in nominal exchange rate –the price of domestic currency in terms of foreign currency. Given P and P*, the nominal depreciation is reflected one-for-one in a real depreciation. If the dollar depreciates vis-a-vis pound by 10%, and if the price levels in the US and the UK do not change, US goods will be 10% cheaper compared to the UK goods.

Marshall-Lerner Condition Focus on net exports. the real exchange rate affects the trade blance through three channels: Exports increase. Imports decrease. The relative price of foreign goods in terms of domestic goods increases, which increases the import bill. The condition under which a real depreciation leads to an increase in net exports is called Marshall-Lerner condition.

19-4 Depreciation, the Trade Balance, and Output Figure 19-4 The Effects of a real depreciation Assuming Marshall-Lerner condition holds, a depreciation increases net exports. Both the demand relation and the net exports relation shift up. The shift in demand leads in turn to both an increase in domestic output and an improvement in the trade balance.

19-4 Depreciation, the Trade Balance, and Output There is an important difference between the effect of a depreciation and an increase in foreign output. A depreciation works by making foreign goods more expensive. People are worse off.

19-5 Looking at Dynamics: The J-Curve Increase in exports and the decrease in imports do not happen over night. In the first few months, the effect of depreciation is reflected much more in prices than in quantities. A depreciation leads to an initial deterioration of the trade balance. The response of exports and imports eventually becomes stronger than adverse price effect, and the eventual effect of the depreciation is an improvement of the trade balance.

19-5 Looking at Dynamics: The J-Curve Figure 19-6 The J-Curve

19-5 Looking at Dynamics: The J-Curve Figure 19-7 The Real Exchange Rate and the Ratio of the Trade Deficit to GDP: United States, 1980–1990