1. The Goods Market in an Open Economy

2. The IS Relation - Open Economy
The Demand for Domestic Goods
In an open economy, the demand for domestic goods is given by:

3. 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.

4. 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.

5. 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.

6. The Demand for Domestic Goods
The Demand for Domestic Goods and Net Exports

7. 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.

8. 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.

9. Equilibrium

10. 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 smaller—the multiplier is smaller—than it would be in a closed economy.

11. 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.

12. 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.

13. ‘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.

14. 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.

15. 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.

16. 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.

17. Dynamics: The J-Curve The J-Curve
A real depreciation leads initially to a deterioration, then to an improvement of the trade balance.

18. 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.

19. 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.

20. The RER and the Trade Balance (U.S.)

21. Saving, Investment, and the Trade Balance
The alternative way of looking at equilibrium from the condition that investment equals saving has an important meaning:

23. Saving in the U.S.

24. 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.