ECON1604: Economics

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ECON1604 Economics
MACROECONOMICS11. The Goods Market in an Open
EconomyBlanchard Chapter 19
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The IS Relation in the Open Economy

• Now we must be able to distinguish between
• the domestic demand for goods, and
• the demand for domestic goods.
• Some domestic demand falls on foreign goods.
• Some of the demand for domestic goods comes from
  foreigners.

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The Demand for Domestic Goods

• In an open economy, the demand for domestic
  goods is given by
• Until now, we have only looked at domestic
  demand C I G. But now we have to make two
  adjustments
• First, we must subtract imports. However, the
  value of imports must be converted into their
  value in terms of domestic goods (hence the 1/e).
  Recall e is the price of domestic goods in terms
  of foreign goods.
• Second, we must add exports. The part of demand
  for domestic goods that comes from abroad.

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The Demand for Domestic Goods

• Domestic Demand

The Determinants of Imports

• An increase in domestic income Y, leads to a
  greater demand for imports.
• An increase in the real exchange rate makes
  foreign goods relatively cheaper, and so
  increases demand for imports.

The Determinants of Exports

• An increase in foreign income Y, leads to a
  greater demand for exports.
• An increase in the real exchange rate makes
  domestic goods relatively more expensive, and so
  decreases demand for exports.

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The Demand for Domestic Goods

• Panel (a) The domestic demand for goods is an
  increasing function of income (output).
• Panel (b) The domestic demand for domestic
  goods is obtained by subtracting the value of
  imports from domestic demand.

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The Demand for Domestic Goods

• Panel (c) The demand for domestic goods is
  obtained by subtracting the value of imports from
  domestic demand, and then adding exports.
• Panel (d) 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 domestic
  output equals the total 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

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Equilibrium Output and the Trade Balance

• The goods market is in equilibrium when domestic
  output 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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Increases in Demand, Domestic or Foreign

• The Effects of an Increase in Government Spending

• An expansionary fiscal policy leads to
• an increase in output.
• a worsening of the trade balance.

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Increases in Demand, Domestic or Foreign

• Some important differences you should note
  between open and closed economies
• The multiplier is smaller than in a closed
  economy. Part of the increase in domestic demand
  caused by the expansionary fiscal policy falls on
  imports.
• The more open the economy, the smaller the impact
  of a change in domestic demand on output.
• An expansionary fiscal policy now effects the
  trade balance. The increase in output from Y to
  Y leads to an increase in the trade deficit
  equal to the line BC. Imports increase but
  exports do not change.
• The more open the economy, the larger the impact
  of a change in domestic demand on the trade
  balance.

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Increases in Demand, Domestic or Foreign

• The Effects of an Increase in Foreign Demand

• An increase in foreign demand leads to
• an increase in output.
• an improvement of the trade balance.

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Increases in Demand, Domestic or Foreign

• The direct effect of the increase in foreign
  output is an increase in domestic exports by some
  amount, which we shall denote by
• For a given level of output, this increase in
  exports leads to an increase in the demand for
  domestic goods by so the line shifts by
  from ZZ to ZZ.
• For a given level of output, net exports go up by
  . So the line showing net exports as a
  function of output in Panel (b) also shifts up by
  , from NX to NX.
• The initial increase in demand leads to further
  increases in output through the multiplier
  effect. This increases imports, but the increase
  is less than the initial increase in exports.
  Therefore, the trade balance improves.

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Increases in Demand, Domestic or Foreign

• We have derived two 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.

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International Coordination

• Assume there is a group of countries that are
  trading partners, and all are experiencing a
  recession.
• Increases in demand, either foreign of domestic,
  lead to an increase in output. However, only an
  increase in foreign demand can improve the trade
  balance. An increase in foreign demand is thus
  preferable.
• In times of recession, countries with high trade
  deficits may wait for foreign demand to stimulate
  the economy.
• There is scope for international coordination.

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International Coordination

• There is very little coordination among
  countries, principally because
• Some countries might have to do more than others
  and may not wish to do so.
• Countries have a strong incentive to promise to
  coordinate, and then not deliver on the promise.
• Possible solutions are international
  institutions for coordination among governments,
  for instance
• G8
• EUs Growth and Stability Pact which has
  sanctions against governments not respecting the
  rules.

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Depreciation, the Trade Balance, and Output

• Recall that the real exchange rate is given by
• In words
• The real exchange rate, , is equal to the
  nominal exchange rate, E, times the domestic
  price level, P, divided by the foreign price
  level, P.
• The real exchange rate gives the relative value
  of domestic goods in terms of foreign goods.

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Depreciation, the Trade Balance, and Output

• As the real exchange rate enters the right
  side of the equation in three places, this makes
  it clear that the real depreciation, e?, affects
  the trade balance through three separate
  channels
• Exports, X, increase.
• Imports, IM, decrease
• The relative price of foreign goods in terms of
  domestic goods, 1/e, increases.

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Depreciation, the Trade Balance, and Output
Divide through by X
Assume trade is initially balanced XIM/e
A real depreciation e? leads to an improving
trade balance if
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The Marshall-Lerner Condition

• The Marshall-Lerner condition is the condition
  under which a real depreciation (an decrease in
  ?) leads to an increase in net exports.
• It simply states that both demands for imports
  and exports should be sufficiently elastic to the
  real exchange rate, in order to ensure that a
  real depreciation improves the trade balance.
• This condition is quite realistic in practice.

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The Effects of a Depreciation

• The depreciation leads to
• a shift in demand, both foreign and domestic,
  toward domestic goods.
• Net exports increase (Marshall-Lerner
  Condition).
• Output increases
• The trade balance improves.

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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, e?
• decrease government spending, G?

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Looking at Dynamics The J-Curve
A real depreciation e? Relative prices of
domestic and foreign goods change instantly ?
NXX-IM/e falls Gradually, exports X and import
IM quantities adjust over time. Eventually
NXX-IM/e rises
A real depreciation leads initially to a
deterioration, then to an improvement of the
trade balance.
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Saving, Investment, and the Trade Balance

• Recall

Therefore
We obtain

• Trade surplus net private saving net public
  saving
• An increase in investment must be reflected in
  either an increase in private saving or public
  saving, or in a deterioration of the trade
  balance.
• An increase in the budget deficit must be
  reflected in an increase in either private
  saving, or a decrease in investment, or a
  deterioration of the trade balance.
• A country with a high saving rate must have
  either a high investment rate or a large trade
  surplus.