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The Goods Market in an Open Economy. The IS Relation in the Open Economy. 19-1. The Demand for Domestic Goods In an open economy, the demand for domestic goods is given by:. In an open economy, the “domestic demand for goods” is not the same as the “demand for domestic goods.”.
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The IS Relation inthe Open Economy 19-1 The Demand for Domestic Goods • In an open economy, the demand for domestic goods is given by: • In an open economy, the “domestic demand for goods” is not the same as the “demand for domestic goods.”
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.
The Demand for Domestic Goods The Determinants of Imports • A higher real exchange rate makes foreign goods relatively more expensive, leading to a decrease in the quantity of imports.
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 foreign goods in terms of domestic goods, also leads to an increase in exports.
The Demand for Domestic Goods The Demand for Domestic Goods and Net Exports The domestic demand for goods, DD, is an increasing function of income. To obtain the domestic demand for domestic goods, AA, we must subtract the value of imports from domestic demand.
The Demand for Domestic Goods The Demand for Domestic Goods and Net Exports 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.
Equilibrium Outputand 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.
Increases in Demand,Domestic or Foreign 19-2 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 smaller—the multiplier is smaller—than it would be in a closed economy.
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.
Games That Countries Play • 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.
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, such as the one among the group of seven major countries of the world, or G7, is an attempt to adopt compatible macroeconomic policies.
Depreciation, the TradeBalance, and Output 19-3 • The Marshall-Lerner condition is the condition under which a real depreciation (an increase in ) leads to an increase in net exports.
The Effects of a Depreciation The Effects of a Depreciation Fig. 19-4 here again 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.
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.
Looking at Dynamics:The J-Curve 19-4 • A depreciation may lead to an initial deterioration of the trade balance; increases, but neither X nor M adjusts very much initially. • Eventually, exports and imports respond, and depreciation leads to an improvement of the trade balance.
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.
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.
Saving, Investment,and the Trade Balance 19-5 • The alternative way of looking at equilibrium from the condition that investment equals saving has an important meaning:
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.
Key Terms • demand for domestic goods, • domestic demand for goods, • coordination, G-7, • Marshall-Lerner condition, • J-curve,
