The Goods Market in an Open Economy. The IS Relation - Open Economy. The Demand for Domestic Goods In an open economy, the demand for domestic goods is given by:. The Demand for Domestic Goods. The Determinants of C, I, and G.
The Demand for Domestic Goods
The Determinants of C, I, and G
The Determinants of Imports
The Determinants of Exports
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.
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.
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.
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.
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:
A real depreciation leads initially to a deterioration, then to an improvement of the trade balance.
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.
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.