Transcript Chapter 19

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).
19-2
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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:
1. 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.
2. Add exports:
•
•
19-3
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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.
19-4
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19-1 The IS Relation in the Open
Economy
Figure 19-1 The Demand for Domestic Goods and Net Exports
19-5
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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:
1. It is flatter than DD.
2. It has a positive slope.
19-6
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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).
19-7
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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.
19-8
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19-2 Equilibrium Output and the
Trade Balance
Figure 19-2 Equilibrium
Output and Net Exports
19-9
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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:
1. There is an effect on the
trade balance.
2. The multiplier is smaller.
• The smaller the slope of
the demand relation, the
smaller the multiplier.
19-10
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19-3 Increases in Domestic Demand
• Two implications for an open economy
1. An increase in domestic demand has a
smaller effect on output than in a closed
economy.
2. 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.
19-11
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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.
19-12
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The basic results so far
1. An increase in domestic demand leads to an
increase in domestic output but leads also to a
deterioration of the trade balance.
2. An increase in foreign demand leads to an
increase in domestic output and an
improvement in the trade balance.
• Implications
1. Shocks to demand in one country affect all
other countries.
2. The interactions between countries complicate
the task of policymakers, especially fiscal
policy.
19-13
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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.
•
19-14
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Marshall-Lerner Condition
Focus on net exports. the real exchange rate
affects the trade blance through three channels:
1. Exports increase.
2. Imports decrease.
3. 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.
•
19-15
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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.
19-16
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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.
19-17
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19-5 Looking at Dynamics: The JCurve
• 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.
19-18
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19-5 Looking at Dynamics: The JCurve
Figure 19-6 The J-Curve
19-19
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19-5 Looking at Dynamics: The JCurve
Figure 19-7 The Real Exchange Rate and the Ratio of
the Trade Deficit to GDP: United States, 1980–1990
19-20
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