2003-7-13 1
Chapter 7:The Goods Market
in an Open Economy
7-1,The IS Relation in the open Economy
7-2,Equilibrium Output and the Trade Balance
7-3,Increases in Demand,Domestic or
Foreign
7-4,Depreciation,the Trade Balance,and
output
7-5,Looking at Dynamics:The J-Curve
7-6,Saving,Investment,and Trade Deficits
2003-7-13 2
7-1,The IS Relation in the
open Economy
The Demand for Domestic Goods
The Determinants of the Demand for
Domestic Goods
? The Determinants of C,I,and G
? The Determinants of Imports
? The Determinants of Exports
2003-7-13 3
The Demand for Domestic
Goods
In an open economy,the demand for
domestic goods is given by
Z ≡ C+I+G-εQ+X (7.1)
2003-7-13 4
The Determinants of C,I,
and G
Domestic demand:
C+I+G=c(Y-T)+I(Y,r)+G
( + ) (+,-)
2003-7-13 5
The Determinants of
Imports
Q=Q(Y,ε) (7.2)
(+,-)
2003-7-13 6
The Determinants of
Exports
X=X(Y*,ε) (7.3)
(+,+)
Figure,The Demand for Domestic Goods and
Net Exports
De m an d DD
( a) Dom e stic d e m an d
( C+ I+G )
ou t p u t DD
De m an d AA
( b )
Im p or t s( ε Q)
O u t p u t
Figure,The Demand for Domestic Goods and
Net Exports
D e m an d D D
ZZ
AA
( c ) C
B E x p o r t s ( X )
A
N e t e xp or t s,N X Y Y
TB
O u t p u t
T r ad e s u r p lu s
( d ) Y
TB
BC N X
T r ad e d e f ic t
2003-7-13 9
7-2,Equilibrium Output and
the Trade Balance
The goods market is in equilibrium when domestic
output equals the demand for domestic goods:
Y=Z
Collecting the relations we derived for the components
of the demand for domestic goods,Z,
Y=c(Y-T)+I(Y,r)+G-εQ(Y,ε)+X(Y*,ε) (7.4)
Figure:Equilibrium Output and net exports
D e m an d
A
( a)
45
0
Y O u t p u t,Y
N e t e xp or t s,N X
( b ) Y
TB
B
C T r ad e d e f i c i t
O u t p ut,Y NX
2003-7-13 11
7-3,Increases in Demand,
Domestic or Foreign
Increases in Domestic Demand
Increases in Foreign Demand
Games That Countries Play
Increases in Domestic Demand
De m an d,Z
ZZ 1
A 1
ZZ
( a) △ G > 0
A
45
0
Y Y 1
Ne t e xp or t s,NX
( b ) B
Y
TB
C T r ad e d e f i c i t
NX
O u t p u t,Y
Increases in Domestic Demand
D e m an d,Z D D D om e st i c d e m an d
△ NX ZZ 1 f or goods
A 1
C Z Z
△ X A
( a )
4 5
0
D
Y Y 1 Ou t p u t,Y
N e t e xp or t s,N X
△ X
( b ) △ NX
Y
T B
NX 1
O u t p u t,Y N X
2003-7-13 14
7-4,Depreciation,the Trade
Balance,and output
Depreciation and the Trade Balance,The
Marshall-Lerner Condition
The Effects of a Depreciation
Combining Exchange-Rate and Fiscal Policies
2003-7-13 15
Depreciation and the Trade Balance,
The Marshall-Lerner Condition
Return to the definition of net exports
NX≡X-εQ
Replace X and Q by their expressions from
equations (7.2) and (7.3)
NX= X(Y*,ε) - ε Q(Y,ε)
As the real exchange rate ε enters in three
place,this equation makes clear that the real
depreciation—an increase in ε—affects the
trade balance through three channels
2003-7-13 16
Depreciation and the Trade Balance,
The Marshall-Lerner Condition
1.X increase,The real depreciation makes U.S,
goods relatively cheaper abroad,leading to an
increase in foreign demand for U.S,goods—an
increase in U.S,exports.
2.Q decrease,The real depreciation makes foreign
goods relatively more expensive in the United States,
leading to a shift in domestic demand toward domestic
goods,to a decrease in the quantity of imports.
3.The relative price of foreign goods,This tends to
increase the import bill,εQ,The same quantity of
imports now costs more to buy(in terms of domestic
goods)
2003-7-13 17
The Effects of a
Depreciation
We have looked so far only at the direct effects
of a depreciation on the trade balance,that is,
the effects given U.S,and foreign output,But
the effects do not end there,The change in net
exports changes domestic output,which affects
net exports further.
Combining Exchange-Rate and Fiscal Policies
D e m an d,Z Z Z 1
A 1 △ G
Z Z
D e m a n d f o r
( a ) △ N X A d om e st i c good s
4 5
0
Y Y 1 O u t p u t,Y
N e t e xp or t s,NX
( b ) △ N X B
O u t p u t,Y
C N X 1
N X
2003-7-13 19
Table 7-1,Exchange-Rate and
Fiscal Policy Combinations
Initial Conditions Trade Surplus Trade Deficit
Low Output ε? G ↑ ε↑ G?
High Output ε ↓ G? ε? G↓
7-5,Looking at
Dynamics:The J-Curve
Ne t e xp or t s,NX
+ De p r e c i at i on
T i m e
0 0
A C
B
-
2003-7-13 21
7-6,Saving,Investment,and
Trade Deficits
Derive the equilibrium condition for the open
economy:
Start from our equilibrium condition
Y=C + I + G – εQ + X
Subtract C+T from both sides,and use the fact that
private saving is given by S=Y-C-T,to get
S=I + G – T - εQ + X
Using the condition of net exports NX≡X- εQ,and
reorganizing gives
NX= S + (T-G) – I (7.5)
2003-7-13 22
Note about equation (7.5)
Note some of the things that equation (7.5) says:
? An increase in investment must be reflected either
in an increase in private or public saving,or in a
deterioration of the trade balance(a smaller trade
surplus,or a larger trade deficit)
? An increase in the budget must be reflected in an
increase in private saving,or a decrease in
investment,or a deterioration of the trade balance.
? A country with a high saving rate,private and public,
must have either a high investment rate or a large
trade surplus.
Chapter 7:The Goods Market
in an Open Economy
7-1,The IS Relation in the open Economy
7-2,Equilibrium Output and the Trade Balance
7-3,Increases in Demand,Domestic or
Foreign
7-4,Depreciation,the Trade Balance,and
output
7-5,Looking at Dynamics:The J-Curve
7-6,Saving,Investment,and Trade Deficits
2003-7-13 2
7-1,The IS Relation in the
open Economy
The Demand for Domestic Goods
The Determinants of the Demand for
Domestic Goods
? The Determinants of C,I,and G
? The Determinants of Imports
? The Determinants of Exports
2003-7-13 3
The Demand for Domestic
Goods
In an open economy,the demand for
domestic goods is given by
Z ≡ C+I+G-εQ+X (7.1)
2003-7-13 4
The Determinants of C,I,
and G
Domestic demand:
C+I+G=c(Y-T)+I(Y,r)+G
( + ) (+,-)
2003-7-13 5
The Determinants of
Imports
Q=Q(Y,ε) (7.2)
(+,-)
2003-7-13 6
The Determinants of
Exports
X=X(Y*,ε) (7.3)
(+,+)
Figure,The Demand for Domestic Goods and
Net Exports
De m an d DD
( a) Dom e stic d e m an d
( C+ I+G )
ou t p u t DD
De m an d AA
( b )
Im p or t s( ε Q)
O u t p u t
Figure,The Demand for Domestic Goods and
Net Exports
D e m an d D D
ZZ
AA
( c ) C
B E x p o r t s ( X )
A
N e t e xp or t s,N X Y Y
TB
O u t p u t
T r ad e s u r p lu s
( d ) Y
TB
BC N X
T r ad e d e f ic t
2003-7-13 9
7-2,Equilibrium Output and
the Trade Balance
The goods market is in equilibrium when domestic
output equals the demand for domestic goods:
Y=Z
Collecting the relations we derived for the components
of the demand for domestic goods,Z,
Y=c(Y-T)+I(Y,r)+G-εQ(Y,ε)+X(Y*,ε) (7.4)
Figure:Equilibrium Output and net exports
D e m an d
A
( a)
45
0
Y O u t p u t,Y
N e t e xp or t s,N X
( b ) Y
TB
B
C T r ad e d e f i c i t
O u t p ut,Y NX
2003-7-13 11
7-3,Increases in Demand,
Domestic or Foreign
Increases in Domestic Demand
Increases in Foreign Demand
Games That Countries Play
Increases in Domestic Demand
De m an d,Z
ZZ 1
A 1
ZZ
( a) △ G > 0
A
45
0
Y Y 1
Ne t e xp or t s,NX
( b ) B
Y
TB
C T r ad e d e f i c i t
NX
O u t p u t,Y
Increases in Domestic Demand
D e m an d,Z D D D om e st i c d e m an d
△ NX ZZ 1 f or goods
A 1
C Z Z
△ X A
( a )
4 5
0
D
Y Y 1 Ou t p u t,Y
N e t e xp or t s,N X
△ X
( b ) △ NX
Y
T B
NX 1
O u t p u t,Y N X
2003-7-13 14
7-4,Depreciation,the Trade
Balance,and output
Depreciation and the Trade Balance,The
Marshall-Lerner Condition
The Effects of a Depreciation
Combining Exchange-Rate and Fiscal Policies
2003-7-13 15
Depreciation and the Trade Balance,
The Marshall-Lerner Condition
Return to the definition of net exports
NX≡X-εQ
Replace X and Q by their expressions from
equations (7.2) and (7.3)
NX= X(Y*,ε) - ε Q(Y,ε)
As the real exchange rate ε enters in three
place,this equation makes clear that the real
depreciation—an increase in ε—affects the
trade balance through three channels
2003-7-13 16
Depreciation and the Trade Balance,
The Marshall-Lerner Condition
1.X increase,The real depreciation makes U.S,
goods relatively cheaper abroad,leading to an
increase in foreign demand for U.S,goods—an
increase in U.S,exports.
2.Q decrease,The real depreciation makes foreign
goods relatively more expensive in the United States,
leading to a shift in domestic demand toward domestic
goods,to a decrease in the quantity of imports.
3.The relative price of foreign goods,This tends to
increase the import bill,εQ,The same quantity of
imports now costs more to buy(in terms of domestic
goods)
2003-7-13 17
The Effects of a
Depreciation
We have looked so far only at the direct effects
of a depreciation on the trade balance,that is,
the effects given U.S,and foreign output,But
the effects do not end there,The change in net
exports changes domestic output,which affects
net exports further.
Combining Exchange-Rate and Fiscal Policies
D e m an d,Z Z Z 1
A 1 △ G
Z Z
D e m a n d f o r
( a ) △ N X A d om e st i c good s
4 5
0
Y Y 1 O u t p u t,Y
N e t e xp or t s,NX
( b ) △ N X B
O u t p u t,Y
C N X 1
N X
2003-7-13 19
Table 7-1,Exchange-Rate and
Fiscal Policy Combinations
Initial Conditions Trade Surplus Trade Deficit
Low Output ε? G ↑ ε↑ G?
High Output ε ↓ G? ε? G↓
7-5,Looking at
Dynamics:The J-Curve
Ne t e xp or t s,NX
+ De p r e c i at i on
T i m e
0 0
A C
B
-
2003-7-13 21
7-6,Saving,Investment,and
Trade Deficits
Derive the equilibrium condition for the open
economy:
Start from our equilibrium condition
Y=C + I + G – εQ + X
Subtract C+T from both sides,and use the fact that
private saving is given by S=Y-C-T,to get
S=I + G – T - εQ + X
Using the condition of net exports NX≡X- εQ,and
reorganizing gives
NX= S + (T-G) – I (7.5)
2003-7-13 22
Note about equation (7.5)
Note some of the things that equation (7.5) says:
? An increase in investment must be reflected either
in an increase in private or public saving,or in a
deterioration of the trade balance(a smaller trade
surplus,or a larger trade deficit)
? An increase in the budget must be reflected in an
increase in private saving,or a decrease in
investment,or a deterioration of the trade balance.
? A country with a high saving rate,private and public,
must have either a high investment rate or a large
trade surplus.
