“Chapter 19: The Goods Market in an Open Economy”
Chapter 19: The Goods Market in an Open Economy
19-1 The IS Relation in an Open Economy
When we were assuming that the economy was closed to trade, there was no need to distinguish between the domestic demand for goods and the demand for domestic goods. They were clearly the same thing. Now, we must distinguish between the two. Some domestic demand falls on foreign goods, and some of the demand for domestic goods comes from foreigners. The Demand for Domestic Goods
In an open economy, the demand for domestic goods is given by Z = C + I + G – IMIe + X
The first three terms – consumption, C, investment, I, and government spending G- constitute the domestic demand for goods. If the economy were closed C+I+G. But now we have to make two adjustments. •First, we must subtract imports
•Second, we must add exports
The Determination of C, I and G
Let’s start with the first three: The C, I and G. Now that we are assuming that the economy is open, how should we modify our earlier descriptions of consumption investment and government spending? The answer: not very much. If it all. How much consumers decide to spend still depends on their income and their wealth. While the real exchange rate surely affects the composition of consumption spending between domestic goods and foreign goods, there is no obvious reason why it should affect the overall level of consumption. The same is true of investment: the real exchange rate may affect whether firms buy domestic machines or foreign machines. The Determinants of Imports
Imports are the part of domestic demand that falls on foreign goods. What do they depend on? They clearly depend on domestic income. Higher domestic income leads to a higher domestic demand for all goods, both domestic and foreign. So a higher domestic income leads to higher imports. Imports also clearly depend on the real exchange rate- the price of domestic goods in terms of foreign goods. The more expensive domestic goods are relative to foreign goods – equivalently, the cheaper foreign goods are relative to domestic goods – the higher the domestic demand for foreign goods. So a higher real exchange rate leads to higher imports. Thus we write imports as IM = IM(Y,e)
The Determinants of Exports
Exports are the part of foreign demand that falls on domestic goods. What do they depend on? They depend on foreign income: Higher foreign income means higher foreign demand for all goods, both foreign and domestic. So, higher foreign income leads to higher exports. Let Y* denote foreign income (equivalently, foreign output). We therefore write exports as
X= X(Y*, e)
(+, - )
*An Increase in foreign income, Y* leads to an increase in exports *An increase in the real exchange rate, 3, leads to a decrease in exports.
19.2 Equilibrium Output and the Trade Balance
The goods market is in equilibrium when domestic output equals the 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
Y= C( Y-T) + I (Y,r) + (G – IM(T,e)/e = X(Y*,e)
19-3 Increases in Demand, Domestic or Foreign
Increases in Domestic Demand
Suppose the economy is in in a recession, and the government decides to increase government spending in order to increase domestic demand and output.
Increases in Foreign Demand
Considering now an increase in foreign output – that is, an increase in Y*. This could due to an increase in foreign government spending. G* - the policy change we analyzed, but now taking place abroad. But we do not need to know where the increase in Y*comes from to analyze its effects on the U.S economy.
Fiscal Policy Revisited
•An increase in domestic demand leads to an increase in domestic output but leads also to a deterioration of the trade balance....
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