C H A P T E R Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez The Goods Market in an Open Economy 19

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The IS Relation in the Open Economy The Demand for Domestic Goods  In an open economy, the demand for domestic goods is given by: 19-1

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The IS Relation in the Open Economy  In an open economy, the “domestic demand for goods” …  (foreign or domestic goods, demanded by domestic residents)  …is not the same as the “demand for domestic goods”  (domestic goods, bought by domestic or foreign residents)

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods The Determinants of C, I, and G The real interest rate r = i – expected inflation

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods The Determinants of C, I, and G  The real exchange rate does not affect the overall level of consumption and investment.  It is income, taxes, and the real interest rate that determine how many consumer or capital goods a country should buy.  E does affect the composition of consumption and investment.  Should we buy foreign or domestic goods?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods  C + I + G includes some demand for foreign goods.  We must exclude imports to obtain the domestic demand for domestic goods.  The AA curve is flatter than the DD curve:  If income increases…  …some of the extra income goes to saving,  some of the extra income goes to domestic goods,  and some of the extra income goes to imports, which are now excluded.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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, so DD is upward-sloping.  But we must exclude imports: the domestic demand for domestic goods, AA, we must subtract the value of imports from domestic demand.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods  AA is just the domestic demand for domestic goods:  It’s the amount spent by domestic residents on domestic goods.  So it doesn’t include imports.  …but it doesn’t include exports, either.  Since exports are also part of domestic production, we want to count them.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 (total) demand for domestic goods, ZZ.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods DD Slope = =0.6 Autonomous consumption –mpc(T) + autonomous investment + G= (400) r+500 = (0.05) =1400

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods DD Slope = =0.5 Autonomous consumption –mpc(T) + autonomous investment + G + X -  IM= =1600 Slope=0.6 =1400 ZZ

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Demand for Domestic Goods The Demand for Domestic Goods and Net Exports The trade balance (X – IM) is a decreasing function of output. Higher income raises IM but leaves X constant, reducing the trade balance. Y TB is the value of output that corresponds to balanced trade.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Output and 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. 19-2

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving, Investment, and the Trade Balance  So far, we’ve been looking at equilibrium by asking:  At what value of Y is Y = Expenditure?  Knowing that expenditure is a function of Y.  Alternatively, we could look at equilibrium by asking:  At what level of Y is S = I?  Knowing that S and I are both functions of Y. 19-6

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving, Investment, and the Trade Balance  The S=I condition for equilibrium has an important meaning:  We knowand that

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Saving, Investment, and the Trade Balance  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.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Increases in Demand, Domestic or Foreign 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. because some spending “escapes” into the rest of the world and is not multiplied.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Increases in Demand, Domestic or Foreign  In a closed economy, equilibrium output is given by  In an open economy, expenditure is  So equilibrium Y is given by Some spending “leaks” into saving (1-c); some spending “leaks” the rest of the world (  im 1 ) and is not multiplied; therefore the multiplier is smaller.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. At point A, the amount demanded by domestic residents is less than the amount of domestic goods demanded. Many domestic goods are demanded, so exports are probably high. Because domestic demand is relatively low (but demand for domestic goods is high), imports are relatively low.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. Note that A’ is an equilibrium even though NX>0. Also note NX = X – IM is equal to the vertical difference between DD and ZZ. NX=0 only when DD and ZZ intersect.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 domestic demand increases output but worsens the trade deficit.  An increase in foreign demand is preferred to an increase in domestic demand because it also leads to an improvement in the trade balance.  Trade deficits  capital inflows = accumulating debts to foreigners.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Games That Countries Play  Suppose there’s a recession.  An expansionary fiscal policy can eliminate it, but it would generate a trade deficit.  Moreover, since the multiplier is smaller in an open economy, the required increase in G might be very large.  Alternatively, a country may wait for foreign demand to stimulate the economy.  This would give us a trade surplus and an expansion.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Games That Countries Play  What if all countries increased G at the same time?  Then output and import demand would rise for all countries at the same time. IM rise, but X rise too, keeping the trade balance constant.  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.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Games That Countries Play  But what if only some countries have a recession?  Expansionary fiscal policy by all countries might generate inflation in non-recession countries.  Some countries may start with high budget deficits and government debt.  Alternatively, what if countries promise to play as a team and then cheat?  They would benefit from foreign expansion, without the domestic deficit.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output 19-4  Suppose a currency loses value vis-à-vis a foreign currency.  This is called a depreciation.  Theory and empirical evidence suggests that, most often, NX will improve with a depreciation.  In this case, a rise in  will have the same effect as an increase in foreign demand: it will increase our output and improve NX.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output  Will Net Exports improve with a depreciation?  The Quantity of Exports will rise.  The Quantity Imports will fall.  But the domestic price of imports will rise, because the depreciation makes imports more expensive at home.  What will happen to  IM, the value of imports?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output  As  rises,  The Marshall-Lerner condition is the condition under which a real depreciation (an increase in  ) leads to an increase in net exports.  It’s all about elasticity: assume |%  IM| > |%  |

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output  If the Marshall-Lerner condition holds

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output  In this chapter, we will assume prices are fixed.  This means that a change in E is the same as a change in .

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Depreciation, the Trade Balance, and Output  Chapter 21 shows that even though a nominal depreciation may have a short-run effect…  when prices are flexible, in the medium run, a change in E never changes  and therefore doesn’t change output.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 for us … … and making domestic goods cheaper for foreigners.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Effects of a Depreciation  Increases in foreign income and depreciations have the same effects on income and the trade balance.  Because both increase foreign demand for domestic goods, Y and TB increase.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Effects of a Depreciation  But depreciations reduce the purchasing power of our income and makes imports more expensive.  What if you worked for a company that imported foreign raw materials and exported the output?  What if most of your food was imported?  Depreciations are equivalent to an across the board wage-cut.  It makes everyone’s labor cheaper but also everyone poorer. They don’t improve productivity.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Combining Exchange-Rate and Fiscal Policies Reducing the Trade Deficit Without Changing Output To reduce the trade deficit without changing output, the currency must depreciate and the government must decrease spending. A depreciation will increase output, while reduced government spending will decrease output.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Combining Exchange-Rate and Fiscal Policies  Full-employment Output and Trade Balance are two different goals.  Exchange-rate depreciation and fiscal policy are two different tools.  You may need two tools to be able to achieve two goals.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Looking at Dynamics: The J-Curve  The Marshall-Learner condition says that 19-4  The key point is that imports are relatively elastic: a given percentage change in  will cause a large change in IM.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Looking at Dynamics: The J-Curve  But Imports aren’t always elastic.  Prices and quantities of imports are set through contracts, which may last many months or years.  Imports are very inelastic with respect to changes , in the very short run.  As time goes on,  elasticity of IM rises.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Looking at Dynamics: The J-Curve  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.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. Starting from a trade deficit, a depreciation first causes a deterioration of NX, but later an improvement: a J-curve, where NX first dips and then improves.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Looking at Dynamics: The J-Curve The Real Exchange Rate and the Ratio of Net Exports to GDP: United States, 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.