Open Economy Goods Market Equilibrium 1

Introduction:
 As we know from the circular flow of economic activity, the economy is in equilibrium when total
domestic output equals total expenditures on domestic output.
 In a closed economy, where total spending by domestic residents could only be spent on domestic
goods and total output was sold entirely to domestic residents, equilibrium output was expressed by
o Y =C + I + G
 In addition, in a closed economy where domestic residents could only save in domestic financial
markets and domestic firms could only borrow in domestic financial markets, equilibrium output
could also be expressed as
o Y −C−G=I
o S=I Leakages=Injections
 In an open economy, domestic residents can now exchange goods and services and borrow and lend
with other countries. As discussed, the Balance of Payments provides us with a record of all
international transactions between the domestic countries and rest of the world.
 From our simplified version of the BOP, we had four possible transactions: imports, exports, lending
(Capital Outflows: Buying Foreign Financial Assets), and borrowing (Capital Inflows: Selling Domestic
Financial Assets to Foreigners).
 The exchange of goods and services is accounted for in our goods market (Current Account),
whereas outflows and inflows are accounted for in our financial markets (Capital Account).

Open Economy Injections & Leakages:

 When we open the economy, we have 2 leakages and 2 injections in addition to the closed economy
leakages and injections (savings & investment).

Leakages Injections
Closed Economy S I
Open Economy S+Imports I+Exports

 In an open economy, domestic residents can now exchange goods and services (Imports & Exports) and
borrow (Capital Inflow) and lend (Capital Outflow) with other countries.
 As discussed, open economies exchange goods and services through international trade with imports as
leakages and exports as injections. Leakages=InjectionsS+M=I+X
 In addition to international trade, open economies can also borrow and lend to each other through
capital flows. Individuals in Canada who want to invest their savings in U.S markets can easily purchase
U.S government bonds, corporate bonds, or equities fairly easily. On the other hand, foreigners can
easily invest their savings in Canada.
o In an open economy, savings no longer has to equal investment. S-I measures net capital
outflows (NCO=Outflows-inflows). Assume that S=300 and I=200. This would mean that net
capital outflows is 100 (S-I=NCO). Now the question is, what are inflows and outflows.
o It could be the case that inflows are 100 and outflows are 200. However, this would mean
that of the 200 in investment, 100 is financed by domestic savings and 100 is financed by
foreign borrowings.
 Open Economy Goods Market Equilibrium 2

o Therefore, investment includes the amount of inflows and we cannot assume that S-I
measures total outflows, it measures outflows net of inflows.
o Therefore, when we open the economy, inflows are added to investment since inflows are
used by firms to fiancé investment. Savings still measures domestic savings and the difference
is NCO. If I>S, then we have negative net capital outflows, which just means inflows are
greater than outflows.
 Canada’s GDP (Y) represents total domestic production. Since imports represent expenditures on
foreign goods and services, we have to subtract them from total expenditures. In addition, since exports
represent foreign expenditures on domestic output, we have to add them to aggregate expenditures.
Equilibrium in the goods market is where total expenditures on domestic output equals total domestic
output.
 The international flow of capital represents either investing or saving in other countries. A capital
outflow is when a domestic resident lends money to foreigners by putting their savings into foreign
financial markets (leakage) (depositing dollars in foreign banks, buying foreign bonds and stocks, etc).
In addition, Canadian firms who want to borrow funds can borrow from foreigners (Injection) by selling
bonds, stocks, or other financial assets to them.
 Capital Outflows: Similar to how domestic savings represented a leakage out of the income stream,
purchasing foreign financial assets represents domestic savings in foreign financial markets and also
represents a leakage out of the income stream. Capital outflows represent lending to foreign
counties.
 Inflows: When foreigners purchase domestic financial assets, we are essentially borrowing from
foreign countries. This represents an injection back into our economy because we would only
borrow if we could invest the funds in the domestic economy. Therefore, Capital Inflows represent
an injection into the domestic economy.
o

 Therefore, leakages can result from imports or domestic savings. On the other hand, injections now
represent domestic investment or exports.
 Therefore, we know have two types of leakages (savings &
imports) and two types on injections (investment and exports).
We can express this as:
 S+ M =I + X We can modify our Injections and Leakages
Model with income to include imports and exports. Both
domestic savings and imports are a function of income
(YS & M) and investment and exports are not affected by
income.
 The AE/Y model equates total domestic income with total
spending on domestic goods and services. Therefore, we must
subtract imports from domestic spending and add exports. This leads to our AE line to be
AE=C+I+G+NX.
 Y=(C-CF)+(I-IF)+(G-GF)+X
o CF+IF+GF=Imports (M)
o Y=CD+ID+GD+X-M
 Open Economy Goods Market Equilibrium 3

o Net exports (NX) equals Exports (X) minus Imports (M).

o If NX is positive, we are selling more domestic output to foreigners than our purchases of
foreign output (X>M).
o If NX is negative, then we are buying more foreign goods than our sales of domestic goods to
foreigners. (M>X)
 Bringing together the four international transactions (Imports, Exports, Inflows, and Outflows) we
can rewrite our equilibrium conditions as
o Y=C+I+G+NX
o Y-C-G=I+NX  S=I+(X-M)
o This can be written in two ways: S+M=I+X or S-I=NX
o S-I measures NCO, so we have NCO=NX in equilibrium.
 We can now adjust the graph above to a slightly different perspective:
o This graph also measures leakages and injections (S+M=I+X),
but from the perspective of capital flows and net exports. Net
Exports is downward sloping because higher income increases
imports reducing net exports. Any increase in NX shifts the
curve upward and any decrease shifts it down.
o S-I is upward sloping because higher income raises savings
causing S-I (NCO) to increase. Where they intersect, we have
equilibrium.
o S-I=NXS+M=I+XY=C+I+G+NX

Exports>Imports+NX
 At point B total spending by domestic residents (C+I+G) is less than
output. Point B is below the 45-degree line. This means that total
income generated in the economy is greater than domestic spending.
Domestic income flows to domestic residents. However, some of the
domestic income is generated by exports (foreign spending). Therefore,
domestic residents will be spending less than their incomeY>C+I+G.
This will lead to an excess of savings. If we start from equilibrium with
NX=0, we would have S=IY-C-G=I. Now if exports increase, Y will
increaseS>IY-C-G>IS>I.
o The excess of domestic income over domestic spending must be
saved since it is not spent.
o Exports>importsY>C+I+GS>I A-B in the loanable funds
model.
 Open Economy Goods Market Equilibrium 4

 We can show the excess of savings over

investment in our S&I income graph as
the difference between A-B. When we
add imports of 0 to savings and the
positive exports to investment, we get an
equilibrium using the open economy
injections and leakages model.
 As shown above, we can also measure this
as S-I=NX with income. As we can see, at
point A savings is greater than investment
and net exports are positive.
 And of course, we can also use the loanable
funds model where the difference between investment and savings is NCO
or foreign lending, which will equal NX in equilibrium.
 What incentives do domestic residents have to lend to foreign countries (Capital Outflows) to help
finance their imports, which are the domestic countries exports.
o Essentially, exports drive higher domestic income which provides for higher levels of savings for
domestic residents. In order for the foreign country to continue to finance their imports (our exports),
domestic residents have to be willing to lend to them,
which then will be paid back in the future. As such, Trade Surplus
domestic residents get higher income and higher future Exports>Imports
consumption when the savings is paid back. Net Exports>0
Y>C+I+G
o In addition to supporting foreign purchases of our goods
Saving>Investment (Foreign Lending)
and services, domestic residents have another incentive to
lend money or engage in capital outflows. When exports are greater than imports, the supply of
foreign currency is greater than demand for foreign currency. The excess supply of foreign currency
leads to a decrease in the exchange rate (R). The decrease in R leads to an increase in the expected
appreciation of foreign currency (holding the expected future exchange rate constant) and as a result,
the foreign return is greater than the domestic return on savings. The return to investing in a foreign
country is the foreign interest rate plus the expected appreciation of the currency. When you exchange
the foreign dollars back into Canadian, and appreciation of the foreign currency will provide an extra
source of return.

Imports>Exports-NX
 Let’s assume that the economy has more imports than exports. This is referred to as a trade deficit or
current account deficit. This means that more income is leaving our circular flow than is entering the
circular flow. When we purchase foreign goods, we are spending our income in a foreign country,
which is then used to pay foreign workers to produce the goods.
 Open Economy Goods Market Equilibrium 5

 If we start from equilibrium with NX=0, we would have S=IY-

C-G=I. Now if imports increase, consumers are spending part of
their income on imports. This means that when we include
expenditures on imports, consumers are beginning to spend more
than what their income will be. As soon as they spend money on
foreign goods, domestic demand will decrease causing income to
go down. Therefore, we have savings less than investment. In
order for Canadians to maintain expenditures beyond income they
have to borrow from foreign countries. Higher exports would also
generate the extra income to the Canadian economy needed to finance imports.


 At point A total spending by domestic residents equals total income. When domestic residents
spend some of their income on foreign goods this leads to total spending (AE+M) being greater
than spending on domestic goods (AE). Point B shows total expenditures by domestic residents
is greater than Y* (above the 45 degree line). This is not the same as aggregate spending on
domestic goods.

 Since residents are spending a portion on foreign goods, we know that domestic spending on domestic
output (C+I+G) will be less than domestic output, which means that S<I.
 In other words, there is not enough domestic production/income to support total expenditures
(expenditures on domestic output and spending on foreign output).
 At output of 1000, actual spending on domestic output is at point B. As
we know, this will cause the economy to contract to point C. However,
we can spend more than we are contributing to domestic output as long
as we can borrow from other countries. Foreign borrowing will allow
investment spending to maintain its current level and domestic residents
can use savings to finance imports.
 Therefore, with spending greater than income, savings will be less than
investment. In order to maintain that level of spending, the economy must
borrow from international markets. This is represented as the amount of S-
I. At the current interest rate, I>S.
 S<INCO<0Negative NCO means positive capital inflows.
 As we can see, we can show I>S in our two S&I graphs. Looking at the
S&I interest rate graph, we can see that if the country is unable to
borrow to finance the imports, the interest rate will increase driving
Investment down and savings up (C).
 Open Economy Goods Market Equilibrium 6

 As we can see in S+M=I+X graph, higher imports increase the S+M

curve from A-B. This leads to S+M>I+X. Therefore, in order to bring the
economy to equilibrium, either I must increase through higher inflows or
exports must increase.
 Looking at the S-I=NX graph, the increase in imports reduces the NX line
down to NX’. To restore equilibrium, either exports must increase
shifting the NX line back up or investment increases through capital
inflows shifting the S-I line down.

Trade Surplus Balanced Trade Trade Deficit

Exports>Imports Exports=Imports Exports<Imports
Net Exports>0 Net Exports = 0 Net Exports<0
Y>C+I+G Y=C+I+G Y<C+I+G
Saving>Investment (Foreign Saving = Investment Saving < Investment
Lending)+NCO NCO=0 (Foreign Borrowing) -NCO

Open Economy Injections & Leakages:

 When we open the economy, we have 2 leakages and 2 injections in addition to the closed economy
leakages and injections (savings & investment).

Leakages Injections
Closed Economy S I
Open Economy Capital Outflows + Imports Capital Inflows + Exports

Imports:
 When domestic residents import foreign goods, they are taking domestic income out of the circular flow
and spending it on foreign output.
 Since that income is not spent on domestic output or saved domestically, it represents a leakage out of
the economy, and without other transactions would cause the economy to shrink.
 The simplest way to see how imports function in the circular flow is to use an example starting with an
increase in government spending. When we open our economy, consumers will spend part of their
income on domestic consumption, savings, and imports. Therefore, we have to adjust our explanation of
the marginal propensity to consume and save.
 Because imports are simply domestic consumption of foreign goods, there is a positive relationship
between income and imports. Higher income leads to higher imports.
 YM & YM
 As shown in the following graph, the import curve measured with
income on the x-axis has a positive slope. The slope of this line is
equal to the following:
∆M
 Slope= =Marginal Propensity to Import (MPM)
∆Y
o Therefore, a consumer can now do 1 of 3 things with each dollar of income: spend on
domestic consumption (C), spend on foreign consumption (m), or save (S).
 Price of Imports:
 Open Economy Goods Market Equilibrium 7

o Canadian Price of Foreign Goods P= PF *R

o Increases in either the price of the foreign goods in terms of foreign currency or an increase in
the exchange rate (depreciation of the $) will lead to a decrease in imports.

Open Economy Multiplier

oThe goods market multiplier is based on the idea that every dollar change in output results in a change
in consumption of domestic goods, which causes further changes to output. As output changes so does
1 1
income. Some of the income is spent and some of it is saved. The multiplier is then ∨ .
1−MPC MPS
oBecause imports represent a leakage out the economy, we have to add it to the MPS.
1 1
= 1=MPC+MPS+MPM.
MPS+ MPM 1−MPC
oThe MPC now measure sonly the change in domestic consumption from a change in income. The open
economy MPC is less than the closed economy MPC.

Exports:
 When a foreigner buys a Canadian good, this represents an injection into the economy. Therefore,
exports represent foreign spending (consumption) on domestic goods, which causes some of the foreign
country’s income to leak out of their economy and into ours.
 Since our exports are the foreign country’s imports of our goods, the primary determinants of our
exports are the foreign country’s income (YF), and the
domestic price of our goods in terms of the foreign
country’s currency.
 YFX & YFX
 Therefore, as domestic income changes there will be no
change in exports as they are based on the foreign level of
income.
 Price of Exports: Any increase in the Canadian price level or decrease in the exchange rate (appreciation
of the $) will lead to a decrease in the price of exports.
F 1
 Foreign Price of Canadian Goods P =P*
R