Lecture 10.

The Goods (and

Services) Market in an Open
Economy
Reading: Blanchard, Chapter 18.
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
The demand for domestic goods
• Remember that GDP = Gross Domestic Product
• Demand for domestically produced goods?
𝑍 = 𝐶 + 𝐼 + 𝐺 − 𝐼𝑀/𝜖 + 𝑋

= Domestic demand for goods 𝐶 + 𝐼 + 𝐺

− Domestic demand for foreign goods imports , 𝐼𝑀/𝜖

+ Foreign demand for domestic goods exports , 𝑋.

Some examples
• If I purchase an imported music CD of a K-Pop artist here, that is
included in C. But it is not about what is produced in HK. So, it should
not be included in the demand for goods domestically produced.
.

• If Koreans watch HK movies in Korea, that is about what is produced

in HK but used in a foreign country. .

• If Korean tourists visit HK, HK is exporting tourism services produced

domestically. .
Why 𝐼𝑀/𝜖?
• 𝐼𝑀: the amount of imported goods (and services) in terms of foreign goods
•𝜖=𝜖 → 1/𝜖 = 𝜖 .
• 1 foreign good = 1/𝜖 domestic goods
• Thus, 1/𝜖 changes the units from foreign goods to the domestic goods.

• 𝐼𝑀/𝜖: the amount of imports in terms of domestic goods

• We assume that
𝐼𝑀 = 𝐼𝑀 , .

• Higher domestic income leads to a higher domestic demand for all

goods, both domestic and foreign.
• 𝜖 = 𝜖𝐹/𝐷 ↑: With one domestic good, we can buy more foreign goods,
i.e., foreign goods become relatively cheaper. Thus, 𝐼𝑀 ↑.
• We also assume that
𝑋=𝑋 , .

• If Koreans earn more income 𝑌 ∗ ↑ , more Korean tourists will visit

HK. As a result, HK exports tourism more.
• 𝜖 = 𝜖𝐹/𝐷 ↑: With one domestic good, we can buy more foreign goods,
i.e., foreign goods become relatively cheaper. Thus, 𝑋 ↓.
• Example) If traveling in Korea becomes relatively cheaper, less
Koreans will visit HK. As a result, HK exports less tourism to Korea.
A Summary
• Demand for the domestic goods

𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺 − 𝐼𝑀 𝑌, 𝜖 /𝜖 + 𝑋 𝑌 ∗ , 𝜖
+ + - + + + -
• 𝑁𝑋 = 𝑋 𝑌 ∗ , 𝜖 − 𝐼𝑀(𝑌, 𝜖)/𝜖

• Remark: In the textbook, Blanchard uses the real interest rate, 𝑟,

rather than 𝑖. Because it makes no material difference in the short run
(and we will focus on the short run), we stick to 𝑖.
ZZ curve in an open econ.
• Given 𝑐0 , 𝑐1 , 𝐺, 𝑇, 𝑌 ∗ , and 𝜖, we
will illustrate 𝑍 and 𝑁𝑋 as a
function of 𝑌.

• DD: 𝐶 + 𝐼 + 𝐺
• AA: 𝐶 + 𝐼 + 𝐺 − 𝐼𝑀/𝜖

• 𝐼𝑀 𝑌, 𝜖 increases in 𝑌 given 𝜖.
Thus, AA is flatter than DD.
ZZ curve in an open econ.
• DD: 𝐶 + 𝐼 + 𝐺
• AA: 𝐶 + 𝐼 + 𝐺 − 𝐼𝑀/𝜖

• ZZ: 𝐶 + 𝐼 + 𝐺 − 𝐼𝑀/𝜖 + 𝑋
• Given 𝑌 ∗ and 𝜖, 𝑋 𝑌 ∗ , 𝜖 is constant.
Thus, ZZ is parallel to AA.

• 𝑁𝑋 = 𝑋 − 𝐼𝑀/𝜖
• The distance BC = AC - AB
• 𝑌 ⋚ 𝑌𝑇𝐵 ⇔ 𝑁𝑋 ⋛ 0
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
 Equilibrium output (and NX)
• Assumption:
The slope of ZZ curve is between 0 and 1.
Slope = 𝑀𝑃𝐶 + MP to invest − MP to import/𝜖
• Equilibrium condition: 𝑌 = 𝑍
Domestic output 𝑌
= Demand for the domestic goods 𝑍

• 𝑌 = 𝑌𝐴 , 𝑁𝑋 = 𝑁𝑋𝐴 < 0.
• This economy runs a trade deficit 𝑋 < 𝐼𝑀/𝜖 .
• Can you draw a diagram for a case, where 𝑁𝑋 > 0?
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
 When 𝐺 ↑
• Point A: Initially equilibrium. 𝑁𝑋 = 0.
• As 𝐺 increases by Δ𝐺 > 0,
1. ZZ curve shifts upward by Δ𝐺.
2. NX curve does not shift.

Remember that c0 , c1 , 𝑇, 𝑌 ∗ , 𝜖 are given here.

For any 𝑌, 𝑍 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 increases by Δ𝐺.
Given 𝑌 ∗ and 𝜖, the relationship between 𝑌 and
𝑁𝑋 = 𝑋(𝑌 ∗ , 𝜖) − 𝐼𝑀(𝑌, 𝜖)/𝜖 does not change.
When 𝐺 ↑
• Point A’: the new equilibrium
•𝑌↑
• 𝑁𝑋 ↓ because 𝐼𝑀 𝑌, 𝜖 /𝜖 ↑, while
𝑋 𝑌 ∗ , 𝜖 does not change.

• ZZ is ( flatter/steeper ) than DD. So, the

government spending multiplier under ZZ
is lower than that under DD: the multiplier
is ( smaller/larger ) in the open economy.
 Why a smaller spending multiplier in an open
economy?
• 𝐺: 1 ↑ → 𝑍: 1 ↑ → 𝑌: 1 ↑ → 𝐶: 𝑐1 ↑ → 𝑍: 𝑐1 ↑ → …
• Here, an increase in consumption, 𝑐1 , consists of both domestic goods and
foreign (imported) goods. Thus, 𝑍 in the next round increase less than 𝑐1 .
• Investment is similar. As a result, we have a multiplier than it
would be in a closed economy.

• 𝐺 ↑ → Demand for the imported goods ↑ → 𝐼𝑀 ↑ → 𝑁𝑋 = 𝑋 − 𝐼𝑀/𝜖 ↓

• Note that 𝑋 𝑌 ∗ , 𝜖 is unchanged because we take 𝑌 ∗ and 𝜖 as given.
Implications and further questions
• What is the implication of this result on the spending multiplier in HK?
• HK has a very open economy. Thus, when 𝑌 ↑, HK people may increase
the demand for foreign goods more than the demand for domestic
goods. So, the multiplier might be small.

• Is it reasonable to assume that 𝑌 ∗ does not change?

• 𝐺 ↑→ 𝑌 ↑→ 𝐼𝑀 ↑. But 𝐼𝑀 ↑ means more export from the counterpart’s
point of view. Then, we will see that 𝑌 ∗ will also increase in this case.
• Question: What is the effect of 𝐼𝑀 ↑ on 𝑌 ∗ ?
Or, what is the effect of 𝑋 ↑ on 𝑌?
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
When 𝑌 ∗ ↑
• Point A: Initial equilibrium. 𝑁𝑋 = 0.
• 𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺
−𝐼𝑀 𝑌, 𝜖 /𝜖 + 𝑋 𝑌 ∗ , 𝜖

• As 𝑌 ∗ increases, 𝑋 increases by Δ𝑋 > 0

for all 𝑌 given 𝜖.
1. NX curve shifts upward by Δ𝑋.
2. ZZ curve shifts upward by Δ𝑋.
When 𝑌 ∗ ↑
• Point A’: the new equilibrium
• DD: 𝐶 + 𝐼 + 𝐺
• ZZ: 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (for 𝑌𝐴∗ )
• ZZ’: 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (for 𝑌𝐴∗′ > 𝑌𝐴∗ )

• 𝑌 . Thus, 𝐼𝑀 𝑌, 𝜖 /𝜖 ↑.
• But 𝑋 𝑌 ∗ , 𝜖 ↑ more.
• Thus, 𝑁𝑋 = 𝑋 − 𝐼𝑀/𝜖 ↑
from 0 to the distance
Implications
1) Shocks to demand in one country affect all other countries via trade.
• 𝑐0 ↑, 𝑇 ↓, 𝐺 ↑ → 𝑌 ↑, 𝐼𝑀 ↑, 𝑁𝑋 ↓.
• But 𝐼𝑀 ↑ = 𝑋 ∗ ↑ (our import is foreign economy’s export).
So foreign country’s NX curve shifts upward, 𝑌 ∗ ↑, 𝐼𝑀∗ ↑, 𝑁𝑋 ∗ ↑

2) Policy coordination is important, but not easy.

• Why policy coordination is important?
a) Govt. spending multiplier in an open economy is small.
Expansionary fiscal policies in foreign countries 𝐺 ∗ ↑, 𝑇 ∗ ↓ can
help because 𝑌 ∗ ↑ → 𝑋 ↑ → 𝑌 ↑.
Implications
2) Policy coordination is important, but not easy.
• Why policy coordination is important?

b) To improve the trade balance, there is an incentive to wait without

changing 𝐺 until other countries increase their demand, 𝐺 ∗ .
• 𝐺 ↑ → 𝑌 ↑ and 𝑁𝑋 ↓
• 𝐺 ∗ ↑ → 𝑌 ↑ and 𝑁𝑋 ↑
But if every government thinks in that manner, no country will act.

• In many cases, countries promise to coordinate and then not deliver on

their promises.
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
 Real exchange rates and net exports
• 𝑁𝑋 𝑌, 𝑌 ∗ , 𝜖 = 𝑋 𝑌 ∗ , 𝜖 − 𝐼𝑀(𝑌, 𝜖)/𝜖
- + ?
• 𝑌 ↑ → 𝐼𝑀 ↑ → 𝑁𝑋 ↓
• 𝑌∗ ↑ → 𝑋 ↑ → 𝑁𝑋 ↑
• 𝜖 ↑ (foreign goods cheaper, domestic goods more expensive) → 𝑋 , 𝐼𝑀 , 1/𝜖
• If “1/𝜖 ↓” dominates “𝐼𝑀 ↑”, 𝐼𝑀/𝜖 ↓. If this decline is very big, then 𝑁𝑋 may
increase when 𝜖 ↑.

• (Marshall-Lerner condition) We ASSUME that given 𝑌 and 𝑌 ∗ , 𝜖 ↑ → 𝑁𝑋 ↓

always.
Real depreciation 𝜖 ↓
• Point A: Initial equilibrium. 𝑁𝑋 = 0.
• 𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺 + 𝑁𝑋 𝑌, 𝑌 ∗ , 𝜖

• As 𝜖 decreases, 𝑁𝑋 increases. Thus,

1. NX curve shifts upward.
2. ZZ curve shifts upward.

• Point A’: As a result, 𝑌 ↑ and 𝑁𝑋 ↑.

• Which variables are assumed to be fixed?
𝑖, 𝑇, 𝐺, 𝑌 ∗ .
Welfare implications
• Similar figures, different welfare implications (how happy people are).
Case 1) 𝑌 ∗ ↑ → 𝑋 ↑ → 𝑁𝑋 ↑ → 𝑌 ↑
• In this case, 𝐶 ↑ and 𝐼𝑀 ↑.
Case 2) 𝜖 ↓ → 𝑁𝑋 ↑ → 𝑌 ↑
• (𝐼𝑀 ↓) By making foreign goods expensive, i.e., by making it costly for
consumers to purchase foreign goods, 𝑁𝑋 improves. People cannot buy
as many imported goods as before, so they are worse off in some senses.
• Example) Oil price in HK ⇑ → People take MTR instead of driving a car.
→ Oil import ↓, having a positive effect on 𝑁𝑋.
But will this change make people happier?
Thinking a little bit further…
• Case 2) 𝜖 ↓ → 𝑁𝑋 ↑ → 𝑌 ↑
• 𝐼𝑀 ↓. Note that our import is foreign country’s export. So, 𝑋 ∗ .
• As we demand less foreign goods, 𝑍 ∗ . As a result, 𝑌 ∗ .

• 𝜖 ↓: Our country becomes richer 𝑌 ↑ by making our trade partners

poorer 𝑌 ∗ ↓ .
• An example of the beggar-thy-neighbor policy, which solves our
problem 𝑌 ↑, 𝑁𝑋 ↑ by harming the economic interest of our
partners.
Mixing exchange rate
and fiscal policies
• Point A: Initial equilibrium. 𝑁𝑋 < 0.
• 𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺 + 𝑁𝑋 𝑌, 𝑌 ∗ , 𝜖
• Goal: Maintain 𝑌 while 𝑁𝑋 ↑

• Combine 𝜖 ↓ and 𝐺 ↓ . Thus,

1. NX curve shifts upward 𝜖 ↓ .
2. ZZ curve shifts upward 𝜖 ↓ and downward
𝐺↓ .

• Point A’: 𝜖 ↓ w/o 𝐺 ↓. 𝑌 ↑ but 𝑁𝑋 < 0.

• Point A: 𝜖 ↓ w/ 𝐺 ↓. 𝑌 − and 𝑁𝑋 = 0.
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
Investment and Saving in an open economy
• 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
⇒ 𝑌 − 𝑇 − 𝐶 = 𝐼 + 𝐺 − 𝑇 + 𝑁𝑋
⇒ 𝑌 + 𝑁𝐼 + 𝑁𝑇 − 𝑇 − 𝐶 = 𝐼 + 𝐺 − 𝑇 + 𝑁𝑋 + 𝑁𝐼 + 𝑁𝑇
⇒ 𝑆 = 𝐼 + 𝐺 − 𝑇 + 𝐶𝐴

• 𝑁𝐼 = net financial income from abroad

• 𝑁𝑇 = net transfers from abroad
• 𝑌𝐷 = 𝑌 + 𝑁𝐼 + 𝑁𝑇 − 𝑇, 𝐶𝐴 = 𝑁𝑋 + 𝑁𝐼 + 𝑁𝑇.

• In Keynesian cross and IS-LM-IP, we assume that 𝑁𝐼 and 𝑁𝑇 are

constant. So, we will also call 𝑌 − 𝑇 disposable income.
𝐶𝐴 = 𝑆 + 𝑇 − 𝐺 − 𝐼
• In the US, 𝐶𝐴 < 0 in most years since 1980.
• The US invests more than it saves 𝐼 > 𝑆 + 𝑇 − 𝐺 .
• It borrows from the rest of the world (RoW) to finance these excess
investment. In other words, capital flows from the RoW to the US.
Outline
• Derivation
• 𝑁𝑋 as a function of 𝑌, 𝑌 ∗ , and 𝜖
• Determination of 𝑌 and 𝑁𝑋

• Application
• Domestic demand 𝐺 ↑
• Foreign demand 𝑌 ∗ ↑
• Exchange rate policy 𝜖 ↓

• 𝑆 + 𝑇 − 𝐺 = 𝐼 + 𝐶𝐴
• Dynamics: the J-curve
The J-Curve
• 𝑁𝑋 = 𝑋 − 𝐼𝑀/𝜖

• In real world, it takes some

time for 𝑋 and 𝐼𝑀 to adjust
when 𝜖 changes.
• 𝜖 ↓. In the beginning, 𝑋 and
𝐼𝑀 do not change much.
Then, 𝑁𝑋 ↓.
• Over time, as 𝑋 and 𝐼𝑀
adjust, 𝑁𝑋 ↑ as discussed.
In the next class…
• An open economy version of the IS-LM model.

• Mundell-Fleming model: IS + LM + UIP.