The Goods Market

in an Open
Economy

CHAPTER 19
CHAPTER19
Prepared by:
Fernando Quijano and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier

 The IS Relation in
19-1
the Open Economy
Chapter 19: The Goods Market in an

Now we must be able to distinguish between the

domestic demand for goods and the demand for
domestic goods.
Some domestic demand falls on foreign goods,
and some of the demand for domestic goods
comes from foreigners.
Open Economy

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 The Demand for Domestic Goods
Chapter 19: The Goods Market in an

In an open economy, the demand for domestic

goods is given by:

Z  C  I  G  I M /  X

Until now, we have only looked at C + I + G. But

Open Economy

now we have to make two adjustments:

 First, we must subtract imports.
 Second, we must add imports.

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 The Determinants of C, I, and G
Chapter 19: The Goods Market in an

Domestic Demand:

C  I  G  C (Y  T )  I (Y ,r )  G
( ) (  , )
The real exchange rate affects the composition
of consumption and investment, but not the
Open Economy

overall level of these aggregates.

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 The Determinants of Imports
Chapter 19: The Goods Market in an

A higher real exchange rate leads to higher

imports, thus:
IM  IM (Y , )
(  , )
 An increase in domestic income, Y, leads to an
increase in imports.
Open Economy

 An increase in the real exchange rate, , 

leads to an increase in imports, IM.

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 The Determinants of Exports
Chapter 19: The Goods Market in an

Let Y* denote foreign income, thus for exports we

write:
X  X (Y * , )
(  , )

 An increase in foreign income, Y*, leads to an

increase in exports.
Open Economy

 An increase in the real exchange rate, , 

leads to a decrease in exports.

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 Putting the Components Together
Chapter 19: The Goods Market in an

Figure 19 - 1
The Demand for
Domestic Goods and
Net Exports
The domestic demand
for goods is an
increasing function of
income (output). (Panel
Open Economy

a) The demand for

domestic goods is
obtained by subtracting
the value of imports from
domestic demand, and
then adding exports.
(Panel b)

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 The Demand for Domestic Goods
Chapter 19: The Goods Market in an

Figure 19 - 1
The Demand for Domestic
Goods and Net Exports

The demand for

domestic goods is
obtained by subtracting
the value of imports from
Open Economy

domestic demand, and

then adding exports.
(Panel c) The trade
balance is a decreasing
function of output.
(Panel d)

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 The Demand for Domestic Goods
Chapter 19: The Goods Market in an

We can establish two facts about line AA, which

will be useful later in the chapter:
 AA is flatter than DD. As income increases,
the domestic demand for domestic goods
increases less than total domestic demand.
 As long as some of the additional demand
Open Economy

falls on domestic goods, AA has a positive

slope.

YTB is the value of output that corresponds to a

trade balance.

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 Equilibrium Output
19-2
and the Trade Balance
Chapter 19: The Goods Market in an

The goods market is in equilibrium when

domestic output equals the demand – both
domestic and foreign – for domestic goods:

Y Z
Collecting the relations we derived for the
Open Economy

components of the demand for domestic goods,

Z, we get:

Y  C (Y  T )  I (Y , r )  G  M (Y ,  )  X (Y * ,  )

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 Equilibrium Output
and the Trade Balance
Chapter 19: The Goods Market in an

Figure 19 - 2
Equilibrium Output and
Net Exports

The goods market is in

equilibrium when
domestic output is equal
to the demand for
Open Economy

domestic goods. At the

equilibrium level of
output, the trade balance
may show a deficit or a
surplus.

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 Increases in Demand,
19-3
Domestic or Foreign
Chapter 19: The Goods Market in an

Figure 19 - 3
The Effects of an
Increase in Government
Spending
An increase in
government spending
leads to an increase in
output and to a trade
Open Economy

deficit.

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 Increases in Demand,
Domestic or Foreign
Chapter 19: The Goods Market in an

There are two important difference you should

note between open and closed economies:
 There is now an effect on the trade balance.
The increase in output from Y to Y’ leads to a
trade deficit equal to BC. Imports go up, and
exports do not change.
Open Economy

 Government spending on output is smaller

than it would be in a closed economy. This
means the multiplier is smaller in the open
economy.

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 Increases in Foreign Demand
Chapter 19: The Goods Market in an

Figure 19 - 4
The Effects of an
Increase in Foreign
Demand
An increase in foreign
demand leads to an
increase in output and to
a trade surplus.
Open Economy

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 Increases in Foreign Demand
Chapter 19: The Goods Market in an

The direct effect of the increase in foreign output

is an increase in U.S. exports by some amount,
which we shall denote by  X :
 For a given level of output, this increase in
exports leads to an increase in the demand
for U.S. goods by  X , so the line shifts by  X
Open Economy

from ZZ to ZZ’.
 For a given level of output, net exports go up
by  X . So the line showing net exports as a
function of output in Panel (b) also shifts up
by  X , from NX to NX’.

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 Fiscal Policy Revisited
Chapter 19: The Goods Market in an

We have derived two basic results so far:

 An increase in domestic demand leads to an
increase in domestic output, but leads also to
a deterioration of the trade balance.
 An increase in foreign demand leads to an
increase in domestic output and an
Open Economy

improvement in the trade balance.

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 Fiscal Policy Revisited
Chapter 19: The Goods Market in an

The so-called G-7 – the seven major countries of

the world – meet regularly to discuss their
economic situation; the communiqué at the end
of the meeting rarely fails to mention
coordination. The fact is that there is very
limited macro-coordination among countries.
Open Economy

Here’s why:
 Some countries might have to do more
than others and may not want to do so.
 Countries have a strong incentive to
promise to coordinate, and then not
deliver on that promise.
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 Depreciation, the Trade
19-4
Balance, and Output
Chapter 19: The Goods Market in an

Recall that the real exchange rate is given by :

EP
 *
P
In words:
The real exchange rate,  , is equal to the
nominal exchange rate, E, times the domestic
Open Economy

price level, P, divided by the foreign price level,

P*.

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 Depreciation and the Trade Balance:
The Marshall-Lerner Condition
Chapter 19: The Goods Market in an

N X  X ( Y  , )  I M ( Y , ) / 


As the real exchange rate enters the right side
of the equation in three places, this makes it clear
that the real depreciation affects the trade
balance through three separate channels:
Open Economy

 Exports, X, increase.
 Imports, IM, decrease
 The relative price of foreign goods in terms of

domestic goods, 1/ , increases.

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 Depreciation and the Trade Balance:
The Marshall-Lerner Condition
Chapter 19: The Goods Market in an

The Marshall-Lerner condition is the condition

under which a real depreciation (an increase in )
leads to an increase in net exports.

The French Socialist Expansion:

Open Economy

1981-1983
Table 1 Macroeconomic Aggregates,
France: 1980-1983
1980 1981 1982 1983
Table 1 summarizes the
GDP growth (%) 1.6 1.2 2.5 0.7
macroeconomic results of the
EU growth (%) 1.4 0.2 0.7 1.6
policy of the Socialist party in
the early 1980s geared at Budget Surplus 0.0 -1.9 -2.8 -3.2
improving the economy. Current Account
Surplus -0.6 -0.8 -2.2 -0.9

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 The Effects of a Depreciation
Chapter 19: The Goods Market in an

Figure 19 – 4 again
Let’s summarize: The
depreciation leads to a
shift in demand, both
foreign and domestic,
toward domestic
Open Economy

goods. This shift in

demand leads, in turn,
to both an increase in
domestic output and
an improvement in the
trade balance.
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 Combining Exchange-Rate
and Fiscal Policies
Chapter 19: The Goods Market in an

Figure 19 - 5
Reducing the Trade Deficit
Without Changing Output

To reduce the trade deficit

without changing output,
the government must both
achieve a depreciation and
Open Economy

decrease government
spending.

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 Combining Exchange-Rate
and Fiscal Policies
Chapter 19: The Goods Market in an

If the government wants to eliminate the trade

deficit without changing output, it must do two
things:
 It must achieve a depreciation sufficient to
eliminate the trade deficit at the initial level of
output.
Open Economy

 The government must reduce government

spending.
Table 19-1 Exchange-Rate and
Fiscal Policy
Combinations
Trade
Initial Conditions Surplus Trade Deficit

Low output ?G  G?

High output G? ?G

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 Looking at Dynamics:
19-5
The J-Curve
Chapter 19: The Goods Market in an

A depreciation may lead to an initial deterioration

of the trade balance;  increases, but neither X
nor M adjusts very much initially.
   ( X   IM ) 
Open Economy

Eventually, exports and imports respond, and

depreciation leads to an improvement of the
trade balance.

( X  , IM  ,   )  ( X  IM ) 

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 Looking at Dynamics:
The J-Curve
Chapter 19: The Goods Market in an

Figure 19 - 6
The J-Curve

A real depreciation leads

initially to a deterioration,
then to an improvement
of the trade balance.
Open Economy

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 The U.S. Trade Deficit:
Origins and Implications
Chapter 19: The Goods Market in an

Figure 1
U.S. Exports and
Imports as Ratios to
U.S. GDP since 1990
Open Economy

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 The U.S. Trade Deficit:
Origins and Implications
Chapter 19: The Goods Market in an

Table 1 Average Annual Growth Rates in the United States, Japan,

the European Union, and the World, 1991-2003 (percent per
Year)

1991-1995 1996-2000 2001-2003

United States 2.5 4.1 2.9

Japan 1.5 1.5 0.9

European Union 2.1 2.6 1.9

Open Economy

World (excluding U.S.) 3.2 2.8 1.5

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 The U.S. Trade Deficit:
Origins and Implications
Chapter 19: The Goods Market in an

Figure 2
The Multilateral Real
Exchange Rate since
1990
Open Economy

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 Looking at Dynamics:
The J-Curve
Chapter 19: The Goods Market in an

Figure 19 - 7
The Real Exchange Rate
and the Ratio of Net
Exports to GDP: United
States, 1980-1990

The real appreciation and

the depreciation of the
dollar in the 1980s were
Open Economy

reflected in increasing,
then decreasing trade
deficits. There were,
however, substantial lags
in the effects of the real
exchange rate on the
trade balance.

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 Saving, Investment,
19-6
and the Trade Balance
Chapter 19: The Goods Market in an

The alternative way of looking at equilibrium from

the condition that investment equals saving has
an important meaning:

Y  C  I  G  IM /  X
S  Y  C  T
Open Economy

S  I  G  T  IM /  X
N X  X  IM /

N X  S  (T  G ) I

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 Saving, Investment,
and the Trade Balance
Chapter 19: The Goods Market in an

N X  S  (T  G ) I
From the equation above, we conclude:
 An increase in investment must be reflected
in either an increase in private saving or
public saving, or in a deterioration of the trade
balance.
Open Economy

 An increase in the budget deficit must be

reflected in an increase in either private
saving, or a decrease in investment, or a
deterioration of the trade balance.
 A country with a high saving rate must have
either a high investment rate or a large trade
surplus.
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 Key Terms
Chapter 19: The Goods Market in an

 demand for domestic goods  Marshall-Lerner condition

 domestic demand for goods  J-curve
 coordination, G-7
Open Economy

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