Net trade balance

The foreign sector and aggregate demand

• Adding the foreign sector, we get an open economy

and an extra component of aggregate demand in the
form of net exports:
NX = X – M or NX = Ex – Im
• Exports is an injection, because it increases demand
for the domestic output
• Imports is a leakage that decreases demand for
domestic goods and services, moving replacing
domestic demand with demand for foreign goods and
services
 Determinants of export
• Exports X are autonomous, because they don’t depend on domestic income
• Exports are determined by the willingness of foreigners to buy goods and
services
The determinants of exports are:
• the income of foreigners (YF)
– The higher the income of foreigners; the higher are their preferences to buy goods
from this economy
• tastes & preferences of foreigners to buy domestic goods
• the exchange rate of the national currency (e)
– the weaker the national currency, the cheaper are domestic goods and/or the more
expensive are foreign goods, the more goods and services foreigners would desire to
buy
• the relation between domestic and foreign prices (P/PF)
 Determinants of imports
•• Domestic
  income (Y): the wealthier the citizens, the more
foreign goods and services they are eager to buy.
– It means that part of imports is induced (i.e. depends on income).
• Non-income factors:
– the exchange rate of national currency (e)
– tastes and preferences for foreign goods
– the relationship between domestic and foreign prices (P/PF)
– Hence part of imports is autonomous
• So imports have two parts: autonomous and non-autonomous:

where is the marginal propensity to import

 Marginal propensity to import
• The
  is a behavioral parameter that shows the
change in imports with a change in income:

• We usually assume that imports are a normal good:

– Imports provide more choice than domestic production
– Imports are often more expensive
– Households tend to buy more expensive, higher quality,
exotic goods with an increase in income
• So
 The multiplier in the open economy

• •In  the open economy there is the full set of leakages

(withdrawals):
– Savings
– Taxes
– Imports
• The marginal propensity to withdraw is now

• The multiplier in the open economy is

• The closer is to 1, the lower the value of the multiplier and

the less effect there will be from an injection into the circular
flow.
Aggregate demand
 The Keynesian Cross and AD
• The aggregate demand (AD) curve shows the quantity of goods
and services demanded at each price level
– the relationship between real GDP (Y) and the price level (P).
• Suppose prices go up
– the willingness of macroeconomic agents (households, firms, government
and foreigners) to buy goods and services produced in the domestic
economy decreases
– they reduce spending
• Suppose prices go down
– agents wish to buy more (aggregate planned expenditure curve shifts up).
• Thus, the relationship between aggregate demand and
the level of prices is negative.
AD AD=Y
AD(P2)
B P2 < P1
AD(P1)
A AD(P3)
P3 > P1
C

Y3 Y1 Y2 Y
P

P2 C

P1 A

P3 B
AD
Y3 Y1 Y2 Y
 The slope of the AD
• Aggregate demand shows the total demand in the economy
– it is NOT a simple aggregation of individual demand curves for
particular goods
– it is NOT a market demand curve.
• AD shows changes in demand when the price level for ALL
goods increases or decreases
– but NOT when the price of ONE good changes relative to the price
of another.
• When the general price level increases, we do NOT
substitute one good for another, rather we as a nation buy
FEWER goods and services.
Effects explaining the negative slope of AD

There are 3 effects at work:

• Real wealth effect
– Real balances effect (Pigou Effect)
• Interest rate effect
– Keynes’ Effect
• Foreign trade effect
– Mundell-Fleming Effect
 The Real Wealth Effect
•Suppose
  the price level (P) increases
• the value (purchasing power) of money, such as
cash and checking account balances, and of non-
money assets falls
• For a given sum of money (M), if prices become
higher, people can buy fewer goods
– Real money balances are M/P, also called real financial
wealth
• They feel less wealthy and decrease consumption (C)
• Resulting in a decrease in real GDP (Y)
 The Interest Rate Effect
•Suppose
  the price level (P) increases
• The real quantity of money (its purchasing power)
decreases
• People need more money even to continue their
current consumption levels
• This increases the demand for money (MD) in the
form of loans, and decreases the supply of loanable
funds
• The interest rate (r) increases
• The higher interest rate leads to a decrease in the
investment of firms (I)
 The Foreign Trade Effect
•Suppose
  the price level (P) increases
• the imports from other countries becomes relatively
less expensive for domestic buyers
• but exports from this country become relatively more
expensive for foreigners
• Thus, more imported goods and services (M) are
purchased and fewer exports (X) are sold
• Domestic firms will also find it relatively more
profitable to invest abroad.
• Net exports (NX) decrease
• Leading to a decrease in real GDP
 Moving along the AD curve
These three effects explain the influence of a change in
the price level on real GDP through the changes in
quantities of goods and services demanded at each
price level, and correspond to the movement along the
AD curve
P
P
P
(M/P)
(M/P) C;
C;
B
r 
r  I;
I; P2
Im; Ex
Im;Ex NX
NX P1 A

AD
Y
Y
Y2 Y1 Y
 Shifts in Aggregate Demand
• If P changes, there is movement along the AD
curve
• If the components of AD change for a reason
other than a change in then price level, then AD
will shift
• If these changes lead to an increase in aggregate
demand, the AD curve shifts to the right
• Otherwise, the AD curve shifts to the left
 Non-price factors affecting AD: C
Among the non-price factors that influence consumption are:
• expectations (or consumer confidence):
– of a change in prices
– of a change in income
– of shortages or abundance in the future
– about jobs and employment;
• changes in disposable income due to changes
– in personal income taxes
– in transfer payments
• The interest rate
– Has an impact on the consumption of durable goods
• the level of wealth
 Non-price factors affecting AD: I
Major factors that influence investment are:
• interest rates
• business confidence (including “animal
spirits”)
• Government rules, regulations, licensing, etc.
 Non-price factors affecting AD: G
The Government can affect aggregate demand
by conducting fiscal and monetary policy, i.e. by
changing:
• government spending
• taxes
• transfer payments
• money supply (influencing the interest rate)
Non-price factors affecting AD: NX
Net exports are influenced by the changes in:
• exchange rate of national currency
• foreign income
• domestic income
• tastes & preferences
• the relationship between domestic and
foreign prices.