CHAPTER
19
The Goods Market
in an Open Economy
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
19-1
The IS Relation in
the Open Economy
The Demand for Domestic Goods
 In an open economy, the demand for domestic
goods is given by:
Z  C  I  G   IM  X
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Macroeconomics, 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)
C  I G
 …is not the same as the “demand for domestic
goods”
 (domestic goods, bought by domestic or foreign
residents)
Z  C  I  G  X   IM
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The Demand for Domestic
Goods
The Determinants of C, I, and G
C  I  G  C(Y  T )  I (Y , r )  G
( )
(  , )
The real interest rate
r = i – expected inflation
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The Demand for Domestic
Goods
The Determinants of C, I, and G
C  I  G  C(Y  T )  I (Y , r )  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?
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Olivier Blanchard
The Demand for Domestic
Goods
The Determinants of Imports
IM = IM(Y ,ε )
(  , )
 A higher real exchange rate makes foreign
goods relatively more expensive, leading to a
decrease in the quantity of imports.
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The Demand for Domestic
Goods
The Determinants of Exports
X = X(Y * ,ε )
(  , )
 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.
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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.
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Macroeconomics, 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.
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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.
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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.
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The Demand for Domestic Goods
C  500  0.5YD
I  500  2000r  0.1Y
G  500
T  400
r  0.05
DD  C  I  G
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The Demand for Domestic Goods
DD  500  0.5YD  500  2000r  0.1Y  500
T  400
r  0.05
DD  500  0.5(Y  400)  500
 2000 * (0.05)  0.1Y  500
DD  1400  0.6(Y )
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Olivier Blanchard
The Demand for Domestic Goods
Autonomous
consumption –mpc(T)
+ autonomous
investment + G=
DD
Slope
=0.5+0.1
=0.6
500- .5(400) +5002000r+500 =
1300+2000(0.05)
=1400
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Olivier Blanchard
The Demand for Domestic Goods
DD  1400  0.6(Y )
X  0.1(Y )  100
IM  0.1(Y )  100 / 
ZZ  C  I  G  X  IM
ZZ  1400  0.6(Y )
For
 0.1(Y )  100
  0.1Y   100 /  
For
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The Demand for Domestic Goods
ZZ  C  I  G  X  IM
ZZ  1400  0.6(Y )
 0.1(Y )  100
  0.1Y   100 /  
For
ZZ  1300  0.6   0.1(Y )
 0.1(Y
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For
)  100
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The Demand for Domestic Goods
ZZ  1300  0.6   0.1(Y )
 0.1(Y
 1
For
)  100
Y  2000
ZZ  1600  0.5(Y )
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For
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Olivier Blanchard
The Demand for Domestic Goods
Slope=0.6
Autonomous
consumption –mpc(T)
+ autonomous
investment + G + X IM=
DD
ZZ
Slope = 0.6-0.1
=0.5
=1600
=1400
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Macroeconomics, 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.
YTB is the value of
output that corresponds
to balanced trade.
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Olivier Blanchard
Equilibrium Output
19-2
and the Trade Balance
Y = C(Y - T ) + I(Y ,r ) + G - εM(Y ,ε ) + X(Y * ,ε )
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.
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Saving, Investment,
and the Trade Balance
19-6
 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.
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Olivier Blanchard
Saving, Investment,
and the Trade Balance
 The S=I condition for equilibrium has an
important meaning:
 We know
S  Y  C T
and that
Y = C + I + G - εIM + X
S  C  I  G  X  IM   C  T
S = I + G - T - εIM + X
 IM  X  NX
NX  S  (T  G)  I
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Olivier Blanchard
Saving, Investment,
and the Trade Balance
NX  S  (T  G)  I
 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.
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Olivier Blanchard
Increases in Demand,
19-3
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 Hall
andBusiness
is notPublishing
multiplied.
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Macroeconomics, 3/e
Olivier Blanchard
Increases in Demand,
Domestic or Foreign
 In a closed economy, equilibrium output is
given by
1
Y
1  c1
c0  c1T0  I 0  G0 
 In an open economy, expenditure is
Z  c0  c1 Y  T0   I 0  G0  X 0   im0  im1Y 
 So equilibrium Y is given by
1
c0  c1T0  I 0  G0  X 0  im0 
Y
1  c1   im1 
Some spending “leaks” into saving (1-c); some spending “leaks” the rest of
the world (im1) andPublishing
is not multiplied; therefore
the multiplier is smaller.
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Macroeconomics, 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 Publishing
Macroeconomics, 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 Publishing
Macroeconomics, 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 Publishing
Macroeconomics, 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.
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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.
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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.
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Macroeconomics, 3/e
Olivier Blanchard
Depreciation, the Trade
19-4
Balance, and Output
 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.
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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?
NX  X  IM
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NX = X(Y * ,ε ) - εIM(Y ,ε )
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Depreciation, the Trade
Balance, and Output
 As  rises,
   X  and IM 
IM ?
X  IM ?
 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 |%DIM| > |%D|
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Olivier Blanchard
Depreciation, the Trade
Balance, and Output
 If the Marshall-Lerner condition holds
   X  and IM 
IM 
X  IM 
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Macroeconomics, 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 .
EP *

P
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 EP * 
 E  

 P 
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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 Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of a Depreciation
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.
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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.
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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.
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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.
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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 Publishing
Macroeconomics, 3/e
Olivier Blanchard
Looking at Dynamics:
19-4
The J-Curve
 The Marshall-Learner condition says that
   X  and IM 
IM 
X  IM 
 The key point is that imports are relatively
elastic: a given percentage
%DIM
change in  will cause a
1
large change in IM.
%D
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Macroeconomics, 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. %DIM
0
%D
 As time goes on, 
%DIM
elasticity of IM rises. %D  1
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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.
  X  IM  
 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
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.
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Looking at Dynamics:
The J-Curve
The Real Exchange
Rate and the Ratio of
Net Exports to GDP:
United States, 19801990
The real appreciation
and the depreciation
of the dollar in the
1980s were reflected
in increasing, then
decreasing trade
deficits.
© 2003 Prentice Hall Business Publishing
There were, however,
substantial lags in the
effects of the real
exchange rate on the
trade balance.
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