ECO202Y5 Chapter Notes - Chapter 7: Exchange Rate, Government Spending, Autarky
Prof. Michael Ho ECO202 Page 1 of 8
Chapter 7 – The Goods Market in an Open Economy
Chapter 7 – The Goods Market in an
Open Economy
IS Relation in the Open Economy; Equilibrium Output & Trade Balance; Increases in
Demand, Domestic or Foreign; Depreciation, Trade Balance, and Output; J-Curve
7.1: THE IS RELATION IN THE OPEN ECONOMY
The Demand for Domestic Goods
Now that we’re looking at an open economy, we must distinguish demand into demand for domestic
goods and demand for foreign goods.
Demand for domestics goods is given by:
≡ ++ − +
The first three terms (C, I, and G) make up domestic demand for goods. We now have to make 2
adjustments to the identity to prepare it for open-economy modeling:
o First, we must subtract imports (the part of domestic demand that falls on foreign goods). To do
this, we must express foreign goods in terms of domestic goods. Recall that ϵ is the real exchange
rate, the price of foreign goods in terms of domestic goods. Thus, ϵQ is the value of imports in
terms of domestic goods.
o Second, we must add exports (the demand for domestic goods that comes from abroad). X.
The Determinants of the Demand for Domestic Goods
The Determinants of C, I, and G
Luckily, we don’t have to worry to much about these 3. There aren’t many good reasons why
opening the economy will change the nature of these in any significant way. We can continue to use
the descriptions of consumption, investment, and government spending we developed earlier.
Domestic Demand: ++=( − )+(,)+
( + ) (+, −)
We assume that consumption depends positively on disposable income YD and that investment
depends positively on production Y and negatively on the interest rate i. Government spending G is
still exogenous.
The Determinants of Imports
The quantity of imports Q is positively related to the overall level of domestic demand. It also
depends on the real exchange rate ϵ: the higher the price of foreign goods relative to domestic goods,
the lower the relative domestic demand for foreign goods.
=(,)
(+, −)
Therefore, imports depends on income and the real exchange rate.
The Determinants of Exports
Our exports are their imports. Therefore, the determinants of their imports will decide our exports.
=(∗,)
(+, +)
Y* is foreign
income or output.
Prof. Michael Ho ECO202 Page 2 of 8
Chapter 7 – The Goods Market in an Open Economy
Graphing Demand for Domestic Goods
o In graph (a), line DD plots domestic demand (C + I + G) as a function of output Y. The slope of
this line is positive but less than 1 (refer to CH3).
o In graph (b), we subtract imports. The distance between DD and AA equals the value of imports,
ϵQ. Because the quantity of imports increases with income, the distance between the two lines
increases with income as well. We can establish 2 facts about line AA.
AA is flatter than DD: As income increases, some of the additional domestic demand falls on foreign goods
rather than on domestic goods. As income increases, the domestic demand for domestic goods increases less
than does total domestic demand.
AA has a positive slope: This is true as long as some of the additional demand falls on domestic goods: An
increase in income leads to some increase in the demand for domestic goods.
o In graph (c), we add exports. This gives us ZZ, where the distance between AA and ZZ is exports.
Exports does not depend on domestic output, so ZZ and AA are parallel. This makes ZZ flatter
than DD, as well.
o From the information in (c), we can characterize the behaviour of net exports (X – ϵQ) in (d). Net
exports are a decreasing function of output: As output increases, imports increase and exports are
unaffected, leading to lower net exports. YTB (TB for trade balance) is the level of output at which
the value of imports is equal to exports, so that net exports is 0.
7-2: EQUILIBRIUM OUTPUT AND THE TRADE BALANCE
The goods market is in equilibrium when domestic output equals the demand for domestic goods:
=( − )+(,)+ − (,)+(∗,)
Prof. Michael Ho ECO202 Page 3 of 8
Chapter 7 – The Goods Market in an Open Economy
Note: There is, in general, no reason why the equilibrium level of output, Y, should be the same as
the level of output at which trade is balanced, YTB. The way it’s drawn here is just an example.
7-3: INCREASES IN DEMAND, DOMESTIC OR FOREIGN
Increases in Domestic Demand
Suppose government spending increases during a recession, to increase domestic demand and output.
Assume that, initially, trade is balanced; Y = YTB. This is all shown on the graphs on the next page.
ZZ shifts up to ZZ' by ∆G. Equilibrium moves right from A to A', and output increases from Y to Y'.
The increase in output leads to a trade deficit. The increase in output is greater than the increase in
government spending because there’s a multiplier. However, it’s less than what it would be in a
closed economy. This is because the slope of ZZ is now flatter, and has a smaller multiplier.
The trade deficit and the smaller multiplier arise from the same cause: An increase in demand now
falls not only on domestic goods but also on foreign goods. Thus, when income increases, the effect
on the demand for domestic goods is smaller than it would be in a closed economy, leading to a
smaller multiplier. And because some of the increase in demand falls on imports—and exports are
unchanged—the result is a trade deficit.
These two implications are important. In an open economy, an increase in domestic demand has a
smaller effect on output than in a closed economy as well as an adverse effect on the trade balance.
