Before I built a wall I’d ask to know

What I was walling in or walling out . . .

Robert Frost

What is Open Economy?

Economic activity between domestic community and outside

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FOREIGN TRADE AND

ECONOMIC ACTIVITY

Open-economy macroeconomics is the study of

how economies behave when the trade and financial
linkages among nations are considered.

Total Aggregate demand (or AD ) is the total or aggregate

quantity of output that is willingly bought at a
given level of prices, other things held constant. AD
is the desired spending in all product sectors: consumption,
private domestic investment, government
purchases of goods and services, and net exports.

Total aggregate demand = C+I+G+X

It has four components:

1. Consumption. As we saw in the last chapter,
consumption (C ) is primarily determined by disposable income, which is personal income
less taxes. Other factors affecting consumption
are longer-term trends in income, household
wealth, and the aggregate price level. Aggregate
demand analysis focuses on the determinants
of real consumption (that is, nominal or dollar
consumption divided by the price index for
consumption).
2. Investment. Investment (I ) spending includes
purchases of buildings, software, and equipment
and accumulation of inventories. Our analysis in
Chapter 21 showed that the major determinants
of investment are the level of output, the cost of
capital (as determined by tax policies along with
interest rates and other fi nancial conditions),
and expectations about the future. The major
channel by which economic policy can affect
investment is monetary policy.
3. Government purchases. A third component of aggregate
demand is government purchases of goods
and services (G ). This includes the purchases of
goods like tanks and school books, as well as the
services of judges and public-school teachers.
Unlike private consumption and investment, this
component of aggregate demand is determined
directly by the government’s spending decisions;
when the Pentagon buys a new fi ghter aircraft,
this output directly adds to the GDP.
4. Net exports. A fi nal component of aggregate
demand is net exports (X ), which equal the
value of exports minus the value of imports.
Imports are determined by domestic income
and output, by the ratio of domestic to foreign
prices, and by the foreign exchange rate of the
dollar. Exports (which are imports of other
countries) are the mirror image of imports,
and they are determined by foreign incomes
and outputs, by relative prices, and by foreign
exchange rates. Net exports, then, will be determined
by domestic and foreign outputs, relative
prices, and exchange rates..

x= net exports

Net exports are defined as exports of goods and

services minus imports of goods and services.

imports, which are goods and services produced

abroad and consumed domestically. Exports are
goods and services produced domestically and purchased
by foreigners.

X= Ex – Im

In
2007, net exports for the United States were minus
$708 billion, as calculated from $1662 billion worth of exports minus $2370 billion worth of
imports.
When a country has positive net exports, it is accumulating
foreign assets. The counterpart of net
exports is net foreign investment, which denotes
net U.S. savings abroad and is approximately equal
to the value of net exports. Because the U.S. had
negative net exports, its net foreign investment
was negative, implying that the U.S. foreign indebtedness
was growing.

Exports are the mirror image of imports: U.S.

exports are other countries’ imports.

Figure 28-1

Determinants of Trade and Net Exports

What determines the levels of exports and imports

and therefore of net exports?

Imports into the United States are positively

related to U.S. income and output. When U.S. GDP
rises, imports into the U.S. increase
(1) because some of the increased C +I +G purchases (such as
cars and shoes) come from foreign production and
also
(2) because America uses foreign-made inputs
(like oil or lumber) in producing its own goods.

To calculate the total production of American

goods and services, we need to add trade to domestic
demand. That is, we need to know the total production
for American residents as well as the net production
for foreigners. This total includes domestic
expenditures ( C + I +G ) plus sales to foreigners
( Ex ) minus domestic purchases from foreigners ( Im ).
Total output, or GDP, equals consumption plus
domestic investment plus government purchases plus
net exports:
Total domestic output =GDP
=C +I +G +X

Imports and exports are determined primarily by incomes, relative price differences, and foreign
exchange rates. When a nation’s exchange rate rises, the prices of imported goods fall while its
exports become more expensive to foreigners.

Two basic exchange rate systems:

Flexible exchange rate - the market forces of supply and demand determine the rate at which
currencies are traded

Fixed exchange rate - the government specifies the rate at which its nation’s currency will be
traded for other currencies.
SHORT-RUN IMPACT OF
TRADE ON GDP

How do changes in a nation’s trade fl ows affect its

GDP and employment?

There are two major new macroeconomic elements

in the presence of international trade: First, we have a fourth component of spending, net
exports, which adds to aggregate demand. Second,
an open economy has different multipliers for private
investment and government domestic spending
because some spending leaks out to the rest of the
world.

Table 28-1

Figure 28.2

Marginal propensity to import, Mpm- measures the changes in spending on imports for each
dollar change in GDP

Mpm= change in imports

Change in GDP

Slope of total spending line= total change in spending

Change in GDP