Intermediate Macroeconomics

Lecture 20: the goods market in an open economy

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 This lecture

1- More on goods market equilibrium in an open economy

– increases in demand
– fiscal policy and exchange rate policy
– the J curve
– saving, investment, and the current account balance

2- Equilibrium in the goods market and financial markets

3- Reading: Blanchard, chapter 18, sections 18.3-18.6 and chapter 19, sections 19.1-19.2

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 Equilibrium output and net exports

The goods market is in equilibrium when production Y is equal to the demand for domestic goods Z. At
the equilibrium level of output, trade balance may be in deficit or surplus.
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 Increases in domestic demand

• Suppose the economy is in a recession and the government decides to increase

government spending

• Increase in government spending raises aggregate demand

• Output increases, what else?

• Changes in government spending also affect trade balance

– the multiplier is smaller in the open economy, why?

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 Effects of increased government spending

Increase in government spending leads to increase in output and to lower net exports (here, a trade
deficit). The effect of government spending in the open economy is smaller — i.e., the multiplier is smaller
— than it would be in a closed economy.
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 Increases in foreign demand

• Suppose foreign output increases

• Increase in foreign output raises aggregate demand and net exports

• Output increases

• What happens to trade balance?

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 Effects of increased foreign demand

An increase in foreign demand leads to an increase in output and to higher net exports (here, a trade
surplus). Trade balance improves because the increase in imports does not offset the increase in exports.
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 Games countries play

• Increases in demand, both domestic and foreign, lead to increases in output. But they
have opposite effects on trade balances

• Increase in foreign demand is often preferred to an increase in domestic demand

because it leads to an improvement in the trade balance

• In a recession, countries with high trade deficits may wait for foreign demand to
stimulate their economy

⇒ may be difficult to achieve coordinated fiscal policy responses to global recession

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 Fiscal policy and exchange rate policy

• Suppose output is at its natural level, but the economy is running a large trade deficit

• Consider an exchange rate policy which leads to a real depreciation

– trade deficit falls

– output rises

• To avoid overheating, the government can use a contractionary fiscal policy

• If government cares about both the level of output and the trade balance, both fiscal
policy and exchange rate policy should be used

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 Reducing trade deficit without changing output

To reduce the trade deficit without changing output, the government must both achieve a depreciation and
decrease government spending.
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 The J-curve

The J-curve refers to the dynamic adjustment process of the trade balance in response to a real
depreciation. In the short run, the effect of a real depreciation is likely to be reflected much more in prices
than in quantities. In the long run, the real depreciation improves the trade balance (assuming the
Marshall-Lerner condition is satisfied).

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 The J-curve: evidence from US

The real exchange rate and the ratio of the trade deficit to GDP: United States, 1980-1990. The large real
appreciation and subsequent real depreciation from 1980 to 1990 were mirrored, with a lag, by an increase
and then decrease in the trade deficit.

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 Savings, investment and the trade balance

• The alternative way of looking at equilibrium from the condition that investment
equals saving has an important meaning

Y = C + I + G + NX

• Private saving is

S ≡Y −T −C
= I + G − T + NX

• So net exports are

N X = (S − I) + (T − G)

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 Savings, investment and the trade balance

• Net exports

N X = (S − I) + (T − G)

• A trade surplus must correspond to an excess of total saving over investment

• If saving remains constant, an increase in investment results in a deterioration of the

trade balance

• An increase in the government’s budget deficit, all else the same, leads to a
deterioration of the trade balance

– “twin deficits hypothesis ”

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 Equilibrium in the goods market

• Goods market

Y = C(Y, T ) + I(Y, i) + G + X(Y ∗ , ε) − IM (Y, ε)/ε

• Define net exports

N X(Y, Y ∗ , ε) ≡ X(Y ∗ , ε) − IM (Y, ε)/ε

• Net exports decreasing in domestic Y , increasing in foreign Y ∗ , decreasing in real

exchange rate ε (the Marshall-Lerner condition)

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 Key simplifications

(i) Actual and expected inflation constant (and zero, for simplicity). Since inflation is
zero, domestic price level P is constant

(ii) Similarly, foreign actual and expected inflation is zero so that P ∗ is constant (and
equal to P , again for simplicity). Implies nominal and real exchange rates are the same

P
=1 ⇔ E=ε
P∗
So equilibrium condition is

Y = C(Y, T ) + I(Y, i) + G + N X(Y, Y ∗ , E)

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 Equilibrium in financial markets
• Assuming there is perfect capital mobility. So domestic and foreign bonds are perfect
substitutes (apart from the currency in which they are denominated)

• Interest parity condition

Et
(1 + it ) = (1 + i∗t ) e
Et+1

• If expected future exchange rate is Ē e , then

E
i = (1 + i∗ ) −1
Ē e
• Also, if interest rates are i and i∗ then exchange rate is

(1 + i) e
E= Ē
(1 + i∗ )

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 Equilibrium in financial markets
• Exchange rate in terms of interest rates
(1 + i) e
E= Ē
(1 + i∗ )
• Domestic monetary policy contraction (i.e., i increases) will increase demand for
domestic bonds

– domestic currency appreciates

• Foreign monetary policy contraction (i.e., i∗ increases) will increase demand for
foreign bonds

– domestic currency depreciates

• If expected future value of domestic currency Ē e increases, demand for domestic

bonds increases

– domestic currency appreciates

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 Exchange rates and interest rates

Interest parity: i = (1 + i∗ )(E/Ē e ) − 1. Lower domestic interest rate leads to lower exchange rate, a
depreciation of the domestic currency. Higher domestic interest rate leads to higher exchange rate, an
appreciation of the domestic currency.
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 Equilibrium in financial markets

• So far we take expected exchange rate as given

• The more the dollar appreciates now, the more investors expect it to depreciate over
time in the future

• If i rises, initial $A appreciation must be such that expected future depreciation

compensates for increase in domestic interest rate

Ē e − E (1 + i∗ )
= − 1 ≈ i∗ − i
E (1 + i)
• Mundell-Fleming model focuses on short run for which expected exchange rate is given

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 Next

• Output, the interest rate and the exchange rate

– Blanchard, chapter 19, sections 19.3–19.5

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 Example #10: problem
Setup: Consider the following two-country economy. The real exchange rate is fixed
and equal to 1. Domestic consumption, investment and taxes are given by
C = 110 + 0.4(Y − T ), I = 40, T = 25
Import and exports are given by
IM = 0.2Y, X = 0.2Y ∗
(asterisks denote foreign variables).

(a) Solve for domestic output in terms of G and Y ∗ .

(b) How does the government purchases multiplier compare to the closed economy
case?
(c) Suppose both countries are symmetric, just with asterisks reversed. Solve for
output in each country in terms of G, G∗ .
(d) How does the multiplier compare to the one you found in (b)?
(e) Suppose both countries have G = G∗ = 100. Calculate Y, Y ∗ .