Week 9 Tough

Demand for Domestic goods in an open economy

Z ≡𝐶+𝐼+G - (IM/𝜀) + X

The first three terms C I G constitute the domestic demand for goods (DD)

No we subtract imports in terms of domestic goods and add exports

Net exports formula

NX = X(Y*, ε) − IM(Y, ε)/ε

X = Exports

Y* = Foreign income

ε = real exchange rate = (e x P*)/ P = (nominal exchange rate x foreign price level)/ domestic price level

IM = Imports

The determinants of imports

Higher real exchange rate leads to higher imports therefore IM = IM(Y,ε)

An increase in domestic income Y leads to an increase in IM, an increase in the real exchange rate leads to an increase in imports IM.

The determinants of exports

X = X(Y*,ε)

An increase in foreign income leads to an increase in X.

An increase in the real exchange rate ε leads to a decrease in X

DD Domestic demand for goods

AA Demand for domestic goods

First obtained by subtracting the value of imports from domestic demand

DD,AA and ZZ lines and there effect on the trade surplus

DD - Domestic Demand C + I + G

AA - Domestic Demand for Domestic goods. Demand - Imports C + I +G-IM

ZZ = C+I+G-IM+X

Goods market in equilibrium

Y = Z In equilibrium when domestic output equals the demand - both domestic and foreign for domestic goods

Equilibrium formula in an open economy

these two are the same because of the NX formula

NX formula ( net exports) = Exports - Imports

As we are studying in the short run we assume prices are sticky and therefore we can assume prices to be constant

In this case we can assume the P/P* = 1 so that ε=E

The interest parity condition (UIP)

Where Et = exchange rate

Eet+1 = exchange rate expected in the next period

Rearranged UIP to get current exchange rate

This relations tells us that the current exchange rate depends on the domestic interest rate, on the foreign interest rate, and on the expected future exchnage rate

The more the pound appreciates the more investors expect it to depreciate in the future

What does the UIP imply

It implies a positive relation between the domestic interest rate and the exchange rate

UIP

i increase = E Increase

i* increase = E decrease

Ee increase = E increase

2 effects of an increase in the interest rate

• Reduction in investment which was already present in the closed economy

• Appreciation in the exchange rate which is only present in the open economy

IS-LM model in an open economy

Effects of increases in domestic demand in closed and open economies

• Now an effect on the trade balance in open economy

• Effect of government spending on output is smaller than it would be in a closed economy. Meaning the multiplier is smaller in the open economy

Why is there low macro-coordination amongst G7 countries

• Some countries may be required to do more than others

• Countries have strong incentive to promise to coordinate and then not deliver on that promise

Fiscal Multiplier in an open economy for home country

Formula shows us how much output changes for every unit of increase in government spending

m = marginal propensity to import - how much imports rise when income rises

Fiscal Multiplier

Measure of how output changes to a change in fiscal policy.

Fiscal multiplier in an open economy for the foreign economy

The Marshall-Lerner condition

Condition in which a real depreciation leads to an increase in net exports.

A depreciation leads to a shift in demand, both foreign and domestic, to domestic goods as they now appear cheaper.

Real exchange rate formula

Real exchange rate = Nominal exchange rate x Foreign price level/ Domestic price level

What two things must the government do if it wants to reduce the trade deficit without changing output

• It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output.

• The government must reduce government spending

The J curve

A real depreciation leads initially to a deterioration of the trade balance because initially exporters and importers don’t respond immediately. This means that goods abroad appear more expensive and our domestic goods appear cheaper. But the quantity of each has not changed, meaning we are paying more for the same amount of imports and receiving less for the same amount of exports. Eventually, markets respond and the trade balance improves.

Investment (Saving) formula in a closed economy

I = S + (T-G)

S = private sector saving

(T-G) = government savings

Investment (Saving) formula in an open economy

CA = S + (T - G) - I

IS-LM UIP curve

Fixed exchange rate

(1+i) = (1+i*)

Under a fixed exchange rate and perfect capital, the domestic interest rate must be equal to the foreign interest rate.