305 PPT WK13.2-CH18 STUDENT F24

Page 1: Demand Impact on Trade Balance

• Increase in Domestic Demand:

  • An increase in consumption (C), investment (I), or government spending (G) raises output (Y).

  • However, this also deteriorates the trade balance due to increased imports.

• Increase in Foreign Demand:

  • An increase in foreign demand (Y*) leads to higher export levels (X) and improvements in net exports (NX).

  • Notably, higher foreign demand contributes positively to the trade balance (↑ Y* → ↑X and NX ↑).

• Implications of Demand Shocks:

  • Demand shocks in one country have a ripple effect on other countries through trade connections.

  • Economic interactions necessitate careful policy coordination which can be challenging to implement effectively.

• Depreciation Effects on Trade Balance:

  • A real depreciation (↓ε) causes:

    • Increased exports (↑X) as foreign goods become cheaper.

    • Decreased imports (↓IM) as domestic goods become more expensive.

  • Leads to an increase in net exports (NX):

    • The M-L condition holds, supporting the increase in NX.

Page 2: Marshall-Lerner Condition and Effects of Depreciation

• Marshall-Lerner Condition:

  • If satisfied, a real depreciation leads to increased net exports (NX).

  • Formula:

    • NX = X(Y*, ε) - IM(Y, ε)

• Effects of Real Depreciation:

  • A real depreciation (↓ε) results in:

    • An upward shift in the NX curve at every output level.

    • Increased demand (Z) leading to shifts in output (Y to Y‘).

    • Outcomes include ↑Y and ↑NX along with a reduction in purchasing power for domestic consumers due to more expensive imports.

Page 3: Combining Policies to Achieve Trade Goals

• Scenario:

  • Given starting point A (Y = Yn) with a trade deficit (BC), objectives include:

    • Reducing trade deficit without affecting Y.

  • Policy Combination:

    • Implement real depreciation (↓ε) to boost NX while managing output (↑Y to A‘).

    • Combine with contractionary fiscal policy (↓G) to bring Z down, ensuring final equilibrium leading to NX increase without changing Y (final at B).

Page 4: Current Account Deficit Case Study - Greece

• Greece's CA Deficit Trends:

  • CA deficit rose notably from 2000 onwards, peaking at almost 15% of GDP.

  • Improvement observed by 2018, but mainly due to a 30% decrease in output (Y) which decreased imports (IM) by 36%.

  • Tied to the euro, Greece had limited ability to depreciate (↓ε) without decreasing wages and prices for competitiveness.

• Expectations:

  • As Y begins to recover, forecasts suggest CA deficits might re-emerge.

Page 5: Current Account Balance and Investment

• Current Account Balance Fundamentals:

  • In an open economy, investment (I) can be funded by both domestic and external savings.

  • Equilibrium condition involves:

    • Y = C + I + G + NX

    • Adjustments highlighting the necessity of external savings.

• Current Account Balance Dynamics:

  • Rearranged, the current account balance (CA) reflects savings (S) and investment:

    • CA = S + T - G - I

  • Key insight:

    • An increase in investment must align with increases in savings (either private, public, or external) or result in a decrease in CA.

Conclusions and Future Directions

• Capital Flows and Short-Run Equilibrium:

  • Variations in the current account are interconnected with savings and investment patterns.

  • Integration of findings into IS-LM to analyze short-run output fluctuations and impacts on economic models (IS-LM-UIP).

  • Key Equations include:

    • IS: Y = C(Y-T) + I(Y, r+x) + G + NX(Y, Y*, ε)

    • LM: r = 𝑟̅

    • UIP: i*−i = EM = $