305_PPT_WK13.1-CH18_STUDENT_F24

Fluctuations in an Open Economy

• The global financial crisis began in 2008 in the U.S., leading to a worldwide recession.

• To understand how demand shocks propagate across economies, we need to expand the goods market model to an open economy.

• GDP growth rates (2000-2018).

Goods Markets in an Open Economy

• Short-run fluctuations in domestic output consist of:

  • Changes in domestic demand (C + I + G)

  • Changes in demand for domestic goods (Z), which includes foreign demand.

• Key equation:

  • Total domestic demand for goods (domestic or foreign):( Z = C(Y - T) + T_g + I(Y_r) + x + G )

• Total domestic demand can be expressed as:( C + I + G = C(Y - T) + T_g + I(Y_r) + x + G )

Demand in the Open Economy

• Net Exports (NX) represent net demand for domestic goods from the rest of the world:

  • ( NX = X - IM )

  • where IM = value of imports in terms of domestic goods.

• Imports and exports relationship:

  • Imports ( ( IM = m_1Y + ext{other factors} )

  • Exports ( ( X = X + ext{effects of foreign income and exchange rate} )

Net Exports Relations

• Net Exports (NX) fundamentals:

  • ( NX = NX(Y, Y^*, \epsilon) )

  • Effects observed when changing incomes:

    • Increase in domestic income (Y) leads to increase in imports (IM) and decrease in NX.

    • Increase in foreign income (Y*) leads to increase in exports (X) and thus increase in NX.

    • Increase in real exchange rate (( \epsilon )) leads to increase in IM and decrease in X, thus decreasing NX.

• Linear representation:

  • ( NX = NX + \delta_1 Y^* - m_1Y - (\delta_2 + \gamma)\epsilon )

Goods Market Equilibrium in the Open Economy

• Demand for domestic goods (Z) and Net Exports (NX) relationship:

  • Graphically, DD represents domestic demand and AA represents domestic demand for domestic goods excluding imports.

  • ZZ represents the total demand for domestic goods, including exports. The distance between AA and ZZ is constant because exports do not depend on domestic income.

Goods Market Equilibrium and Trade Balance

• In an open economy, the equilibrium level of output (Y) can yield NX in surplus or deficit.

  • Trade Balance: NX = 0

  • Trade Surplus: NX > 0

  • Trade Deficit: NX < 0

• Implications of Equilibrium:

  • An increase in income impacts domestic demand minimally due to m1, leading to a smaller effect of government spending on output.

Changes in Domestic or Foreign Demand

• Differences with a closed economy:

  • An increase in output leads to a trade deficit due to increased imports.

  • Can lead to Twin Deficits: combination of budget and trade deficits.

  • Fiscal policy's smaller effect on output: as Z is flatter than D, the multiplier is smaller in an open economy.

Changes in Domestic Demand (Expansionary Fiscal Policy)

• Increase in G (government spending) leads to:

  • Increase in output (Y).

  • Deterioration in trade balance (NX decreases).

Changes in Foreign Demand

• An increase in foreign income (Y*) leads to:

  • Increase in output (Y).

  • Improvement in trade balance (NX increases).

• The increase in foreign demand predominantly results in a trade surplus due to stronger exports offsetting potential import increases.

Summary of Demand Changes

• An increase in domestic demand (C, I, or G) leads to:

  • Higher Y and deterioration in trade balance.

• An increase in foreign demand (Y*) leads to:

  • Higher Y and improvement in trade balance.

• Implications:

  • Demand shocks in one country affect other countries through trade, complicating policymaking and coordination.