Term 1 Lecture 8: The Goods Market in an Open economy Flashcards
What is the demand for domestic goods in an open economy (2)
-Z = C + I + G + X - IM/ε
-C + I + G represents the total demand for goods, domestic or foreign
How to convert imports in terms of domestic goods (4)
-You divide imports by epsilon (the real exchange rate) to convert imports in terms of domestic goods
-ε = EP/P*
-E = ER, P = price of domestic goods, P* = price of foreign goods
-IM/ε = (value of imports x price of foreign goods)/(exchange rate x price of domestic goods)
What is the formula for net exports (2,1)
-Imports are positively related to domestic income and the real exchange rate
-Exports are positively related to foreign income and negatively related to the real exchange rate
-NX= X(y*, ε) - IM(Y, ε)/ε
How can we graphically represent the demand for goods in a closed vs open economy (3)
-Imagine your DD curve, upwards sloping with output on the x axis and demand on the y axis
-Adding imports gives us the AA curve, which is both lower and has a lower gradient than the DD curve (imports positively related to domestic income, as domestic income rises so does imports and thus lower domestic demand vs without imports at that income level)
-Adding exports shifts the AA curve upwards to the ZZ curve (gradient the same as exports don’t depend on Y)
How can we graphically represent a trade surplus/deficit with the DD, AA and ZZ graphs (2)
-There is a trade surplus before the intersection of DD and ZZ, and a deficit after (think about how before, (C + I + G + X - IM/ε > C + I + G)
-To draw this, below the diagram with DD, AA and ZZ curves draw a graph with output on the x axis, net exports on the y axis and the NX curve, which is downwards sloping and ZZ-DD for all points of output
What are the formulas for the DD, AA and ZZ curves (3)
-DD = C + I + G (domestic demand for domestic goods)
-AA = C + I + G - IM/ε (Domestic demand for goods)
-ZZ = C + I + G + X - IM/ε (Demand for domestic goods)
How do we represent the equilibrium condition for output (2,1)
-The equilibrium condition for output can be expressed by: Y = C(Y-T) + I(Y, r) + G + X(Y*, ε) - IM(Y, ε)/ε
-Graphically, this is the intersection of ZZ and the 45 degree line
-We could have either a trade surplus or deficit at equilibrium
How does the multiplier change in an open and closed economy (1,2)
-The multiplier is smaller in an open economy than a trade economy, as ZZ is flatter than DD
-In a closed economy, the multiplier is 1/1-c1
-In an open economy, the multiplier is 1/1-c1+m1 (m1 = marginal propensity to import)
How do increases in domestic/foreign demand impact domestic output and the trade balance (2,2)
-An increase in domestic demand lead to an increase in domestic output, but also a deterioration of the trade balance
-Think about how a movement/shift of the DD curve affects the NX curve
-An increase in foreign output leads to both an increase in domestic output and the trade balance
-An upwards shift of the ZZ curve shifts the NX curve up by the same amount
How does a real depreciation affect the trade balance (3)
-An increase in X
-A decrease in IM
-An increase in 1/ε (the relative price of foreign goods in terms of domestic goods)
What is the Marshall-Lerner condition (2)
-The ML condition is that a real depreciation leads to an increase in net exports
-A depreciation leads to a shift in demand (both foreign and domestic) towards their domestic goods, thus leading to an increase in domestic output and the trade balance
How can we derive the equation for the ML condition (6,1)
-Assume trade is initially balanced, so NX = X - IM/ε = 0
-εNX = εX - IM
-Consider the effect of a change in the real exchange rate ∆ε
-Its effect is ∆ε(NX) + ε(∆NX), and if trade is initially balanced, NX = 0
-Therefore, ε(∆NX) = ∆ε(X) + ε(∆X) - (∆IM)
-Divide both sides by εX, then assume if trade is initially balanced then εX = IM
-You are then left with ∆(NX)/X = ∆ε/ε + ∆X/X - ∆IM/IM
What is the martial-lerner condition formula (2)
-∆(NX)/X = ∆ε/ε + ∆X/X - ∆IM/IM
-The change in trade balance as a ratio of exports in response to a real exchange rate change is = the proportional change in the real exchange rate + the proportional change in exports - the proportional change in imports
-If the ML condition holds, the sum of the three terms is positive (ER change < X - IM change)
What must the government do to eliminate a trade deficit without changing output + diagram (2)
-They must achieve a depreciation sufficient to eliminate the trade deficit
-They must reduce government spending
-On the 2 diagrams, the change in NX should shift ZZ up by the same amount the reduction in government spending shifts ZZ’ back down, allst whilst the NX curve shifts up
What is the J curve (3)
-The J curve is the adjustment process in the trade balance in response to a real depreciation
-With time on the x axis and NX on the y axis, it shows how a depreciation initially leads to a deterioration (MLC not satisfied) than an improvement (ML satisfied) in the trade balance
-This is due to the initial inelasticity of imports/exports to changes in the exchange rate
How can the current account be rewritten in terms of AD, and what does this show us (2,3)
-CA = S - I + (T-G)
-To work this out, start with Y = C + I + G + CA, then make Y - C -T = S, then rearrange
-An increase in investment must lead either to an increase in private/public saving, or a deterioration of the CA
-A deterioration in the government budget must lead either to an increase in private saving/investment, or a deterioration of the CA
-A country with a high saving rate must either have a high investment rate or large CA surplus
