Christina Zauner. June 8 th, Department of Economics, University of Vienna. The Goods Market of an Open Economy. Christina Zauner.

Transcription

1 Department of Economics, University of Vienna June 8 th, 2011 The for

2 In the final chapter we analyse the equilibrium in the goods market in an open economy Changes in domestic as well as foreign demand or the exchange rate affect the equilibrium in the domestic goods market and the trade balance of an economy Furthermore, there exists an important relation between saving and investment on the one hand and the trade balance on the other hand in an open economy The for

3 for In an open economy we have to distinguish between domestic demand for goods and the demand for domestic goods Reason: some domestic demand falls on foreign goods while some demand for domestic goods comes from foreigners The demand for domestic goods Z in an open economy is defined as The for Z C + I + G IM/ɛ + X C + I + G constitutes the domestic demand for goods (both domestic and foreign goods)

4 for The Special Case of Imports From the domestic demand for goods we have to subtract the value of imports IM/ɛ and add exports X in order to get the demand for domestic goods Z Note that imports IM are measured in terms of foreign goods; since all other aggregates are expressed in domestic goods we first have to express imports in terms of domestic goods 1/ɛ is the price of foreign goods in terms of domestic goods and thus IM/ɛ is the value of imports in terms of domestic goods The for

5 The Determinants of C, I and G In an open economy the determinants of consumption C, investment I and government spending G do not change Though the real exchange rate affects the composition of consumption, there is no reason why it should affect the overall level of consumption The same is true for investment: the real exchange rate may affect whether firms buy at home or abroad but not total investment Finally, we still assume that government spending is exogenously given The for Domestic demand: C(Y T ) + I (Y, r) + G

6 The Determinants of Imports Imports, which are domestic demand that falls on foreign goods, depend on domestic income and the real exchange rate Higher domestic income increases the demand for both domestic and foreign goods Besides, the more expensive domestic goods are relative to foreign goods (i.e. the higher ɛ), the higher will be the domestic demand for foreign goods Thus, imports depend positively on domestic income Y and the real exchange rate ɛ: The for with IM Y Imports: IM(Y, ɛ) > 0 and IM ɛ > 0

7 The Determinants of Exports Exports, which are foreign demand that falls on domestic goods, depend on foreign income and the real exchange rate Higher foreign income means higher foreign demand for both foreign and domestic goods In addition, the higher the real exchange rate, i.e. the higher the price of domestic goods in terms of foreign goods, the lower will be foreign demand for domestic goods Thus, exports depend positively on foreign income Y and negatively on the real exchange rate ɛ: The for with X Y Exports: X (Y, ɛ) > 0 and X ɛ < 0

8 for and Net Exports From domestic demand (DD line) we subtract the value of imports (IM/ɛ) The AA line is the domestic demand for domestic goods The distance between the DD and the AA line equals IM/ɛ Because IM increases with income/output Y, this distance increases with Y The for

9 for and Net Exports To domestic demand for domestic goods (AA line) we add exports X The resulting ZZ line is the demand for domestic goods From panel (c) we can deduce net exports X IM/ɛ as a function of output At output Y exports are equal to the distance AC while imports are equal to AB Net exports BC are positive trade surplus The for

10 Output and the Trade Balance Net exports are a decreasing function of output; this function is represented by the NX line in panel (d) on the previous slide Reason: as output/income Y increases, imports increase while exports stay the same At the output level Y TB the subscript stands for trade balance net exports are equal to zero, i.e. exports equal imports Output levels above Y TB lead to a trade deficit while levels below Y TB lead to a trade surplus The for

11 Output and the Trade Balance An equilibrium in the goods market requires that domestic output Y equals the demand (domestic and foreign) for domestic goods Z The equilibrium condition is therefore given by Y = C(Y T ) + I (Y, r) + G IM(Y, ɛ)/ɛ + X (Y, ɛ) The exogenous variables are taxes T, government spending G, foreign output/income Y and the real exchange rate ɛ The for

12 Output and the Trade Balance Graphical Illustration The demand for domestic goods Z is given by the ZZ line The condition Y = Z is represented by the 45-degree line output is determined by the intersection of these lines There is no reason why equilibrium output should be equal to the level of output where trade is balanced The for

13 Increase in Z In the following we analyse the effects that changes in one of the exogenous variables have on the equilibrium We start our investigation by analysing an increase in government spending (G ), i.e. an increase in domestic demand As we can see from panel (a) on the next slide, we start from an equilibrium at point A We assume that in this equilibrium trade is balanced, i.e. net exports are zero and equilibrium output equals Y TB The for

14 Increase in Government Spending Graphical Illustration G demand at any level of output increases, i.e. ZZ shifts up The equilibrium moves to A and output increases to Y The increase in Y is larger than the increase in G (multiplier effect) We move along the NX line as output increases The increase in Y increases imports while exports are not affected trade deficit The for

15 Increase in Government Spending An increase in government spending not only results in a trade deficit but its positive effect on output is smaller than in a closed economy Reason: the smaller the slope of the demand curve, the smaller the multiplier; since the slope of the demand curve in an open economy (ZZ line) is smaller than the slope of the demand curve in a closed economy (DD line), we have a smaller multiplier Intuition: in an open economy an increase in demand not only falls on domestic goods, but is split over domestic and foreign goods The for

16 Next consider an increase in foreign output (Y ), i.e. an increase in foreign demand As before, we start from an equilibrium at point A (see panel (a) on the next slide) Again we assume that in this equilibrium trade is balanced, i.e. net exports are zero and equilibrium output equals Y TB The ZZ line represents demand for domestic goods while the DD line is domestic demand for goods The difference between both lines corresponds to net exports NX since trade is balanced the lines intersect at the equilibrium The for

17 Graphical Illustration Higher foreign output leads to an increase in exports Thus, at any level of output we get a higher demand for domestic goods ZZ shifts up Further, at any level of output net exports are higher NX line shifts up The equilibrium moves to A and output increases to Y The for

18 The increase in foreign demand leads to an increase in domestic output Complication: while exports of domestic goods increase, higher domestic output also implies an increase in imports; could the trade balance deteriorate? Answer: no, the trade balance will improve since the increase in exports offsets the increase in imports Thus, an increase in foreign output increases domestic output and improves the trade balance The for

19 Revisited Our results imply that a demand shock (e.g. a fiscal expansion) in one country affects output and the trade balance in all other countries The stronger the (trade) links between countries, the stronger will these effects and the interdependence of countries be Dilemma: governments do not want to run trade deficits consistently because of the debt accumulation they prefer increases in foreign demand (higher output and improved trade balance in the domestic country) As a result, governments could be reluctant to increase domestic demand (worsening trade balance) and wait until foreign demand increases governments should coordinate their actions The for

20 and the Trade Balance In the following we analyse a change in the (real) exchange rate and how this affects the equilibrium in the goods market Assume that the nominal exchange rate decreases (nominal depreciation) and that the domestic and the foreign price level remain unchanged (short run) Therefore the real exchange rate ɛ EP/P decreases (real depreciation), i.e. the price of domestic goods in terms of foreign goods decreases (domestic goods become relatively cheaper) How is this real depreciation going to affect the trade balance? The for

21 and the Trade Balance Transmission Channels Recall that the trade balance (or net exports) is given by NX = X (Y, ɛ) IM(Y, ɛ)/ɛ Thus, a real depreciation affects the trade balance through three separate channels: 1. exports X increase because domestic goods are relatively cheaper than foreign goods 2. imports IM decrease because foreign goods become relatively more expensive than domestic goods 3. the price of foreign goods in terms of domestic goods, i.e. 1/ɛ, increases; thus the same quantity of imports now costs more (in terms of domestic goods) Therefore, the effect of a real depreciation on the value of imports is hard to determine The for

22 and the Trade Balance Marshall-Lerner A real depreciation leads to an improvement in the trade balance only if the effect on X is larger than the effect on IM/ɛ The condition under which a real depreciation actually leads to an increase in net exports is known as Marshall-Lerner condition (MLC) Since there is empirical evidence that the MLC actually holds, we will always assume that a decrease in ɛ leads to an increase in NX The for

23 and Output A real depreciation not only affects the NX line but also the ZZ line. Like an increase in Y, it shifts the ZZ and the NX line up the equilibrium moves to A and domestic output increases to Y In summary: the depreciation shifts demand towards domestic goods; this leads to both an increase in domestic output and an improved trade balance The for

24 Dynamics: the J-Curve Consider again the effects of a change in the (real) exchange rate on the trade balance If the Marshall-Lerner condition holds then a real depreciation leads to an improvement in the trade balance This improvement, however, will not occur over night but will take some time dynamic process Recall that a real depreciation, i.e. ɛ, affects the trade balance via three channels: 1. it leads to an increase in exports X The for 2. it leads to a decrease in imports IM 3. it leads to an increase in the value of imports IM/ɛ

25 Dynamics: the J-Curve Initially the effect of the depreciation is likely to be reflected more in the value of imports than in the quantities of exports and imports Reason: while the price of imports (exports) goes up (down) immediately, traded quantities are likely to change much slower because consumers first have to realise that prices have changed Thus, the third channel will dominate in the beginning, leading to a deterioration in the trade balance (ɛ decreases while neither X nor IM adjust initially and so X IM/ɛ goes down) As time goes by, the effects of the depreciation on traded quantities become stronger The for

26 Dynamics: the J-Curve Graphical Representation Eventually domestic consumers switch to relatively cheaper domestic goods (IM ) and Foreign consumers increase their demand for domestic goods (X ) The Marshall-Lerner condition guarantees that in the end the trade balance improves This dynamic adjustment process is captured by the J-curve The for

27 Case Study: Combining Exchange Rate and Fiscal Policies Assume an economy is running a large trade deficit, i.e. NX < 0, while output is at the natural level Can the government reduce the trade deficit without changing the level of output? A (real) depreciation alone reduces the trade deficit but increases output A fiscal contraction (e.g. G, T ) not only leads to a reduction in the trade deficit but also to lower output Solution: the government should use a combination of both The for

28 Case Study: Combining Exchange Rate and Fiscal Policies Graphical Illustration The real depreciation must be such that the NX line in panel (b) shifts to NX The increase in net exports shifts the ZZ line up to ZZ To offset this shift a fiscal contraction is needed to shift ZZ back to ZZ This combination eliminates the trade deficit while output remains at the natural level The for

29 Saving, Investment, and the Trade Balance In a closed economy, the equilibrium condition for the goods market is equivalent to the condition that investment equals saving (private and public) There is a corresponding condition for the open economy; recall that the equilibrium condition for the goods market is given by Y = C + I + G IM/ɛ + X Rewriting this equilibrium condition yields The for NX = S + (T G) I (1) Thus, in equilibrium the trade balance NX is equal to private saving S plus public saving (T G) minus investment I

30 Saving, Investment, and the Trade Balance In other words, a trade surplus (NX > 0) corresponds to an excess of saving over investment while a trade deficit (NX < 0) corresponds to an excess of investment over saving From the balance of payments we know that a trade deficit implies that a country has to borrow from the rest of the world Thus, an excess of investment over saving, corresponding to a trade deficit, has to be financed by the rest of the world (1) has a number of other important implications: I either S or (T G) or NX (T G) either S or I or NX S + (T G) relatively high either I or NX high The for