University of Leicester

Department of Economics

EC2024

FOUNDATIONS OF MACROECONOMIC THEORY

9a. The Goods Market in an Open Economy

Unless stated otherwise, all graphs used in the following notes are taken from
Blanchard, O. 2010. Macroeconomics – Updated Edition, 5th edition, Pearson Education
 The Demand for Domestic Goods

IM
Z C I G EX . (9a.1)
ε
 C I G is the domestic demand for goods (domestic and foreign).
 In order to get the overall (domestic and foreign) demand for domestic
goods we add exports and subtract imports.
 Since foreign goods are different from domestic goods, we multiply imports
1
by the term to express the price of foreign goods in terms of domestic
ε
goods.

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 The Determinants of Imports

We assume that the domestic demand for foreign goods (i.e., imports) is

IM IM ( Y , ε ). (9a.2)
( ) ( )

 An increase (decrease) in domestic output/income, will increase (decrease)

the demand for all goods and services, including foreign ones. This is
captured by the positive effect of Y .
 An appreciation (depreciation) means that foreign goods become cheaper
(more expensive) in relation to domestic goods. Hence, the demand for these
goods will increase (decrease). This is captured by the positive effect of ε .

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 The Determinants of Exports

We assume that the foreign demand for domestic goods (i.e., exports) is

EX EX ( Y * , ε ), (9a.3)
( ) ( )

where Y * denotes foreign income/output.

 An increase (decrease) in foreign output/income, will increase (decrease) the

demand for domestic goods. This is captured by the positive effect of Y * .
 An appreciation (depreciation) means that foreign goods become cheaper
(more expensive) in relation to domestic goods. Hence, the demand for
domestic goods will fall (increase). This is captured by the negative effect of
ε.

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 Goods Market and the Trade Balance

Substituting (9a.2) and (9a.3) in (9a.1), we get

IM ( Y , ε )
Z C (Y T ) I (Y , i ) G EX (Y * , ε ) . (9a.4)
ε

Now, let us use the following notation:

DD
 DD C ( Y T ) I ( Y , i ) G , where 0.
Y
IM (Y , ε ) AA
 AA DD , where 0.
ε Y

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 Goods Market and the Trade Balance

Then, given (9a.4),

Z AA EX ( Y * , ε ),
Z
where 0.
Y

Furthermore, it is straightforward to check that we get

Z DD
AA EX ( Y * , ε ) DD

IM (Y , ε )
DD EX ( Y * , ε ) DD
ε
IM (Y , ε )
EX (Y * , ε ) NX ( Y , Y * , ε ) . (9a.5)
ε

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 Goods Market and the Trade Balance

Equation (9a.5) gives us net exports, denoted NX.

 If NX >0 then the economy has a trade surplus.

 If NX <0 then the economy has a trade deficit.
NX
 Clearly, 0 : other things being equal, higher domestic output leads to
Y
lower trade surplus or higher trade deficit.

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 Goods Market and the Trade Balance

Let us use YTB to denote the level of domestic output for which the economy has
a trade balance, i.e.,
NX ( YTB , Y * , ε ) 0 .

Given the above, our previous results reveal that (for given exchange rate and
foreign output)
0 if Y YTB
NX .
0 if Y YTB

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Goods Market and the Trade Balance

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Goods Market and the Trade Balance

9
 Equilibrium in the Goods Market

Given the equilibrium condition Z Y , we can use (9a.4) and (9a.5) to express
the equilibrium in the goods market as

Y C ( Y T ) I (Y , i ) G NX (Y , Y * , ε ) . (9a.6)

 If equilibrium output is associated with NX >0 then the economy has a trade
surplus.
 If equilibrium output is associated with NX <0 then the economy has a trade
deficit.

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Equilibrium in the Goods Market

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 Fiscal Policy

Consider an economy, that is in trade balance; that is, NX 0 . Now suppose

that the government introduces an expansionary fiscal policy (higher spending or
lower taxes).
 As we know, equilibrium output will increase.
 As equilibrium output is now higher, it is Y YTB , therefore NX 0 .

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Fiscal Policy

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 Changes in Foreign Demand

Consider an economy, that is in trade balance; that is, NX 0 . Now suppose

that there is an increase in foreign income Y * .
 For a given level of domestic income, total expenditure on domestic goods
will increase due to higher exports.
 With higher expenditure, domestic income must increase as well.
 What about the trade balance? Here we have two conflicting effects. On the
one hand, a direct increase in exports; on the other hand, a higher equilibrium
income will increase imports as well. As it turns out, the first effect
dominates and, in the new equilibrium, there is a trade surplus.

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Changes in Foreign Demand

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 Changes in the Exchange Rate

EP
Recall, that the real exchange rate is given by ε *
. For given domestic and
P
foreign prices, this implies that
ε ε( E ) .
( )

NX
Marshall-Lerner Condition: 0.
ε

NX
Therefore, the Marshall-Lerner condition implies that 0 as well.
E

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 Changes in the Exchange Rate

Consider an economy that is in trade balance, NX 0 , and assume that the

Marshall-Lerner condition holds. Now suppose that there is a depreciation of the
domestic currency, i.e., a lower E .
 For given prices, the real exchange rate ε will fall as well.
 Net exports will increase, thus increasing total expenditure on domestic
goods.
 In equilibrium, domestic output must be higher.
 Again we have two conflicting effects on the trade balance. On the one hand,
the increase in exports and, on the other hand, an increase in imports due to
higher equilibrium output domestically. Once more, the first effect dominates
and, in the new equilibrium, there is a trade surplus.

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