Intermediate Macroeconomics Ch19 notes

Intermediate Macroeconomics Ch19 notes - Chapter 19 The...

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Chapter 19: The Goods Market in an Open Economy The Demand for Domestic Goods Z = C + I + G – IM/є + X C is private consumption, I is private investment and G is public expenditure. IM/є is the price of imports in terms of domestic goods/currency. X is exports. The Determinants of C, I and G Domestic demand for local goods = C + I + G = c 0 + c 1 (Y – T) + I (Y, r) + G ( + ) + ( +, - ) where Y is the income level, T is taxes, r is real interest rate, c 0 is autonomous consumption and c 1 is marginal propensity to consume. The Determinants of Imports IM = IM(Y, є) It shows that imports depend on domestic income and higher domestic income leads to a higher domestic demand for goods, on both domestic and foreign products. Then imports increase with domestic income. Imports depend also on real exchange rate (not only the nominal exchange rate) which is the price of domestic goods in terms of foreign goods. A higher real exchange rate є, that is the more expensive the domestic products relative to foreign products, leads to lower imports. The Determinants of Exports X = X(Y * , є) The foreign demand for domestic goods depend on foreign income level Y * . Higher foreign income leads to higher exports. Exports depend also on real exchange rate. The higher the price of domestic goods in terms of foreign goods, the lower the foreign demand for domestic goods. In other words, the higher the real exchange rate є, the lower the exports. The demand functions in the open economy in consideration of total imports and exports are drawn in p.398 of the textbook. Equilibrium Output and the Trade Balance In the goods market equilibrium Y = Z Y = C(Y-T) + I (Y, r) + G – IM(Y, є)/ є + X(Y * , є) Given demand and output as the units of the X and Y axis, the aggregate demand function ZZ should be an upward sloping function like before, with slope less than 1. It may be flatter than the demand function under a closed economy given the negative relationship between imports and domestic income. It is important to state that equilibrium in the goods money refers to Y = Z or production equals output. Goods market equilibrium does not always imply a balanced trade account. It can be in a surplus or deficit balance. 1
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Increases in Domestic Demand The Impacts of an increase in government spending (for output expansion) on trade balance. An increase in G leads to a much bigger increase in Y. Given Y increases, imports tend to growth as well. Exports, however, is independent of domestic income. Then trade balance tends to worsen. (It also gives raise to twin deficit problem.) The impact of G increase on output in an open economy is smaller than the case in a closed economy. It is because an increase in G expands both the demand for
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Intermediate Macroeconomics Ch19 notes - Chapter 19 The...

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