VII_goods_market_openeconomy_ho

VII_goods_market_openeconomy_ho - ECON110B VII The Goods...

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118 ECON110B VII. The Goods market in an open economy To expand our treatment of the goods market in the closed economy to take into openness in goods markets To characterize equilibrium in the goods market for an open economy To show the effects of domestic shocks and foreign shocks on the domestic economy’s output and trade balance To look at the effects of a real depreciation on output and the trade balance Alternative description of the equilibrium: the close connection between saving, investment, and the trade balance 1. The IS relation in the open economy 1) The demand for domestic goods a. Demand for domestic goods ( Z ) - X IM G I C Z + + + ε / - C + I + G : Domestic demand for goods 119 - IM/ ε : The value of imports in terms of domestic goods - Now we must be able to distinguish between the domestic demand for goods and the demand for domestic goods . - Some domestic demand falls on foreign goods, and some of the demand for domestic goods comes from foreigners. b. Domestic demand for goods - C + I + G Also the demand for domestic goods if the economy was closed - Two adjustments i) First, we must subtract imports - Part of the domestic demand that falls on foreign goods rather than on domestic goods - To express the value of imports in terms of domestic goods IM/ ε - ε : The price of domestic goods in terms of foreign goods - 1/ ε : The price of foreign goods in terms of domestic goods
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120 ii) Second, we must add exports ( X ) - Part of the demand for domestic goods that comes from abroad 2) The determinants of C, I, and G a. Domestic demand - G r Y I T Y C G I C + + = + + + + ) , ( ) ( b. No role of expectations at the moment 3) The determinants of imports a. Imports - The part of domestic demand that falls on foreign goods i) They depend on domestic income: - Higher income Higher domestic demand for domestic goods and foreign goods Imports ii) They also depend on the real exchange rate - More expensive domestic goods relative to foreign goods Cheaper foreign goods relative domestic goods Higher domestic demand for foreign goods Higher imports 121 b. Imports function - ( , ) IM IM Y ε + + = - An increase in domestic income, Y , leads to an increase in imports. - An increase in the real exchange rate, ε , leads to an increase in imports, IM 4) The determinants of exports a. Exports ( X ) - The part of foreign demand that falls on domestic goods i) It depends on foreign income ( Y * ) - Higher foreign income Higher foreign demand for foreign and domestic goods Higher exports ii) It depends also on the real exchange rate - Higher price of domestic goods in terms of foreign goods (higher real exchange rate) Lower foreign demand for domestic goods Lower exports b. Exports function - ) , ( * + = ε Y X X
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122 - An increase in foreign income, Y* , leads to an increase in exports - An increase in the real exchange rate, ε , leads to a decrease in exports 5) Putting the components together Graph VII – 1: The demand for domestic goods and net exports 123 a. Domestic demand ( DD ) - C + I + G as function of Y - 0 < the slope of DD < 1: An increase in output increases
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