Summary EC 108 The goods market in an open market Review

The goods market in an open economy

The IS relation in an open economy

𝐼𝑀
● In an open economy, the demand for goods: 𝑍 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − Ɛ
○ Closed economy - domestic demand = domestic supply
○ Domestic demand for goods is an increasing function of income
○ Demand for domestic goods - imports + exports
○ Trade balance is a decreasing function of output
● Imports are positively related to domestic income (Y) and the real exchange
rate (Ɛ)
● Exports are positively related to foreign income Y* and negatively related to Ɛ
𝐸𝑃
● Ɛ= - real appreciation makes foreign
𝑃∗
goods relatively cheaper, increasing imports
● Domestic demand for domestic goods (AA) is
flatter than the domestic demand (DD)
○ +ve as long as some additional
demand falls on domestic goods
● Difference between the demand for domestic
goods (ZZ) and the domestic demand for
domestic goods (AA) is constant because
exports only depend on foreign income

Equilibrium output and the trade balance

𝐼𝑀
● 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑌, 𝑟) + 𝐺 + 𝑋(𝑌 ∗, Ɛ) − (𝑌, Ɛ)
Ɛ
○ At the intersection of ZZ and the 45-degree line
○ Domestic output = demand for domestic goods
■ Trade balance may be in deficit or surplus
● Higher domestic demand increases domestic output but worsens the trade
balance
● Higher foreign demand increases domestic output and improves the trade
balance
● Means shocks to one country affect other countries
○ Policy coordination is not easy to achieve

In a closed economy:
● An increase in output causes a trade deficit
● Smaller effect of government spending on output


Open economy: