Chapter 19. The Goods Market in anOpen EconomyAt the time of this writing, countries around the world are hoping for a strongand lasting U.S. expansion. Their hopes are not for the United States, butfor themselves. To them, a strong and lasting U.S. expansion means higherexports to the United States, an improvement of their trade positions, and ahigher probability of expansion for their own economy.Are their hopes justified? Does the United States economy really drive othereconomies? Conversely, would a U.S. recession really throw other countries inrecession? To answer these questions, we must expand our treatment of thegoods market in the core (Chapter 3), to take into account openness in goodsmarkets. This is what we do in this chapter.Section 19–1 characterizes equilibrium in the goods market for an open econ-omy.Sections 19–2 and 19–3 show the effects of domestic shocks and foreign shockson the domestic economy’s output and trade balance.Sections 19–4 and 19–5 look at the effects of a real depreciation on outputand on the trade balance.Section 19–6 gives an alternative description of the equilibrium, which showsthe close connection between saving, investment, and the trade balance.119–1. The IS Relation in the Open EconomyWhen we were assuming the economy was closed to trade, there was noneed to distinguish between the domestic demand for goods and the de-mand for domestic goods: They were clearly the same thing. Now, we mustdistinguish between the two: Some domestic demand falls on foreign goods,and some of the demand for domestic goods comes from foreigners.1Let’slook at this distinction more closely.The Demand for Domestic GoodsIn an open economy, the demand for domestic goods is given byZ ≡ C + I + G − IM/² + X (19.1)The first three terms—consumption, C, investment, I, and governmentspending, G—constitute the domestic demand for goods. If the econ-omy were closed, C + I + G would also be the demand for domestic goods.This is why, until now, we have only looked at C +I + G. But now we haveto make two adjustments:• First, we must subtract imports—that part of the domestic demandthat falls on foreign goods rather than on domestic goods.We must be careful here: Foreign goods are different from domesticgoods, so we cannot just subtract the quantity of imports, IM. Ifwe were to do so, we would be subtracting apples (foreign goods)from oranges (domestic goods). We must first express the value ofimports in terms of domestic goods. This is what IM/² in equation(19.1) stands for: Recall from Chapter 18 that ², the real exchangerate, is defined as the price of domestic goods in terms of foreign1. “The domestic demand for goods” and “The demand for domestic goods” soundclose, but are not the same. Part of domestic demand falls on foreign goods. Part offoreign demand falls on domestic goods.2goods. Equivalently, 1/² is the price of foreign goods in terms ofdomestic goods. So IM(1/²)—or equivalently IM/²—is the value ofimports in terms of domestic goods.2• Second, we must add exports—that part of the demand for domesticgoods that comes from abroad. This is captured by the term X inequation (19.1).3The Determinants of C, I, and GHaving listed the five components of demand, our next task is to specifytheir determinants. Let’s start with the first three: C, I, and G. Now thatwe are assuming the economy is open, how should we modify our earlierdescriptions of consumption, investment, and government spending? Theanswer: Not very much, if at all. How much consumers decide to spend stilldepends on their income and their wealth. While the real exchange ratesurely affects the composition of consumption spending between domesticgoods and foreign goods, there is no obvious reason why it should affectthe overall level of consumption. The same is true of investment: The realexchange rate may affect whether firms buy domestic machines or foreignmachines, but it should not affect total investment.This is good news because it implies that we can use the descriptionsof consumption, investment, and government spending that we developedearlier. Therefore2. In Chapter 3, I ignored the real exchange rate and subtracted IM , not IM/². Thiswas a cheat; I did not want to have to talk about the real exchange rate—and complicatematters—so early in the book.3.Domestic demand for goods C + I + GMinus Domestic demand for foreign goods (imports), IM/²Plus Foreign demand for domestic goods (exports), XequalsDemand for domestic goods C + I + G − IM/² + X3Domestic demand: C + I + G = C(Y − T ) + I(Y , r) + G( + ) (+, −)We assume that consumption depends positively on disposable income(Y − T ), and that investment depends positively on production (Y ) andnegatively on the real interest rate (r). We continue to take governmentspending (G) as given. We leave aside the refinements introduced in Chap-ters 14 to 17, where we looked at the role of expectations in affecting spend-ing. We want to take things one step at a time to understand the effects ofopening the economy; we shall reintroduce some of those refinements later.The Determinants of ImportsImports are the part of domestic demand that falls on foreign goods. Whatdo they depend on? They clearly depend on domestic income: Higher do-mestic income leads to a higher domestic demand for all goods, both do-mestic and foreign. So a higher domestic income leads to higher imports.4They also clearly depend on the real exchange rate—the price of domesticgoods in terms of foreign goods: The more expensive domestic goods arerelative to foreign goods—equivalently, the cheaper foreign goods are rel-ative to domestic goods— the higher is the domestic demand for foreigngoods. So a higher real exchange rate leads to higher imports. Thus, wewrite imports asIM = IM( Y, ²) (19.2)(+, +)4. Recall the discussion at the start of the chapter. Countries in the rest of the worldare hoping for a strong U.S. expansion. The reason: A strong U.S. expansion means anincrease in the U.S. demand for foreign goods.4• An increase in domestic income, Y , (equivalently, an increase in do-mestic output—income and output are still equal in an open econ-omy) leads to an increase in imports. This positive effect of incomeon imports is captured by the positive sign under Y in equation(19.2).• An increase in the real exchange rate, ², leads to an increase inimports, IM. This positive effect of the real exchange rate on imp
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