economic policy in open economy

trade deficit from $G$ raising $Y$ causing more foreign goods to be bought

foreign output $Y^{\ast }$, effects on domestic economy

• foreign government spending $G^{\ast }$ could be taking place, etc.
• first assume not knowing where $Y^{\ast }$ came from

domestic demand for goods, $C+I+G$

• function of income
• drawn as $DD$, steeper than $ZZ$
• difference between $ZZ$ and $DD$ is net exports, $NX$
  • if trade is balanced at point A, both intersect there

effects of foreign output increase $\Delta Y^{\ast }$

• higher foreign output → higher foreign demand
  • higher foreign demand → higher foreign demand for domestic goods
  • increase in foreign output causes increase in domestic exports, by amount $\Delta X$
• net exports $NX$ and $ZZ$ both go up by $\Delta X$
  

$NX$ is always distance between $ZZ$ and $DD$ at given $Y$

increase in $Y^{\ast }$ always shifts $ZZ$ up, $DD$ below $ZZ$ means surplus

domestic demand increase → increase output, bad $NX$

foreign demand increase → increase output, better $NX$

real exchange rate given as $ϵ=\frac{EP}{P^{\ast }}$

• equal to nominal exchange rate $E$ times price level $P$ divided by foreign price level $P^{\ast }$

real depreciation → fall in $ϵ$

• means domestic goods are cheaper compared to foreign goods

$NX=X-\frac{IM}{ϵ}$

$NX=X(Y^{\ast },ϵ)-IM(Y,ϵ)/ϵ$

• very dependent on real depreciation in exports, imports, relative price ($\frac{1}{ϵ}$)
• decrease in $ϵ$ causes increase in $NX$ by Marshall-Lerner condition (assumed true)

depreciation leads to shift in demand, both foreign and domestic, towards domestic goods

• leads to increase in domestic output, improvement in trade balance

fixing $NX$ without changing output requires

• achieving depreciation to eliminate it, to shift $NX$ to $N{X}^{\prime }$
• reduce government spending to shift $Z{Z}^{\prime }$ back to $ZZ$
  

real depreciation leads to deterioration then improvement in J-curve

$Y=C+I+G-IM/ϵ+X$

$S=I+G-T-IM/ϵ+X$

$NX=S+(T-G)-I$

increase in government spending leads to increase in output, increase in interest rate, real appreciation

monetary contraction causes appreciation as A shifts up to A’

under fixed exchange rate, domestic interest rate equals foreign interest rate, causes necessary monetary accommodation to hold $i$

monetary expansion causes $LM$ down, $Y$ up, $i$ down, depreciation, $NX$ improves

• helps both $Y$ and $NX$

fiscal policy more powerful under fixed $E$, forced monetary accommodation