With consumers and firms having an option to buy goods produced at home and abroad, we now need to distinguish between domestic demand for goods and the demand for domestic goods.

National Income Identity for an Open Economy

In a closed economy, there are three sources of demand for domestic goods – Consumption (C ), government spending (G), and domestic investment (I ). We can write

Y = C + I + G (6.2)

In an open economy, exports (X) constitute an additional source of demand for domestic goods and services that comes from abroad and therefore must be added to aggregate demand. Imports (M) supplement supplies in domestic markets and constitute that part of domestic demand that falls on foreign goods and services. Therefore, the national income identity for an open economy is

Y + M = C + I + G + X (6.3)

Rearranging, we get

Y = C + I + G + X – M (6.4)

Y = C + I + G + NX (6.5)

where, NX is net exports (exports – imports). A positive NX (with exports greater than imports) implies a trade surplus and a negative NX (with imports exceeding exports) implies a trade deficit. To examine the roles of imports and exports in determining equilibrium income in an open economy, we follow the same procedure as we did for the closed economy case – we take investment and government spending as autonomous. In addition, we need to specify the determinants of imports and exports. The demand for imports depends on domestic income (Y) and the real exchange rate (R ). Higher income leads to higher imports. Recall that the real exchange rate is defined as the relative price of foreign goods in terms of domestic goods. A higher R makes foreign goods relatively more expensive, thereby leading to a decrease in the quantity of imports. Thus, imports depend positively on Y and negatively on R. The export of one country is, by definition, the import of another. Thus, our exports would constitute foreign imports. It would depend on foreign income, Yf , and on R. A rise in Yf will increase foreign demand for our goods, thus leading to higher exports. An increase in R, which makes domestic goods cheaper, will increase our exports. Exports depend positively on foreign income and the real exchange rate. Thus, exports and imports depend on domestic income, foreign income and the real exchange rate. We assume price levels and the nominal exchange rate to be constant, hence R will be fixed. From the point of view of our country, foreign income, and therefore exports, are considered exogenous (X = X ). The demand for imports is thus assumed to depend on income and have an autonomous component
M = M + mY, where M > 0 is the autonomous component, 0 < y =" C" y =" A" y =" A">
Equilibrium Output and the Trade Balance

We shall provide a diagrammatic explanation of the above mechanisms and, in addition, their impact on the trade balance. Net exports, (NX = X – M), as we saw earlier, depend on Y, Yf and R. A rise in Y raises import spending and leads to trade deficit (if initially we had trade balance, NX = 0). A rise in Yf , other things being equal, raises our exports, creates a trade surplus and raises aggregate income. A real depreciation would raise exports and reduce imports, thus increasing our net exports.

Change in Prices:
Next we consider the effects of changes in prices, assuming the exchange rate to be fixed. If prices of domestic products fall, while say foreign prices remain constant, domestic exports will rise, adding to aggregate demand, and hence will raise our output and income. Analogously, a rise in prices of a country’s exports will decrease that country’s net exports and output and income. Similarly, a price increase abroad will make foreign products more expensive and hence again raise net exports and domestic output and income. Price decreases abroad have the opposite effects.

Exchange Rate Changes:
Changes in nominal exchange rates would change the real exchange rate and hence international relative prices. A depreciation of the rupee will raise the cost of buying foreign goods and make domestic goods less costly. This will raise net exports and therefore increase aggregate demand. Conversely, a currency appreciation would reduce net exports and, therefore, decrease aggregate demand. However, we must note that international trade patterns take time to respond to changes in exchange rates. A considerable period of time may elapse before any improvement in net exports is apparent.


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