Goods Market and IS Curve in the Open Economy

Let us make in-depth study of the relation of goods market and IS curve in the open economy.

The analysis of determination of national income, employment and rate of interest in open economies is also made in the framework of IS – LM model with a few changes.

In particular, IS curve in the open economy contains a new term of net exports (NX).

An important change in the IS-LM model applicable to an open economy is that in it domestic spending does not determine level of national income and output. Instead, it is spending on domes­tic goods that determines level of national income and employment in an open economy.

A part of spending by domestic residents is done on imports from foreign countries and the rest on domesti­cally produced goods and services. Besides, a part of spending on domestic goods is by foreigners to whom we export goods. Thus, net exports which means exports minus imports together with spending by domestic residents on domestic goods constitute aggregate demand for or spending on domestic goods.

Thus, goods market equilibrium in an open economy is represented by the follow­ing equation:

Y = C + I + G + NX

or Y = C + I + G + (X – M)

Where NX or (X – M) represents next exports. The above equation states that equilibrium level of national income is equal to the sum of consumption demand (C), investment demand (I), govern­ment purchases of goods and services (G) and net exports (NX). Consumption expenditure (C) depends on disposable income or Y – T, investment depends negatively on interest rate, G is autono­mous government expenditure and net exports, among others, depends on exchange rate (e).

Incorporating the above in the IS equation we have the following IS curve for an open economy:

IS curve: Y = C (Y – T) + I (r) + G + N X (e)

Net Exports (NX):

The term net exports (NX) needs further elaboration. Net exports, as men­tioned above, represents the excess of exports over imports, depend on domestic income (Y) which affects spending on imports and therefore net exports.

Besides, net exports depend on:

(1) Foreign income (Y_f) which affects foreign demand for our exports and

(2) The real exchange rate which we denote by R.

Depreciation in real exchange rate will increase our exports and reduce our imports and as a result improves our trade balance as demand shifts from foreign goods to the domestically produced goods.

It may be noted that real exchange rate is the ratio of price of goods at home (P) to price of goods abroad (P_f). That is, R = e.P_f/P. If e is the nominal exchange rate (that is, ratio of prices of domestic and foreign currencies), then the real exchange rate R equals. Now, depre­ciation of national currency will lower the prices of its exports and raise the prices of its imports. This will tend to increase exports and reduce imports and thereby tend to improve trade balance.

The net exports or trade balance can be represented as under:

NX = X – M

NX = X(Y_f, R) – M(Y, R)

NX = NX(Y, Y_f, R)

It follows from the last equation that net exports depend on (1) domestic income or output (Y), which determines imports; (2) foreign income (Y_f) which determines demand for our exports; and (3) real exchange rate (R) which determines prices of our exports and imports.

Three important results follow from the equation for net exports:

1. A rise in our domestic income, other things remaining the same, will raise our spending on imports and hence adversely affect trade deficit.

2. A rise in foreign income, say of the USA, other things remaining the same, will increase our exports and improve our trade balance. As a result, aggregate demand will increase in our country with a favourable effect on our national income, output and employment.

3. A depreciation in real exchange rate of our currency will increase our exports and reduce our imports with a favourable effect on national output and employment.