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3.5.1 The goods market and the IS curve

As in the case of a closed economy, equilibrium in the goods market occurs

where the aggregate demand for and aggregate supply of goods are equal. In

an open economy aggregate demand is composed of not only the sum of

consumption, investment and government expenditure, but also ‘net’ exports,

that is, exports minus imports (X – Im). Exports are assumed to be a function

of: (i) income in the rest of the world; (ii) the price of a country’s goods

relative to those produced by competitors abroad, which may be defined as

ePD/PF, where e is the exchange rate expressing domestic currency in terms

of foreign currency, PD is the price of domestic goods in terms of domestic

currency and PF is the price of foreign goods in terms of foreign currency;

and (iii) other factors such as tastes, quality of the goods, delivery dates and

so on. Imports are assumed to be determined by the same factors that influence

exports (since one country’s exports are another country’s imports) with

the exception that the income variable relevant to imports is domestic income.

As domestic income rises, ceteris paribus, aggregate demand will

increase and some portion of this increase in demand will be met by imported

goods; that is, the marginal propensity to import is greater than zero.

As discussed in section 3.3.1, the IS curve traces out a locus of combinations

of interest rates and income associated with equilibrium in the goods

market. The open economy IS curve is downward-sloping but is steeper than

in the case of a closed economy because of the additional leakage of imports

which increase as domestic income increases, thereby reducing the size of the

multiplier. In addition to the factors which affect the position of the IS curve

in a closed economy, a change in any of the variables which affect ‘net’

exports will cause the IS curve to shift. For example, an increase in exports

due to a rise in world income will be associated with a higher level of

domestic income, at any given level of the rate of interest, causing the IS

curve to shift outwards to the right. Similarly, ceteris paribus, net exports

will increase if: (i) the exchange rate falls (that is, depreciates or is devalued)

providing the Marshall–Lerner conditions are fulfilled, namely that starting

from an initial balanced trade position and also assuming infinite price

elasticities of supply for imports and exports, the sum of the price elasticities

of demand for imports and exports is greater than unity (see De Vanssay,

2002); (ii) the foreign price level rises; and (iii) the domestic price level falls.

In each of these cases the IS curve would shift outwards to the right, as

before, the magnitude of the shift being equal to the size of the shock times

the multiplier. Conversely a change in the opposite direction in any one of

these variables will shift the IS curve to the left.