In an open economy, part of domestic output is sold to foreigners (exports), and part of spending by domestic residents falls on foreign goods (imports). We have to modify the IS cure accordingly.
The most important change is that domestic spending no longer determines domestic output. Instead, spending on domestic goods determines domestic output. Some spending by domestic residents falls on imports, for instance, purchases of imported beer. Demand for domestic goods, by contrast, includes exports, or foreign demand, along with part of spending by domestic residents.
The effect of external transactions on the demand for domestic output was examined.
Recall the definitions
Spending by domestic residents =A=C + I+ G
Spending on domestic goods = A+ NX= (C+I+G) + (X- Q)
= (C + I+ G) + NX
Where X is the level of exports, Q is imports, and NX is the trade (goods and services) surplus, the definition of spending by domestic residents (C + I + G).
Spending on domestic goods is total spending by domestic residents less their spending on imports plus foreign demand, or exports. Since exports is the trade surplus, or net exports (NX), spending by domestic goods is spending by domestic residents plus the trade surplus.
With this clarification we can return to our model of income determination. We will assume that domestic spending depends on the interest rate and income, so that we can write
A= A (Y, i)
Net exports, or the excess of exports over imports, depend on our income, which affects import spending; on foreign income, Y1, which affects foreign demand for our exports; and on the real exchange rate, R, defined previously. A rise in R or a real depreciation improves our trade balance as demand shifts from goods produced abroad to those produced at home:
NX= X (Y1 , R) – Q (Y, R) = NX (Y, Y1, R)
We scan immediately state three important results:
· A rise in foreign income, other things being equal, improves the home country’s trade balance and therefore raises aggregate demand.
· A real depreciation by the home country improves the trade balance and therefore increases aggregate demand.
· A rise in home income raises import spending and hence worsens the trade balance. (Dornbusch and Fischer, 161-162)
With domestic demand in Australia growing at over 5 per cent in 2002/03 and 2003/04, which is well above long-term potential, and with the economy approaching full capacity in a number of sectors, the extra domestic demand generated by the exceptional rises in the terms of trade could well have had serious inflationary consequences if it had continued.
The first reason for the slowing in domestic demand is the change that has occurred in the housing sector. Fuelled by a rapid increase in mortgage lending, house prices rose sharply and house-building activity surged in the first few years of this decade. Over the past year, however, the Australian economy had a turnaround in all three; house prices have flattened, mortgage lending has slowed and house building has contracted modestly. (Manfarlane, 2005)
Growth in borrowing against housing has slowed to an annualised rate of 10 per cent in the first four months of 2005. While this is well down from a year ago, it is still faster than the growth in household incomes. After several years when borrowing was much higher than housing investment as households withdrew equity to fund consumption, it appears that housing equity withdrawal has now ceased. In line with this, growth in consumption has slowed from 5.9 per cent in 2003/04 to an annual rate of 3.4 per cent so far this year. In other words, while households have stopped adding to their consumption by borrowing against the equity in their houses, there has not been a major scaling back in order to build up savings. It is hard to know whether this household consolidation will continue, for how long it will last, or whether it will intensify. It is early times yet and the situation bears close watching.
As a result of these two influences – the slowing in consumption and the fall in house-building – domestic demand growth has fallen from just over 6 per cent to about 3½ per cent so far this financial year. Business investment continues to grow strongly, which is important given our need to increase capacity, particularly in the exporting sector. Strong employment growth is also underpinning the economic expansion. (Macfarlane, 2005)
Consumption has slowed and house building and farm output are falling; these have exerted a moderating influence and may continue to do so. While there is a natural tendency to be disappointed that the second set of influences is now occurring, the fact is that the economy could not have taken on board the external situation without this moderation in the domestic economy. A failure to slow would most probably have produced the set of economic imbalances, particularly rising inflation, that have ended previous expansions. In this respect, the recent moderation in growth is more likely to prolong the expansion than bring it to an end. (Macfarlane, 2005)
We are buying far more than we produce, and the extra purchases come from importing more than we export, financed by net borrowing from abroad. The resulting current account deficit has risen to a record level, in excess of 6 percent of gross domestic product. The counterpart of the current account deficit is low savings generated here at home; in the past year, household saving out of current income fell to the unusually low level of about 1 percent. Several factors have contributed to the willingness of households to spend most of their income, but an important one has been the rapid and continuing rise in housing prices, which has boosted household net worth. That rise in turn probably reflects several influences, one of which have been low long-term interest rates. These imbalances and unusual asset price configurations have persisted for some time. The current account deficit has grown steadily since the mid-1990s; household saving rates have been on a 2 BIS Review 46/2005
Downward trajectory for even longer; the low level of long-term interest rates and the rapid pace of house price increase has been the subject of much commentary for the past few years. These phenomena could well continue for some time longer, but they are not sustainable indefinitely. At some point, global investors will require higher expected rates of return as their portfolios become increasingly concentrated in Australian dollar assets; house price increases will encounter resistance as they rise relative to income and rents; as housing prices level out, households will recognize that they must increase saving out of income to have adequate resources for retirement; and the Federal Reserve already has been raising short-term interest rates as demand recovers from the shocks of recent years.
Dornbusch, R., & Stanley, F., (1996). Macroeconomics. Sixth Edition, Mc-Graw Hill Company. Pp. 161-162.
I.J. Macfarlane, (2005). Global Influences on the Australian Economy, Talk to Australian Institute of Company Directors, Sydney – 14 June 2005