GDP in an open economy model

This chapter deals with international trade in so far as it affects the course of macroeconomic processes. In a closed economy without the government sector, production is determined by private investment and the multiplier mechanism. The government’s activity may expand or contract the market if the government’s expenditure exceeds the demand-depressing effects of taxation so that the resulting budget deficit increases the market. If we incorporate the rest of the world (ROW) in this model, then ROW’s expenditures, resulting in exports, add to the domestic market, and ROW’s revenues, resulting in imports, reduce this market. Thus, if ROW’s expenditures and revenues are equal, then the domestic market volume remains unchanged. However, if ROW’s expenditures are higher than its revenues, then ROW’s deficit leads to an expansion of the domestic market through the foreign trade multiplier. As can be seen, there is a significant similarity between ROW’s deficit (the trade surplus of an individual country) and a budget deficit run by the government, but the macroeconomic roles of the government and ROW differ in some important aspects.