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National Income and Trade Balance

This course in international finance explores the small-country Keynesian model, focusing on the determination of income and the effects on the trade balance. Topics covered include multipliers, effects of fiscal and export expansions, and the transfer problem.

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National Income and Trade Balance

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  1. National Income and Trade Balance IMQF course in International Finance Caves, Frankeland Jones (2007) WorldTradeandPayments, 10e, Pearson

  2. Outline • Small-countryKeynesian Model • Determinationofincome • Nationalsavings – investmentidentity • Multipliers • Multiplierseffectsoffiscalexpansion • Multiplierseffectofexportsexpansion • The transfer problem • Largecountry: two-countryKeynesian model

  3. Small-Country Keynesian Model • Keynesian model • Prices are assumed to be fixed (in terms of currency of producing country), so the changes in demand are reflected in output, instead of prices • Relevant in the short run, in economy with unemployed labor and excess capacity • Import demand depends on the relative prices, but also on income • m is marginal propensity to consume importedgoods, while E is exchange rate • …which is analogous to the Keynesian consumption function (c is marginal propensity to consume) • Keynsean consumption function: HHs consumption increases, but less proportionally, in response to increase in HHs income

  4. Small-Country Keynesian Model • Export demand depends on the relative prices, but also on foreigners’ income • Foreign income is exogenous, as the changes in the small country do not affect the rest of the World • …or when the exchange rate is fixed: • Which means that exports are given exogeneously • In that case, trade balance is given by:

  5. Small-Country Keynesian Model- Determination of income • Determination of income • In closed economy, demand comes from consumption of HHs (C), investment by firms (I) and spending on goods and services by the government (G) • In the simple Keynesian model, I and G are exogeneous, while C is endogeneous • In open economy, demand also comes from abroad (TB=X-M) • Equilibriumcondition in the Keynesian model: supply equals demand ofoutput • A is exogeneous component of affregate demand, while s is marginal propensity to save (1-c)

  6. Small-Country Keynesian Model- Determination of income • If government spending goes up by USD 1 bn, by how much does income go up? • As s+m<1, because import is only a part of consumption (the rest is consumption of domestic goods), which means that multiplier is greater than 1 • Intuition: increase in spending by 1 USD, triggers rise in producer’s income, so they raise their spending, thus triggering rise in income of another producer, and so forth. At each round some of the effect leaks out through savings, so each round is smaller than previousround • In anopen economy, multiplier is less than 1/s, because of the second leakage – the imports

  7. NationalSaving-InvestmentIdentity • Incomecan be decomposed from theviewpointofthosewhoearnanddisposeit: • Where NFI is netfactorincome, whichincludesinvestmentincome from abroad • When C is substracted • If T-G (budgetsuprlus) is governmentsaving, thannationalsavings NS=S+(T-G). In thatcasenationalsavingsidentity is as follows: • Nationalsavingsgoesintobulidingupstockofcapital (I) orstockofforeignclaims • Investmentsmay be fundedeitherbynation’sdomesticsavingsorbyfundslent from abroad (used to finance CA deficit) – Italy (I financed from domesticsavings) vs. USA (I financed from abroad)

  8. SavingsandInvesmtnets in Europe

  9. Multipliers • Savingsgap (NS) is risingfunctionofincome (Y), as savingriseswithincome (slopes) • Tradebalance, (TB=X-M), is decreasingfunctionofincome, withslope–m (higherincomemeanshigherimports) • Equilibrium is set where NS identityand TB identityintersect • itcan be at thepointwhere X=M and NS=I (as presented in thefollowing figure), as wellaboveorbelowthezeroaxis

  10. Multipliers- TheMultiplierEffectof a FiscalExpansion • Let usconsiderthefiscalexpansion • Newequilibrium is at thepoint D. Itimplies rise in income Y, but lessthan in closedeconomy • Therefore, themultiplier for governmentspending is: • Multipliereffect on income is lowerthan in the open economy, due to secondleakege (import), in addition to thefirstleakage (savings)

  11. Multipliers

  12. Multipliers- TheMultiplierEffectof a FiscalExpansion • Fiscalexpansionalsotriggerschange in TB • Rise in G, triggers rise in Y, causingincrease in imports • Tradebalance is usuallycountercyclical • In macroeconomicexpansion period importsandtrade deficit haverisen, while in recessionimportsdeclinedand TB getsnarrowed

  13. Fiscal Multipliers

  14. Multipliers- TheMultiplierEffectofanIncrease in Exports • Thedevaluation (orincrease in foreignincome, etc.), triggersincrease in X-M, by • Magnitudeofchange in X-M, depends on themagnitudeofelasticities • Devaluationtriggerschange in TB, but alsochange in Y • Higherincomemeanshigherimports, so theimprovement in tradebalance is lessthanifincomewereheldfixed • As s/(s+m) is less than 1, the trade balance improves by less than increase in exports, due to rise in imports triggered by increase in income

  15. Multipliers- TheMultiplierEffectofanIncrease in Exports

  16. The Transfer Problem • Transfersbetweencountries • Warreparationpayments (Germany to France) • 1973 oilpriceincrease (transfer from oilimporters to oilexporters) • 1982 debtcrisis • 1991 payment from Japan, Germany, SaudiArabia, Kuwait, etc. to USA for waroperationsagainstIraq • CA=X-M+Transfersreceived • Ifrecepientcountryspendsentire transfer on import, no change in CA willoccur („fullyeffected“ transfer) • Ifrecepientcountryspendsthe most of transfer on domesticgoods, CA willimprove („undereffected“ transfer)

  17. The Transfer Problem • In Keynesian model transfer is necessarilyundereffected • Transfer is financedwithtaxes, so thebudgetbalance is unchanged • Investments are exogeneous, so if S is also unchanged, the trade balance should increase by the amount of transfer (NS-I=CA) • As disposable income declines by the amount of transfer, in Keynesian model that leads to fall in S, which means that trade balance must rise by less than the transfer • Without transfer, equilibrium is set where X-M=NS-I • With transfer, equilibrium is set at X-M-T • When the country pays the transfer, the current account gets lowered (downward shift, X-M-T), so the new savings-investment equlibrium is in R. However, at thislowerlevelofdisposableincome, importshavedeclined, which is whytradebalance is improved (surplus: S). Therefore, thechange in CA due to transfer is thenetof transfer andchange in TB:

  18. The Transfer Problem

  19. LargeCountry: Two-CountryKeynesian Model • Nowexportsbecomesendogenous • There are 2 countries: largehomecountryandallothercountriesaggregated in thesecondcountry • As thehomecountry is large, developments in theWorld are affectedbythehomecountry • Increase in income in theforeigncountry, Y* • m* is foreignmarginalpropensity to import • Newequilibriumincome • Domesticincomedependspositively on foreignincome, theslopebeing m*/(s+m), which is lessthan 1, unlesstheforeigncountry is much more open to import thanhomecountry • e.g. Locomotivetheory, 1977-1978 (USA, GER and JAP) ortheGreatRecession in 1930s

  20. LargeCountry: Two-CountryKeynesian Model • Repercussioneffects • When a largecountry (e.g. USA orChina) expands, import from othercountries is rising. Thiscauses rise in incomeandexpenditure in thetrading partner countries, which in turntriggers import in thesecountry from a largecountrywhichinitiallyexpanded • Theresult is thatincrease in income in thehomecountry is largerthanitwould be expected, based on itsownspending

  21. Largecountry:- TheSolution to theTwo-Country Model • Theequilibriumforeignincome is: • A* is autonomouscomponentofforeignexpenditure, while s* is foreignmarginalpropensity to save • Equilibrium for eachcountrs is obtainedwhensolvingthetwoequationssimultaneously: • Largecountrymultiplierexeedsthesmallcountrymultiplier 1/(s+m)

  22. Largecountry:- TheSolution to theTwo-Country Model • Wecancontinue to usetheversionof X-M=NS-I, because • Can be substitued • Thenewslopeofthe X-M line is

  23. Repercussion Effect Increases the Multiplier

  24. Largecountry:- EmpiricalEvidence on Growthand Import Elasticities

  25. LargeCountry:- EmpiricalEvidence on Growthand Import Elasticities • Whyhavethetradedeficits in the US occured? • USA wereexpanding more rapidlythanthetradepartners (1983-84, 1992-2000, 2002-2005), so assumingthe same m, itleads to worseningofthetradebalance • There is evidencethatimports are more elasticwithrespect to income in the USA than in manytradepartners

  26. Homeworkreading • Cogan, J. F., Cwik, T., Taylor, J. B., & Wieland, V. (2010). New Keynesian versus old Keynesian government spending multipliers. Journal of Economic dynamics and control, 34(3), 281-295. • Sachs, J. D., Cooper, R. N., & Fischer, S. (1981). The current account and macroeconomic adjustment in the 1970s. Brookings Papers on Economic Activity, 1981(1), 201-282.

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