National Income and Trade Balance - PowerPoint Presentation

1. National Income and Trade BalanceIMQF course in International FinanceCaves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

2. OutlineSmall-country Keynesian ModelDetermination of income National savings – investment identityMultipliersMultipliers effects of fiscal expansionMultipliers effect of exports expansionThe transfer problemLarge country: two-country Keynesian model

3. Small-Country Keynesian ModelKeynesian modelPrices are assumed to be fixed (in terms of currency of producing country), so the changes in demand are reflected in output, instead of pricesRelevant in the short run, in economy with unemployed labor and excess capacityImport demand depends on the relative prices, but also on incomem is marginal propensity to consume imported goods, 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 ModelExport demand depends on the relative prices, but also on foreigners’ incomeForeign income is exogenous, as the changes in the small country does not affect the rest of the World…or when the exchange rate is fixed:Which means that exports are given exogeneouslyIn that case, trade balance is given by:

5. Small-Country Keynesian Model- Determination of incomeDetermination of incomeIn 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 endogeneousIn open economy, demand also comes from abroad (TB=X-M)Equilibrium condition in the Keynesian model: supply equals demand of outputA is exogeneous component of affregate demand, while s is marginal propensity to save (1-c)

6. Small-Country Keynesian Model- Determination of incomeIf 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 1Intuition: 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 previous roundIn an open economy, multiplier is less than 1/s, because of the second leakage – the imports

7. National Saving-Investment IdentityIncome can be decomposed from the viewpoint of those who earn and dispose it:Where NFI is net factor income, which includes investment income from abroadWhen C is substractedIf T-G (budget suprlus) is government saving, than national savings NS=S+(T-G). In that case national savings identity is as follows:National savings goes into buliding up stock of capital (I) or stock of foreign claimsInvestments may be funded either by nation’s domestic savings or by funds lent from abroad (used to finance CA deficit) – Italy (I financed from domestic savings) vs. USA (I financed from abroad)

8. MultipliersSavings gap (NS) is rising function of income (Y), as saving rises with income (slope s)Trade balance, (TB=X-M), is decreasing function of income, with slope –m (higher income means higher imports)Equilibrium is set wher NS identity and TB identity intersectit can be at the point where X=M and NS=I (as presented in the following figure), as well above or below the zero axis

9. Multipliers- The Multiplier Effect of a Fiscal ExpansionLet us consider the fiscal expansionNew equilibrium is at the point D. It implies rise in income Y, but less than in closed economyTherefore, the multiplier for government spending is:Multiplier effect on income is lower than in the open economy, due to second leakege (import), in addition to the first leakage (savings)

10. Multipliers

11. Multipliers- The Multiplier Effect of a Fiscal ExpansionFiscal expansion also triggers change in TBRise in G, triggers rise in Y, causing increase in importsTrade balance is usually countercyclicalIn macroeconomic expansion period imports and trade deficit have risen, while in recession imports declined and TB has narrowed

12. Multipliers- The Multiplier Effect of an Increase in ExportsThe devaluation (or increase in foreign income, etc.), triggers increase in X-M, by Magnitude of change in X-M, depends on the magnitude of elasticitiesDevaluation triggers change in TB, but also change in YHigher income means higher imports, so the improvement in trade balance is less than if income were held fixedAs 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

13. Multipliers- The Multiplier Effect of an Increase in Exports

14. The Transfer ProblemTransfers between countriesWar reparation payments (Germany to France)1973 oil price increase (transfer from oil importers to oil exporters)1982 debt crisis1991 payment from Japan, Germany, Saudi Arabia, Kuwait, etc. to USA for war operations against IraqCA=X-M+Transfers receivedIf recepient country spends entire transfer on import, no change in CA will occur („fully effected“ transfer)If recepient country spends the most of transfer on domestic goods, CA will improve („undereffected“ transfer)

15. The Transfer ProblemIn Keynesian model transfer is necessarily undereffectedTransfer is financed with taxes, so the budget balance is unchangedInvestments 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 transferWithout transfer, equilibrium is set where X-M=NS-IWith transfer, equilibrium is set at X-M-TWhen 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 this lower level of disposable income, imports have declined, which is why trade balance is improved (surplus: S). Therefore, the change in CA due to transfer is the net of transfer and change in TB:

16. The Transfer Problem

17. Large Country: Two-Country Keynesian ModelNow exports becomes endogenousThere are 2 countries: large home country and all other countries aggregated in the second countryAs the home country is large, developments in the World are affected by the home countryIncrease in income in the foreign country, Y*m* is foreign marginal propensity to importNew equilibrium incomeDomestic income depends positively on foreign income, the slope being m*/(s+m), which is less than 1, unless the foreign country is much more open to import than home countrye.g. Locomotive theory, 1977-1978 (USA, GER and JAP) or the Great Recession in 1930s

18. Large Country: Two-Country Keynesian ModelRepercussion effectsWhen a large country (e.g. USA or China) expands, import from other countries is rising. This causes rise in income and expenditure in the trading partner countries, which in turn triggers import in these country from a large country which initially expandedThe result is that increase in income in the home country is larger than it would be expected, based on its own spending

19. Large country:- The Solution to the Two-Country ModelThe equilibrium foreign income is:A* is autonomous component of foreign expenditure, while s* is foreign marginal propensity to saveEquilibrium for each countrs is obtained when solving the two equations simultaneously:Large country multiplier exeeds the small country multiplier 1/(s+m)

20. Large country:- The Solution to the Two-Country ModelWe can continue to use the version of X-M=NS-I, because Can be substitued The new slope of the X-M line is

21. Repercussion Effect Increases the Multiplier

22. Large country:- The Solution to the Two-Country Model

23. Large country:- Empirical Evidence on Growth and Import Elasticities

24. Large Country:- Empirical Evidence on Growth and Import ElasticitiesWhy have the trade deficits in the US occured?USA were expanding more rapidly than the trade partners (1983-84, 1992-2000, 2002-2005), so assuming the same m, it leads to worsening of the trade balanceThere is evidence that imports are more elastic with respect to income in the USA than in many trade partners