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Chapter 6
National Income
and the Current
Account
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Learning Objectives
Show how the incorporation of a
foreign trade sector into a Keynesian
income model alters the domestic
saving/investment relationship and
changes the multiplier.
Demonstrate that national income
equilibrium may not be consistent
with equilibrium in the current
account.
Explain why income levels across
countries are interdependent.
The Current Account and National
Income
Aggregate spending is the focus of the
Keynesian income model.
Prices and interest rates are assumed to be
constant.
The economy is assumed to not be at full
employment.
The Keynesian Income Model
Desired aggregate expenditures (E)
can be written as
E = C + I + G + X – M, where
C is consumption
I is investment spending by firms
G is government spending
X is export spending by foreigners
M is domestic import spending
The Keynesian Income Model:
Consumption
Consumption is assumed to be a
function of disposable income (Yd),
which is the difference between
national income (Y) and taxes (T).
More generally, we could write this
as C = a + b(Yd), where
a is autonomous consumption
spending
b is the marginal propensity to
consume (MPC).
For example, C = 200 + 0.8Yd
The Keynesian Income Model:
Consumption
 The MPC is ΔC/ΔYd, where Δ means “change
in.”
 The marginal propensity to save (MPS) is
ΔS/ΔYd.
 Since changes in income can only be
allotted to consumption and saving,
MPC + MPS = 1
 If the MPC = 0.8, the MPS = 0.2
 The saving function, then, is
S = -a + sYd, where s is the MPS.
 In our case
S = -200 + 0.2Yd
The Keynesian Income Model:
I, G, T, and X
Investment (I), government spending (G),
taxes (T), and exports (X) are all assumed
to be independent of income in the
simplest Keynesian model.
We’ll assume I = 300, G = 700, T = 500, and
X = 150
The Keynesian Income Model:
Imports
Imports (M) are assumed to be a
function of income: M = f(Y)
More generally,
M  M  mY
where m is the marginal propensity
to import.
For example
M = 50 + 0.1Y
The Keynesian Income Model:
Imports
MPM = ΔM/ΔY
Also, average propensity to
import is APM = M/Y
A final concept is the income
elasticity of demand for imports
(YEM), originally introduced in
Chapter 11.
YEM = MPM/APM
Equilibrium National Income
Recall our example
C = 200 + 0.8Yd
Yd = Y – T
T = 500
I = 300
G = 700
X = 150
M = 50 + 0.1Y
Equilibrium National Income
This means that desired expenditures (E)
can be calculated as follows:
E = 200+0.8(Y-500)+300+700+150-(50+0.1Y)
E = 200+0.8Y-400+300+700+150-50-0.1Y
E = 900+0.7Y
We can plot this relationship on a graph.
Also, let us plot a 45-degree line
This represents points where Y = E.
Desired spending (C+I+G+X-M)
Equilibrium National
Income
45°
900
Income or production (Y)
Equilibrium National
Income
Equilibrium occurs where desired
spending (E) equals production (Y).
In the graph, this occurs where the
lines cross.
Mathematically, we can solve for
equilibrium
E=Y
900 + 0.7Y = Y
900 = 0.3Y
Y = 3,000
Desired spending (C+I+G+X-M)
Equilibrium National
Income
45°
900
3,000
Income or production (Y)
Equilibrium National Income
At income levels below equilibrium,
spending exceeds production.
 As firms’ inventories decline, they will
increase production levels.
 Eventually Y = 3,000.
At income levels above equilibrium,
production exceeds spending.
 As firms’ inventories expand, they will
decrease production levels.
 Eventually Y = 3,000.
Leakages and Injections
We can think of saving, imports,
and taxes as “leakages” from
spending.
Investment, government spending,
and exports can be seen as
“injections” into spending.
In equilibrium, leakages must
equal injections:
S+M+T=I+G+X
Leakages and Injections
In our example,
S = -200 + 0.2(Y - T)
M = 50 + 0.1Y
T = 500
I = 300
G = 700
X = 150
Leakages and Injections
S+M+T=I+G+X
-200+0.2(Y-500)+50+0.1Y+500=300+700+150
-200+0.2Y-100+50+0.1Y+500=300+700+150
250+0.3Y=1,150
0.3Y=900
Y = 3,000
Equilibrium Income and the
Current Account Balance
Since we have no unilateral transfers in this model,
X – M represents the current account balance.
Starting from the leakages = injections equation we
can rearrange
S+M+T=I+G+X
S + (T – G) – I = X – M
Therefore, the difference between total saving
(private + government) and investment must equal
a country’s current account balance.
Equilibrium Income and the
Current Account Balance
In our example, the current account balance is
X - M = 150 – [50+0.1(Y)]
X – M = 150 – 50 – 0.1(3,000)
X – M = -200
This current account
deficit means that
total saving (100) is
less than investment
(300).
The Autonomous Spending
Multiplier
If autonomous spending on C, I, G, or
X changes, by how much will
equilibrium income change?
Suppose autonomous investment
rises from 300 to 330.
Because of the multiplier process,
this ΔI of 30 will lead to a ΔY of more
than 30.
The Autonomous Spending
Multiplier
The increase of 30 in I increases
disposable income by 30 (since T
does not depend on income).
Because MPC = 0.8, spending rises
by 30 x 0.8 = 24.
Because MPM = 0.1, M rises by 3.
This leaves a net effect of 21 in this
second round.
This process continues, with
spending increasing incrementally in
each round.
The Autonomous Spending
Multiplier
The overall effect is
ΔY = (k0)ΔI, where
k0 
1
MPS  MPM
k0 is called the open-economy
multiplier.
In our example k0 = 3.3333.
That is, the increase in I of 30
ultimately increases Y by 100.
The Current Account and the
Multiplier
In our example, national income equilibrium
(Y=3,000) existed along with a current account
deficit of 200.
If policy-makers wish to eliminate the current
account deficit by lowering imports, by how
much would national income have to fall?
From the definition of MPM,
ΔY = ΔM/MPM = -200/0.1 = -2,000
To make imports fall by 200, Y must fall by
2,000.
The Current Account and the
Multiplier
If policy-makers wish to
eliminate the current account
deficit by increasing exports,
could we simply increase X from
150 to 350?
The multiplier process makes
this more complicated (if X rises,
Y rises, and as a result M rises,
etc.).
Foreign Repercussions and
the Multiplier Process
When home country spending and
income change, changes are
transmitted to the foreign country
through changes in home country
imports.
In our simple model, an increase in
I in the U.S. is transmitted in this
way:
↑IU.S. → ↑YU.S. → ↑MU.S.
Foreign Repercussions and
the Multiplier Process
However, in the real world U.S.
exports are linked to incomes in the
rest of the world (ROW).
This means that increased U.S.
imports lead to higher incomes in the
ROW, and therefore higher U.S.
exports.
This feeds back onto U.S. incomes
↑IUS→↑YUS→↑MUS = ↑YROW→↑MROW→↑MROW→↑XUS
Price and Income
Adjustments and Internal and
External Balance
External balance refers to balance in
the current account (that is, X = M).
Internal balance occurs when the
economy is characterized by low
levels of unemployment and
reasonable price stability.
How does the economy adjust when
there are external and internal
imbalances?
Price and Income Adjustments
and Internal and External Balance
Case I
Deficit in the current account;
unacceptably rapid inflation
Case II
Surplus in the current account;
unacceptably high unemployment
Case III
Deficit in the current account;
unacceptably high unemployment
Case IV
Surplus in the current account;
unacceptably rapid inflation
How should policy-makers respond in
each case?
Internal and External
Imbalance: Case I
Case I: Deficit in the current
account; unacceptably rapid
inflation
The government should pursue
contractionary monetary and
fiscal policy.
Effect:
Price level will
The decrease
fall,
in income will
increasing X
also reduce M
and
through the
decreasing M.
MPM.
Price and Income
Adjustments and Internal and
External Balance
Surplus in the current account;
unacceptably high unemployment
The government should pursue
expansionary monetary and fiscal
policy.
Effect:
Price level will
The increase
rise,
in income will
decreasing X
increase
and
employment.
increasing M.
Price and Income
Adjustments and Internal and
External Balance
Case III: Deficit in the current
account; unacceptably high
unemployment
The direction of the effect is unclear.
Expansionary policy to increase
employment will worsen the current
account deficit.
Contractionary policy to reduce the
current account deficit will worsen
unemployment.
Price and Income
Adjustments and Internal and
External Balance
Case IV: Surplus in the current
account; unacceptably rapid inflation
The direction of the effect is unclear.
Expansionary policy to reduce the
current account surplus will worsen
inflation.
Contractionary policy to reduce the
inflation rate will widen the current
account surplus.
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