Download National Income and the Current Account

Chapter 24
National Income
and the Current
Account
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
24-1
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.
24-2
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.
24-3
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
24-4
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
24-5
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
24-6
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
24-7
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
24-8
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
24-9
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
24-10
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.
24-11
Desired spending (C+I+G+X-M)
Equilibrium National
Income
45°
900
Income or production (Y)
24-12
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
24-13
Desired spending (C+I+G+X-M)
Equilibrium National
Income
45°
900
3,000
Income or production (Y)
24-14
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.
24-15
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
24-16
Leakages and Injections
In our example,
S = -200 + 0.2(Y - T)
M = 50 + 0.1Y
T = 500
I = 300
G = 700
X = 150
24-17
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
24-18
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.
24-19
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).
24-20
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.
24-21
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.
24-22
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.
24-23
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.
24-24
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.).
24-25
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.
24-26
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 = ↑XROW→↑YROW→↑MROW→↑XUS
24-27
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?
24-28
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?
24-29
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 fall, increasing X and
decreasing M.
– The decrease in income will also reduce
M through the MPM.
24-30
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 rise, decreasing X and
increasing M.
– The increase in income will increase
employment.
24-31
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.
24-32
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.
24-33