www.themegallery.com chapter 6 national income and the current account

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Chapter 6

National Income and the Current Account

Learning ObjectivesShow 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 consumptionI is investment spending by firmsG is government spendingX is export spending by foreignersM 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), wherea 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,

where m is the marginal propensity to import.

For exampleM = 50 + 0.1Y

mYMM

The Keynesian Income Model: Imports

MPM = ΔM/ΔYAlso, average propensity to import is

APM = M/YA final concept is the income

elasticity of demand for imports (YEM), originally introduced in Chapter 11.

YEM = MPM/APM

Equilibrium National Income

Recall our exampleC = 200 + 0.8Yd

Yd = Y – T

T = 500I = 300G = 700X = 150

M = 50 + 0.1Y


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+150-50-0.1YE = 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.


Income or production (Y)

45°

900


Equilibrium occurs where desired spending (E) equals production (Y).

In the graph, this occurs where the lines cross.

Mathematically, we can solve for equilibriumE = Y900 + 0.7Y = Y900 = 0.3YY = 3,000


Income or production (Y)

45°

900

3,000


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


In our example, S = -200 + 0.2(Y - T)M = 50 + 0.1YT = 500I = 300G = 700X = 150


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 rearrangeS + M + T = I + G + XS + (T – G) – I = X – MTherefore, the difference between total saving (private + government) and investment must equal a country’s current account balance.

Equilibrium Income and the Current Account Balance

This current account deficit means that total saving (100) is less than investment (300).

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

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 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 overall effect isΔY = (k0)ΔI, where

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.

MPMMPSk

10

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 = -2,000To 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 BalanceExternal 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

BalanceDeficit in the current account;

unacceptably rapid inflation

Case I

Surplus in the current account;

unacceptably high unemployment

Case II

Deficit in the current account;

unacceptably high unemployment

Case III

Surplus in the current account;

unacceptably rapid inflation

Case IV

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

fall,

increasing X

and

decreasing M.

The decrease

in income will

also reduce M

through the

MPM.


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.


and External BalanceCase III: Deficit in the current account;

unacceptably high unemploymentThe 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.


and External BalanceCase IV: Surplus in the current account;

unacceptably rapid inflationThe 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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