24-1 National Income and the Current Account Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 24

24-2 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.

24-3 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.

24-4 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

24-5 The Keynesian Income Model: Consumption Consumption is assumed to be a function of disposable income (Y d ), which is the difference between national income (Y) and taxes (T). More generally, we could write this as C = a + b(Y d ), where a is autonomous consumption spending b is the marginal propensity to consume (MPC). For example, C = Y d

24-6 The Keynesian Income Model: Consumption The MPC is ΔC/ΔY d, where Δ means “change in.” The marginal propensity to save (MPS) is ΔS/ΔY d. 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 + sY d, where s is the MPS. In our case S = Y d

24-7 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

24-8 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 example M = Y

24-9 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

24-10 Equilibrium National Income Recall our example C = Y d Y d = Y – T T = 500 I = 300 G = 700 X = 150 M = Y

24-11 Equilibrium National Income This means that desired expenditures (E) can be calculated as follows: E = (Y-500) (50+0.1Y) E = Y Y E = Y We can plot this relationship on a graph. Also, let us plot a 45-degree line – This represents points where Y = E.

24-12 Equilibrium National Income Income or production (Y) Desired spending (C+I+G+X-M) 45° 900

24-13 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 Y = Y 900 = 0.3Y Y = 3,000

24-14 Equilibrium National Income Income or production (Y) Desired spending (C+I+G+X-M) 45° 900 3,000

24-15 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.

24-16 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

24-17 Leakages and Injections In our example, S = (Y - T) M = Y T = 500 I = 300 G = 700 X = 150

24-18 Leakages and Injections S + M + T = I + G + X (Y-500) Y+500= Y Y+500= Y=1, Y=900 Y = 3,000

24-19 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.

24-20 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).

24-21 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.

24-22 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.

24-23 The Autonomous Spending Multiplier The overall effect is ΔY = (k 0 )ΔI, where k 0 is called the open-economy multiplier. In our example k 0 = That is, the increase in I of 30 ultimately increases Y by 100.

24-24 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.

24-25 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.).

24-26 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: ↑I U.S. → ↑Y U.S. → ↑M U.S.

24-27 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 ↑I US →↑Y US →↑M US = ↑X ROW →↑Y ROW →↑M ROW →↑X US

24-28 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?

24-29 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?

24-30 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.

24-31 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.

24-32 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.

24-33 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.