24-1 national income and the current account copyright © 2010 by the mcgraw-hill companies, inc....

24-1

National Income and the Current

Account

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 24Chapter 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 consumptionI is investment spending by firmsG is government spendingX is export spending by foreignersM is domestic import spending

24-5

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

24-6

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

24-7

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 exampleM = 50 + 0.1Y

mYMM

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 exampleC = 200 + 0.8Yd

Yd = Y – TT = 500I = 300G = 700X = 150

M = 50 + 0.1Y

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• 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.

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Income or production (Y)

45°

900

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• 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

24-14


Income or production (Y)

45°

900

3,000

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• 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

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

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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

24-19

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 + XS + (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.

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• 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.

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• 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

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:

↑IU.S. → ↑YU.S. → ↑MU.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↑IUS→↑YUS→↑MUS = ↑XROW→↑YROW→↑MROW→↑XUS

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?

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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


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.

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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


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.

24-1 national income and the current account copyright © 2010 by the mcgraw-hill companies, inc....

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