International Economics CHAPTER S E V E N T E E N 17 International Economics The Income Adjustment Mechanism and Synthesis of Automatic Adjustments Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand how the equilibrium level of income is determined in an open economy Understand the meaning of foreign repercussions Describe how the absorption approach works Understand how all the automatic adjustments work together in open economies Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction The income adjustment mechanism relies on changes in the level of national income of deficit and surplus nations to adjust the balance of payments. The income adjustment mechanism is Keynesian, while the price adjustment mechanism is more traditional, or classical. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction Assumptions Deficit or surplus arises in the current account. All prices, wages and interest rates remain constant. Nation operates under fixed exchange system. Nations operate at less than full employment. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Closed Economy In a closed economy (no international trade) without a government sector, the equilibrium level of national income and production (Y) is determined by planned flow of consumption (C) plus planned investment (I): Y = C(Y) + I Desired saving is a function of income: S(Y) = Y – C(Y) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Closed Economy Investment (I) is an injection into the system because it adds to total expenditures and stimulates production. Saving (S) is a leakage out of the system because it represents income generated but not spent. The equilibrium level of income is where: S = I At equilibrium, leakages from the economy (S) must be balanced by injections into the economy (I). Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 17-1 National Income Equilibrium in a Closed Economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Closed Economy Since S = I at equilibrium, then: ΔI = (1/MPS)ΔY or ΔY = (1/MPS)ΔI where MPS = marginal propensity to save (change in desired savings with a change in income) If k = 1/MPS, then ΔY = kΔI k is the Keynesian (closed economy) multiplier. Any change in investment will induce a multiplied change in income as given by the above formula. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Closed Economy Example: MPS = ¼ so k = 1/MPS = 1/.25 = 4 So an increase in investment of 100 leads to an increase in income of k(100) = 400. Income will increase by smaller and smaller amounts until total increase is 400. When income has increased by 400, induced savings will have increased by 100, and equilibrium national income (S=I) will again be achieved. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Small Open Economy In an small open economy, the equilibrium condition relating injections and leakages in the income stream is: (Injections = Leakages) I + X = S + M or X - M = S – I A surplus in the nation’s trade balance (X-M) must be accompanied by an equal excess of saving over domestic investment at the equilibrium level of national income. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Income Determination in a Small Open Economy In an small open economy, the equilibrium condition relating injections and leakages in the income stream is: (Injections = Leakages) I + X = S + M or X - M = S – I (Change in Injections = Change in Leakages) Δ I + Δ X = Δ S + Δ M Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 17-2 The Import Function. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 17-3 National Income Determination in Small Open Economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Repercussions In a two-nation world, an autonomous increase in exports in Nation 1 is equal to an autonomous increase in imports in Nation 2. If Nation 2’s imports replace domestic production, income falls, inducing Nation2’s imports to fall, neutralizing part of autonomous increase in imports. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Repercussions This induces foreign repercussions on Nation 1, neutralizing part of autonomous increase in exports. As a result, the foreign trade multiplier for Nation 1 with foreign repercussions is smaller than corresponding trade multiplier without foreign repercussions, and its trade balance will not improve as much. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Repercussions This is how business cycles are propagated internationally: Expansion in economic activity in the U.S. spills into imports (exports of other nations), so U.S. expansion is transmitted to other nations. A rise in exports of other nations expands their economic activity and feeds back to the U.S. through increases in their imports from the U.S. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Foreign Repercussions In 1930s, foreign repercussions were an important contributor to the spread of the Great Depression to the rest of the world. Only a very small nation can safely ignore foreign repercussions from changes occurring in their own economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Domestic equilibrium is given by: Y = C + I + (X – M) Absorption Approach The absorption approach integrates the effect of induced income changes in the process of correcting a balance of payments disequilibrium by a change in the exchange rate. Domestic equilibrium is given by: Y = C + I + (X – M) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Absorption Approach Define A (domestic absorption) = C + I and B (foreign absorption) = X – M. Then: Y = A + B or Y – A = B A depreciation of the currency is expected to increase B. This can only occur if A falls or Y increases. If the economy is at full employment, Y cannot increase. Therefore, a depreciation must result in a fall in A. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Forces that lead to a fall in domestic absorption (A): Absorption Approach Forces that lead to a fall in domestic absorption (A): Income is redistributed from wages to profits. The depreciation increases prices and lowers domestic expenditures. The depreciation pushes people into higher tax brackets, lowering disposable income and consumption. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Balance of payments deficits tend to reduce a nation’s money supply which, unless neutralized, will increase interest rates. Higher interest rates discourage domestic investment, and reduce national income, causing reduction in domestic imports, which reduces deficit. Also attracts foreign capital, helping to finance deficit. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Synthesis of Automatic Adjustments For nation facing unemployment and balance of payments deficit at equilibrium level of income. Fixed Exchange Rate System: Exchange rate can depreciate only within narrow limits allowed, stimulating production and income. Imports rise, reducing part of improvement in trade balance resulting from depreciation. Deficit reduces money supply, increases interest rates, reduces investment and income, so imports fall, reducing deficit. Most of automatic adjustments come from monetary adjustments, unless nation devalues currency. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Synthesis of Automatic Adjustments For nation facing unemployment and balance of payments deficit at equilibrium level of income. Freely Flexible Exchange Rate System: Currency will depreciate until deficit is entirely eliminated. Imports rise, reducing part of improvement in trade balance resulting from depreciation. Depreciation required to eliminate deficit is larger than if automatic adjustment mechanisms were not present. National economy is to large extent insulated from balance of payments disequilibria, and most of adjustments take place through exchange rate variation. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Disadvantages of Automatic Price Adjustments Freely Floating Exchange Rates Overshooting and erratic fluctuations in exchange rates interfere with international trade and impose costly adjustment burdens that may be unnecessary in the long run. Managed Float System Beggar-thy-neighbor monetary policies to stimulate domestic economy are disruptive and damaging to international trade. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Disadvantages of Automatic Price Adjustments Fixed Exchange Rate System Possibility of devaluation can lead to destabilizing international capital flows. Forces nation to rely primarily on monetary adjustments. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Disadvantages of Automatic Income Adjustments Nation facing autonomous increase in imports at the expense of domestic production would have to allow national income to fall in order to reduce trade deficit. Nation facing autonomous increase in exports from full employment position would have to accept domestic inflation to eliminate trade surplus. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Monetary Adjustments and Synthesis of the Automatic Adjustments Disadvantages of Automatic Monetary Adjustments Nation must passively allow money supply to change as a result of balance of payments disequilibria, giving up use of monetary policy to achieve domestic full employment without inflation. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-1 Income Elasticity of Imports Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-2 Private Sector and Current Account Balance Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-3 Growth in the United States and the World and U. S Case Study 17-3 Growth in the United States and the World and U.S. Current Account Deficits Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-4 Growth and Current Account Balance in Developing Economies Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-5 Effect of the Asian Financial Crisis of the Late 1990s on OECD Countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 17-5 Interdependence in the World Economy Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: Derivation of Foreign Trade Multipliers with Foreign Repercussions Let s = MPS and m = MPM From Equation 17-9, the changes in the equilibrium level of income for Nation 1 and Nation 2 are: ∆𝐼+ ∆𝑋= ∆𝑆+∆𝑀 ∆ 𝐼 ∗ + ∆ 𝑋 ∗ = ∆ 𝑆 ∗ +∆ 𝑀 ∗ ∆𝑆=𝑠∆𝑌,∆𝑀=𝑚∆𝑌,∆ 𝑆 ∗ = 𝑠 ∗ ∆ 𝑌 ∗ , ∆ 𝑀 ∗ = 𝑚 ∗ ∆ 𝑌 ∗ Substitute in to initial equations. ∆𝐼+ 𝑚 ∗ ∆ 𝑌 ∗ =𝑠∆𝑌+𝑚∆𝑌 ∆ 𝐼 ∗ +𝑚∆𝑌= 𝑠 ∗ ∆ 𝑌 ∗ + 𝑚 ∗ ∆ 𝑌 ∗ Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: Derivation of Foreign Trade Multipliers with Foreign Repercussions After substituting the second equation into the first, ∆𝐼+ 𝑚 ∗ (𝑚∆ 𝑌)/( 𝑠 ∗ + 𝑚 ∗ ) =𝑠∆𝑌+𝑚∆𝑌 𝑚∆𝑌= 𝑠 ∗ ∆ 𝑌 ∗ + 𝑚 ∗ ∆ 𝑌 ∗ 𝑚∆𝑌=( 𝑠 ∗ + 𝑚 ∗ )∆ 𝑌 ∗ Rearrange and solve for ∆𝑌 ∆𝐼 : ∆𝑌 ∆𝐼 = 𝑠 ∗ + 𝑚 ∗ 𝑠 𝑠 ∗ +𝑚𝑠+ 𝑚 ∗ 𝑠 Then dividing by s* yields the multiplier: 𝑘= 1+( 𝑚 ∗ 𝑠 ∗ ) 𝑠+𝑚+( 𝑚 ∗ 𝑠 𝑠 ∗ ) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: The Transfer Problem Again Assume that both the paying and receiving countries are operating under a fixed exchange rate system and full employment. The transfer of real resources occurs only if expenditures in the paying and/or receiving country are affected. In the paying nation, expenditures must fall (perhaps through an increase in taxes), and in the receiving nation, expenditures must increase. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: The Transfer Problem Again This leads to a trade surplus in paying nation and a trade deficit in the paying nation, representing the transfer or real resources. If the sum of the MPM in the paying nation and the receiving nation equal one, the entire transfer takes place through the equal transfer of real resources, and it is complete. If the sum of the MPMs is less than one, the transfer of real resources is less than the transfer of financial resources, and is incomplete. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: The Transfer Problem Again If the sum of the MPMs is greater than one, the transfer of real resources is greater than the transfer of financial resources, and is over-complete. If the trade balance of the paying nation worsens rather than improves, the adjustment is said to be perverse. In other words, real resources are transferred to the paying country. If adjustment via income changes is incomplete, the terms of trade of the paying country must deteriorate, further reducing real income and imports. (The reverse is true for over-complete transfers.) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix: The Transfer Problem Again If the sum of the MPMs is greater than one, the transfer of real resources is greater than the transfer of financial resources, and is over-complete. If the trade balance of the paying nation worsens rather than improves, the adjustment is said to be perverse. In other words, real resources are transferred to the paying country. If adjustment via income changes is incomplete, the terms of trade of the paying country must deteriorate, further reducing real income and imports. (The reverse is true for over-complete transfers.) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.