National Income and Trade Balance IMQF course in International Finance Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

Outline Small-country Keynesian Model Determination of income National savings – investment identity Multipliers Multipliers effects of fiscal expansion Multipliers effect of exports expansion The transfer problem Large country: two-country Keynesian model

Small-Country Keynesian Model Prices are assumed to be fixed (in terms of currency of producing country), so the changes in demand are reflected in output, instead of prices Relevant in the short run, in economy with unemployed labor and excess capacity Import demand depends on the relative prices, but also on income m is marginal propensity to consume imported goods, while E is exchange rate …which is analogous to the Keynesian consumption function (c is marginal propensity to consume) Keynsean consumption function: HHs consumption increases, but less proportionally, in response to increase in HHs income

Small-Country Keynesian Model Export demand depends on the relative prices, but also on foreigners’ income Foreign income is exogenous, as the changes in the small country do not affect the rest of the World …or when the exchange rate is fixed: Which means that exports are given exogeneously In that case, trade balance is given by:

Small-Country Keynesian Model - Determination of income In closed economy, demand comes from consumption of HHs (C), investment by firms (I) and spending on goods and services by the government (G) In the simple Keynesian model, I and G are exogeneous, while C is endogeneous In open economy, demand also comes from abroad (TB=X-M) Equilibrium condition in the Keynesian model: supply equals demand of output A is exogeneous component of affregate demand, while s is marginal propensity to save (1-c)

Small-Country Keynesian Model - Determination of income If government spending goes up by USD 1 bn, by how much does income go up? As s+m<1, because import is only a part of consumption (the rest is consumption of domestic goods), which means that multiplier is greater than 1 Intuition: increase in spending by 1 USD, triggers rise in producer’s income, so they raise their spending, thus triggering rise in income of another producer, and so forth. At each round some of the effect leaks out through savings, so each round is smaller than previous round In an open economy, multiplier is less than 1/s, because of the second leakage – the imports

National Saving-Investment Identity Income can be decomposed from the viewpoint of those who earn and dispose it: Where NFI is net factor income, which includes investment income from abroad When C is substracted If T-G (budget suprlus) is government saving, than national savings NS=S+(T-G). In that case national savings identity is as follows: National savings goes into buliding up stock of capital (I) or stock of foreign claims Investments may be funded either by nation’s domestic savings or by funds lent from abroad (used to finance CA deficit) – Italy (I financed from domestic savings) vs. USA (I financed from abroad)

Savings and Invesmtnets in Europe

Multipliers Savings gap (NS) is rising function of income (Y), as saving rises with income (slope s) Trade balance, (TB=X-M), is decreasing function of income, with slope –m (higher income means higher imports) Equilibrium is set where NS identity and TB identity intersect it can be at the point where X=M and NS=I (as presented in the following figure), as well above or below the zero axis

Multipliers - The Multiplier Effect of a Fiscal Expansion Let us consider the fiscal expansion New equilibrium is at the point D. It implies rise in income Y, but less than in closed economy Therefore, the multiplier for government spending is: Multiplier effect on income is lower than in the open economy, due to second leakege (import), in addition to the first leakage (savings)

Multipliers

Multipliers - The Multiplier Effect of a Fiscal Expansion Fiscal expansion also triggers change in TB Rise in G, triggers rise in Y, causing increase in imports Trade balance is usually countercyclical In macroeconomic expansion period imports and trade deficit have risen, while in recession imports declined and TB gets narrowed

Fiscal Multipliers

Multipliers - The Multiplier Effect of an Increase in Exports The devaluation (or increase in foreign income, etc.), triggers increase in X-M, by Magnitude of change in X-M, depends on the magnitude of elasticities Devaluation triggers change in TB, but also change in Y Higher income means higher imports, so the improvement in trade balance is less than if income were held fixed As s/(s+m) is less than 1, the trade balance improves by less than increase in exports, due to rise in imports triggered by increase in income

Multipliers - The Multiplier Effect of an Increase in Exports

The Transfer Problem Transfers between countries War reparation payments (Germany to France) 1973 oil price increase (transfer from oil importers to oil exporters) 1982 debt crisis 1991 payment from Japan, Germany, Saudi Arabia, Kuwait, etc. to USA for war operations against Iraq CA=X-M+Transfers received If recepient country spends entire transfer on import, no change in CA will occur („fully effected“ transfer) If recepient country spends the most of transfer on domestic goods, CA will improve („undereffected“ transfer)

The Transfer Problem In Keynesian model transfer is necessarily undereffected Transfer is financed with taxes, so the budget balance is unchanged Investments are exogeneous, so if S is also unchanged, the trade balance should increase by the amount of transfer (NS-I=CA) As disposable income declines by the amount of transfer, in Keynesian model that leads to fall in S, which means that trade balance must rise by less than the transfer Without transfer, equilibrium is set where X-M=NS-I With transfer, equilibrium is set at X-M-T When the country pays the transfer, the current account gets lowered (downward shift, X-M-T), so the new savings-investment equlibrium is in R. However, at this lower level of disposable income, imports have declined, which is why trade balance is improved (surplus: S). Therefore, the change in CA due to transfer is the net of transfer and change in TB:

The Transfer Problem

Large Country: Two-Country Keynesian Model Now exports becomes endogenous There are 2 countries: large home country and all other countries aggregated in the second country As the home country is large, developments in the World are affected by the home country Increase in income in the foreign country, Y* m* is foreign marginal propensity to import New equilibrium income Domestic income depends positively on foreign income, the slope being m*/(s+m), which is less than 1, unless the foreign country is much more open to import than home country e.g. Locomotive theory, 1977-1978 (USA, GER and JAP) or the Great Recession in 1930s

Large Country: Two-Country Keynesian Model Repercussion effects When a large country (e.g. USA or China) expands, import from other countries is rising. This causes rise in income and expenditure in the trading partner countries, which in turn triggers import in these country from a large country which initially expanded The result is that increase in income in the home country is larger than it would be expected, based on its own spending

Large country: - The Solution to the Two-Country Model The equilibrium foreign income is: A* is autonomous component of foreign expenditure, while s* is foreign marginal propensity to save Equilibrium for each countrs is obtained when solving the two equations simultaneously: Large country multiplier exeeds the small country multiplier 1/(s+m)

Large country: - The Solution to the Two-Country Model We can continue to use the version of X-M=NS-I, because Can be substitued The new slope of the X-M line is

Repercussion Effect Increases the Multiplier

Large country: - Empirical Evidence on Growth and Import Elasticities

Large Country: - Empirical Evidence on Growth and Import Elasticities Why have the trade deficits in the US occured? USA were expanding more rapidly than the trade partners (1983-84, 1992-2000, 2002-2005), so assuming the same m, it leads to worsening of the trade balance There is evidence that imports are more elastic with respect to income in the USA than in many trade partners

Homework reading Cogan, J. F., Cwik, T., Taylor, J. B., & Wieland, V. (2010). New Keynesian versus old Keynesian government spending multipliers. Journal of Economic dynamics and control, 34(3), 281-295. Sachs, J. D., Cooper, R. N., & Fischer, S. (1981). The current account and macroeconomic adjustment in the 1970s. Brookings Papers on Economic Activity, 1981(1), 201-282.