Lecture 6 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

2 Macroeconomic Performance Internal Balance Internal Balance Full employment of labor and other resources Full employment of labor and other resources Growth of output (hopefully per capita) Growth of output (hopefully per capita) Price stability Price stability External Balance External Balance Achievement of a reasonable, sustainable balance of payments with the rest of the world Achievement of a reasonable, sustainable balance of payments with the rest of the world The official settlements balance equal to zero, at least on average, implying no change in official reserves. The official settlements balance equal to zero, at least on average, implying no change in official reserves.

3 Basic Framework for Analysis Short run Short run Keynesian Keynesian Price level is sticky in the short run Price level is sticky in the short run Supply cannot fully respond Supply cannot fully respond Long run Long run Monetarist or neoclassical Monetarist or neoclassical Price level does respond fully to supply and demand conditions Price level does respond fully to supply and demand conditions Price inflation depends upon the growth rate of the country’s money supply relative to its output growth (M=kPy) Price inflation depends upon the growth rate of the country’s money supply relative to its output growth (M=kPy)

4 Short-run Model Y = C + I d + G + (X – M) Y = C + I d + G + (X – M) Recall that domestic expenditure (absorption) is E = C + I d + G Recall that domestic expenditure (absorption) is E = C + I d + G G and T are based on fiscal policy decisions, and therefore are exogenous. G and T are based on fiscal policy decisions, and therefore are exogenous. Exports (X ) are not related to domestic macroeconomic conditions. Exports are related to the economic conditions in the countries buying the exports. Exports (X ) are not related to domestic macroeconomic conditions. Exports are related to the economic conditions in the countries buying the exports.

5 Consumption Consumption is based primarily on disposable income. Other variables like interest rates, household wealth, and expectations play a role, but income is the most important variable. Consumption is based primarily on disposable income. Other variables like interest rates, household wealth, and expectations play a role, but income is the most important variable. Disposable income is income less taxes plus transfers, hence Y – T. Disposable income is income less taxes plus transfers, hence Y – T. So: C = C(Y – T) So: C = C(Y – T) Many taxes vary with income, so T = tY and T = T(Y). Many taxes vary with income, so T = tY and T = T(Y). Therefore we can simplify as C = C(Y). Therefore we can simplify as C = C(Y). Typical linear form: C = C 0 + cY Typical linear form: C = C 0 + cY c is the marginal propensity to consume (mpc) c is the marginal propensity to consume (mpc) The mpc is the proportion of the last dollar earned that will be spent on consumer goods The mpc is the proportion of the last dollar earned that will be spent on consumer goods Since Y = C + S + T, then saving is S = S(Y) Since Y = C + S + T, then saving is S = S(Y)

6 Domestic Investment Investment: I d = I d (i) Investment: I d = I d (i) Business decisionmakers compare the cost of financing new plant and equipment and compare it to the expected revenue stream they will bring to the business. (IRR) Business decisionmakers compare the cost of financing new plant and equipment and compare it to the expected revenue stream they will bring to the business. (IRR) So the interest rates is the most important variable. So the interest rates is the most important variable. Note that S(Y) = I(i) Note that S(Y) = I(i)

7 Imports M = M(Y) M = M(Y) As incomes increase, people buy more of everything that they buy, including imported goods. As incomes increase, people buy more of everything that they buy, including imported goods. Typical linear form: M = M o + mY. Typical linear form: M = M o + mY. m is called the marginal propensity to import (mpi) m is called the marginal propensity to import (mpi) The mpi is the proportion of the last dollar of income that will be spent on imports The mpi is the proportion of the last dollar of income that will be spent on imports

8 AE Model We assume interest rates are fixed. We assume interest rates are fixed. Y = AD(Y) = E(Y) + X – M(Y) Y = AD(Y) = E(Y) + X – M(Y) Or, Y = E + X – M. Subtracting C and G from each side, we get: Or, Y = E + X – M. Subtracting C and G from each side, we get: (Y - C - G) = (E – C – G) + (X – M) (Y - C - G) = (E – C – G) + (X – M) Which is S = I d + I f or S – I d = I f Which is S = I d + I f or S – I d = I f

9 AE Model 45° AD(Y) Output, Y AD AD(Y) = E(Y) + X – M(Y) slope is marginal propensity to make expenditures from income Intercept is autonomous expenditure Y*

10 Savings vs. Investment S – I d = I f. Recall that equilibrium occurs when S – I d = I f. 0 Y S - I d I f = X - M Y* This example shows a situation with a current account deficit

11 Spending Multiplier ΔY = ΔG + (1 – s – m)ΔY, or ΔY = ΔG + (1 – s – m)ΔY, or ΔY(1 – 1 + s + m) = ΔG, or ΔY(1 – 1 + s + m) = ΔG, or ΔY/ΔG = 1/(s+m) which is the simple spending multiplier (small open economy) ΔY/ΔG = 1/(s+m) which is the simple spending multiplier (small open economy) This assumes that our country’s imports (based on our incomes) do not affect foreign incomes. This assumes that our country’s imports (based on our incomes) do not affect foreign incomes. To the extent that our imports do affect foreign incomes, the true spending multiplier will exceed the simple one. To the extent that our imports do affect foreign incomes, the true spending multiplier will exceed the simple one.

12 Multipliers (Continued) Note that s and m are fractions, and that s+m is something like 0.5. Note that s and m are fractions, and that s+m is something like 0.5. This means that 1/(s+m) is something like 2. This means that 1/(s+m) is something like 2. This implies that for every dollar that the government increases its spending, GDP increases by 2 dollars. This implies that for every dollar that the government increases its spending, GDP increases by 2 dollars.

13 Trade Repercussions U.S. spending up (G raised?) Output (Y) rises US imports (M) rise US exports (X) rise Foreign output (Y f ) and spending rise