Income Determination International Dimension

Overview nKeynesian Income Determination Models u Private sector n Consumption demand n Investment Demand n Supply & demand for money u Public Sector n Government expenditure n Government taxes n Monetary policy manipulation of money supply u International n imports, exports, net exports

International Trade nImports (M) u goods and services purchased from foreigners u money spent here is subtracted from aggregate demand u we often assume M = mY, or M = l + mY (where m = marginal propensity to import) nExports (X) u addition to aggregate demand

Trade Balance - I nBalance of Payments u all inflows and outflows u transactions that bring in foreign exchange = credits u transactions that lose foreign exchange = debits nBofP includes u Current account u Capital account

Trade Balance - II nCurrent Account u Imports & Exports of goods and services u Income received or paid on investments nTrade Balance u Exports of goods and services minus imports u X - M nTrade "deficit" = M > X nTrade “surplus” = M < X

New identity Y  C + I + G + X - M Y  C + I + G + (X - M) where (X - M) = net X's Y  C + I + G + (X - [l + mY])

Y  C + I +G + (X - M) nEquilibrium when planned expenditures = actual expenditures, or aggregate demand, C + I + G + (X - M) = aggregate output (Y). C + I + G C+I + G + (X - M) w/(X>M) Y C, I, G, X, M YeYe

Y  C + I + G + (X - [l + mY]) nSuppose we assume imports rise with rising income Y C, I YeYe w/(M = M) w/(M = l + mY)

Algebraic Solutions Y  C + I + G u where C = a + bY u where I = I, or I = f + gY u where G = G u where M = M, or M = l + mY u Solve for equilibrium Y S  I + G + (X - M) u where S = -a + (1-b)Y u where I = I, or I = f + gY u where G = G u where M = M, or M = l + mY u Solve for equilibrium Y

Problems nWhat will be the effect on Y of an increase in imports? nWhat will be the effect on Y of an increase in exports? nWhat will be the effects of a trade deficit? nWhat of a trade surplus?

Open Economy Multiplier - I Y  C + I + G Y  a + bY -bT + I + G + (X - [l + mY]) nY = a/(1 - b + m) -bT/(1 - b + m) + I/(1 - b + m) + G/(1 - b + m)+ X/(1 - b + m) - l/(1 - b + m) nWe can solve for any multiplier by taking the derivative, in the process of which all values on right = 0 except for for those with the variable ne.g., dY/dG = 1/(1 - b + m) = government expenditure multiplier

Open Economy Multiplier - II nIn dY/dG = 1/(1 - b + m) we see multiplier is LOWERED by imports nA given increase in G (or I, or X) will have LESS of an impact on Y because some of the increase in Y is spent abroad

Trade Feedback Effect ntrade feedback effect = "tendency for an increased in the economic activity of one country to lead to a world wide increase in economic activity" E.g., US Y  M =  X of other countries  Y in those countries This  in foreign Y  US X's  US Y

Homework nSuppose you followed the kind of policies used by the American administration in 1972, cutting back agricultural production & expanding exports, raising exports by 10%. What would be effect on aggregate Y? On trade balance?

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