Chapter 24: National Income and the Current Account

1. Chapter 24: National Income and the Current Account

3. Opening vignette Catherine Mann argues that the growth of the US economy relative to its trading partners will cause the current account deficit to increase, even with a depreciation… only a restructuring of the economy, including increased savings and an opening of the world to US exports will solve the problem This is Keynesian analysis in practice.

4. John Maynard Keynes Most famous for three things: predicting that the 2nd world war would arise from the Treaty of Versailles and the heavy reparations placed on Germany “The General Theory of Employment, Interest and Money (1936) “Keynesian economics” arose from this book, and its representation by IS-LM graph is thanks to John Hicks being an architect of the Bretton-Woods system And saying “in the long-run we are all dead”

5. Keynesian Income Model Desired aggregate demand is the sum of consumption (C), investment (I), government spending (G) and the current account surplus (X-M) E = C + I + G + X – M Most important component is consumption

6. Consumption Consumption mainly depends on disposable income C = f(Yd) or, in its most common form (the Keynesian consumption function): C = a + b Yd Disposable income is income less taxes Yd = Y – T

7. Consumption function C = a + b Yd there are two components to consumption a represents autonomous consumption this is the amount that people will spend independent of their current level of income (depends on other things besides income) bYd is the induced consumption.

8. Consumption function C = a + b Yd b represents the marginal propensity to consume MPC = ?C/?Yd There is a similar propensity for savings: MPS = ?S/?Yd Since all disposable income is either consumed or saved…. MPC + MPS = 1

9. Consumption function & savings function Using income and the consumption function, we can derive a savings function. Income: Yd = C + S Consumption function is: C = a + b Yd and so income is: Yd = a + b Yd + S rearrange: Yd - a – b Yd = S - a + (Yd – b Yd) = S S = -a + (1 - b) Yd

10. Savings function S = -a + (1 - b) Yd Let s = 1 – b And so, we have the savings function: S = -a + s Yd Example: Let a = 500, b = 0.9, In this case: C = 500 + 0.9 Yd S = -500 + 0.1 Yd

11. Consumption and Savings function We can also graph the consumption and savings functions:

12. More autonomous components Note: can’t get overstrike, so using underline to denote fixed numbers. Investment: I= I Government spending: G = G Taxes: T = T Exports: X = X Note: in more complex models, taxes, government spending and investment can also depend on income. (especially taxes, see Appendix A) Exports are exogenous, because they depend on spending from other countries.

13. Autonomous components Example: I = 200 G = 500 T = 400 X = 150

14. Imports To analyze the external market, we must recognize that imports depend directly on income. M = f(Y) Note, Y is not disposable income, but all income, as all spending can include imports. M = M + mY where M represents autonomous imports, and mY represents induced imports m is the marginal propensity to import

15. Imports M = M + m Y MPM = ?M/?Y Because we are looking at the international market, we will introduce two more import concepts: average propensity to import APM=M/Y income elasticity of demand for imports YEM = (%M)/(%Y) = (?M/M) / (?Y/Y) = (?M/?Y) / (M/Y) = MPM / APM

16. Imports income elasticity of demand for imports YEM = (%M)/(%Y) = MPM / APM If a country’s MPM is greater than APM , then the demand for imports is elastic at that income level, and if income rises, then imports will rise more than proportionally to income

17. Imports Example: M = 40 + 0.15 Y MPM = 0.15

18. You do Consumption: Let a = 1000, b = 0.95 Find the consumption and savings functions. Also write the MPC and MPS. Let M = 25 , m = 0.30 Find the import function, as well as the MPM

19. Putting it together: Equilibrium Income We can look at equilibrium with the expenditure equation. E = C + I + G + X – M Y = E Graphically:

20. Putting it together: Equilibrium Income We can introduce all the components into one expenditure equation. E = C + I + G + X – M C = a + b Yd Yd = Y - T I = I G = G X = X T = T M = M + mY Put it all together: E = a + b (Y – T) + I + G +X – (M + mY)

21. Putting it together: Equilibrium Income The expenditure equation can be used to find one equilibrium income equation. E = C + I + G + X – M E = Y Y = a + b (Y – T) + I + G +X – (M + mY) Y – bY + mY = a – b T + I +G +X - M Y(1-b+m) = a – b T + I +G +X - M Equilibrium income: Y = a – b T + I +G +X - M ----------------------------------------------------------------------------------------------------- (1 – b + m)

22. Putting it together: Equilibrium Income The expenditure equation can be used to find one equilibrium income equation. E = C + I + G + X – M E = a + b (Y – T) + I + G +X – (M + mY) E = Y Y = a + b (Y – T) + I + G +X – (M + mY) Y – bY + mY = a – b T + I +G +X - M Y(1-b+m) = a – b T + I +G +X - M Equilibrium income: Y = a – b T + I +G +X - M --- --------------------------------------------------------------------------------------------------- (1 – b + m)

23. Putting it together: Equilibrium Income Example: C = a + b Yd Yd = Y - T I = I G = G X = X T = T M = M + mY Put it all together: E = a + b (Y – T) + I + G +X – (M + mY)

24. Putting it together: Equilibrium Income Book example: C = 100 + 0.8 Yd G = 600 Yd = Y – T X = 140 T = 500 M = 20 + 0.1 Y I = 180 E = C + I + G + X – M = 100 + 0.8 Yd +180+600+140 – (20+0.1Y) = 100+0.8(Y-500)+180+600+140-(20+0.1Y) = 1000 + 0.8Y – 0.8x500 - 0.1Y = 600 + 0.7Y

25. Putting it together: Equilibrium Income Book example: E = C + I + G + X – M = 600 + 0.7Y Y = E Y = 600 + 0.7Y Y(1 – 0.7) = 600 Y = 600 / 0.3 Y = 2000 This is the equilibrium level of income where income equals expenditure.

26. Putting it together: Equilibrium Income Graphically:

27. Putting it together: Equilibrium Income You do: C = 500 + 0.9 Yd G = 500 Yd = Y – T X = 150 T = 400 M = 40 + 0.15 Y I = 200 E = C + I + G + X – M

28. Putting it together: Equilibrium Income Answer, please check : C = 500 + 0.9 Yd G = 500 Yd = Y – T X = 150 T = 400 M = 40 + 0.15 Y I = 200 E = C + I + G + X – M E = 500+0.9Yd +200+500+150-(40+0.15 Y) E = 1310+0.9(Y-400) – 0.15Y E = 950 + 0.75 Y Y= 950+0.75 Y Y= 950/0.25 = 3800

29. Equilibrium Income: meaning and adjustment When income is at equilibrium, the desired spending in the economy is exactly enough to cover the income of the economy. If income is above desired expenditure, there will be unintended increases in firm inventories. This will cause firms to produce less, reducing Y and returning the economy to equilibrium. If income is below desired expenditure, there will be unintended decreases in firm inventories. This will cause firms to produce more, increasing Y and returning the economy to equilibrium.

30. Injections and leakages approach So, far, we have looked at income equals expenditure to find the equilibrium income in the economy. An alternate interpretation of this equilibrium separates the parts of income and expenditure into injections and leakages. This approach uses the same equations as we used in Chapter 19, but with a slightly different arrangement.

31. Injections and leakages approach Recall: Income equals expenditure yields: Y = C + I + G + X – M Uses of income: Y = C + S + T Combining these two yields: C+ I + G + X – M = C + S + T Which we can rearrange to get: I + G + X = S + T + M

32. Injections and leakages approach I + G + X = S + T + M The left hand side of the equation (I + G + X) represents injections into the economy. The right hand side represents leakages from the economy (S + T + M). when money leaks from the economy, it does not contribute toward further income generation.

33. Injections and leakages approach I + G + X = S + T + M

34. Injections and leakages approach q represents the level of injections = leakages at income Ye at Y1 injections are greater than leakages and so the economy expands.

35. Current account balance approach I + G + X = S + T + M This can be rearranged, as in Chapter 19, to examine the current account balance. X - M = S + (T – G) – I The left hand side of the equation represents the current account The right hand side represents private and public net savings in the economy. A CA surplus means that the country is saving more than it is investing, privately or publicly

36. Current Account balance X - M = S + (T – G ) - I Note, there is a current account balance that will prevail at equilibrium, and it is not necessarily 0

37. You do: Find the injections in the book example, and the in-class example. Find the current account balance in the two examples.

38. Equilibrium Income Book example: C = 100 + 0.8 Yd G = 600 Yd = Y – T X = 140 T = 500 M = 20 + 0.1 Y I = 180 Equilibrium income: 2000 Injections = leakages: X-M

39. Equilibrium Income : C = 500 + 0.9 Yd G = 500 Yd = Y – T X = 150 T = 400 M = 40 + 0.15 Y I = 200 Y= 950/0.25 = 3800 Injections = leakages X – M

40. The autonomous spending multiplier The multiplier tells us how much income would rise if any of the positive autonomous components of expenditure rose (or the negative ones fell) For example, if exports rose by 20, then the multiplier tells us how much income would rise once all the effects of the rise in exports have worked through the economy. What are the effects? Because exports will increase income, they will also affect C, and M. But increase in C increases Y, and an increase in M decreases Y, so this is taken into account when calculating the multiplier.

41. The autonomous spending multiplier We have already calculated the multiplier for this simple model when we calculated our equilibrium income. Recall: Equilibrium income: Y = a – b T + I +G +X - M --- --------------------------------------------------------------------------------------------------- (1 – b + m) or Y = 1 x( a – b T + I +G +X – M ) ---------------------------------------------------------- (1 – b + m)

42. The autonomous spending multiplier the first part of the equation is the multiplier, the second part (in brackets) is the autonomous spending in the economy. Y = 1 x( a – b T + I +G +X – M ) ---------------------------------------------------------- (1 – b + m) Multiplier: k = 1 ---------------------------------------------------------- (1 – b + m)

43. The autonomous spending multiplier Recall b = MPC m = MPM Multiplier: k = 1 ---------------------------------------------------------------------------------------- (1 – MPC + MPM) Also, MPS = 1 - b Multiplier: k = 1 ---------------------------------------------------------------------------------------- (MPS + MPM) This is called the basic open-economy multiplier

44. The autonomous spending multiplier Multiplier: k = 1 ---------------------------------------------------------------------------------------- (MPS + MPM) The basic open-economy multiplier tells us that the higher are the marginal propensities to save and import (leakages), the lower is the effect on the economy of an increase in autonomous spending. An open-economy multiplier is larger than a closed economy multiplier (1/MPS).

45. The autonomous spending multiplier Imports enter autonomous spending with a negative sign. Therefore, the import multiplier is: - k = - 1 ---------------------------------------------------------------------------------------- (MPS + MPM) An autonomous increase in imports has the opposite effect of an autonomous increase in C, I, G, or X. Therefore, if autonomous imports and exports increased by the same amount, there would be no effect on income.

46. The autonomous spending multiplier So far, we have looked at the most simple macroeconomic model for an open economy. More often, we will treat taxes as a function of income. (See appendix one) Sometimes, we will consider government spending as a function of income. In both of these cases, when finding equilibrium income, we can find the autonomous spending component (the numerator) and the multiplier (one over the denominator) At its most complex, we can even find the multiplier with foreign repercussions.

47. Foreign repercussions Foreign repercussions occur when an autonomous increase in spending on our economy causes our income to increase, and, this causes our country to import more which causes foreign income to increase which increases their imports, which causes our exports to increase which causes our income to increase further which causes our imports to increase which causes foreign income to increase….

48. Foreign repercussions We can draw the interdependence of two economies, home and foreign * because each country depends on the other’s imports for income growth, there is an simultaneous national income equilibrium income for the two.

49. Internal and External Balance When the economy is open to the world there are two distinct sets of goals that are of concern for policy-makers: keeping the economy near full employment equilibrium (for now, income = expenditure) keeping the balance of payments in balance

50. Internal and External Balance Internal balance: within a country the goal is to achieve low unemployment and price stability. these are congruous with the goal of equilibrium income there is generally a trade-off between unemployment and demand-side inflation, countries seek a balance there. this is one dimension of balance

51. Internal and External Balance External balance: (FIXED exchange rate) for an open economy there is also concern about the balance of payments countries worry about large and sustained current account deficits, because that means they are spending more than their current income internationally.

52. Internal and External Balance We usually think of macroeconomic policy as expansionary or contractionary. When we have imbalances internally and externally that are in conflict, it can be difficult to choose the right policy.

53. Internal and External Balance: Cases of imbalance in two dimensions There are (at least) four different combinations of disequilibria that can require intervention: Case a : Deficit in the current account; unacceptably high unemployment Case b : Deficit in the current account; unacceptably rapid inflation Case c: Surplus in the current account; unacceptably rapid inflation Case d: Surplus in the current account; unacceptably high unemployment

54. Policy prescriptions for each case Let’s start with clear cases (II and IV), then move to the more difficult ones (I and III) Case b : Current account deficit and inflation country is spending more than it should internally and externally, prescription is contractionary monetary and fiscal policy reduce money supply raise taxes and/or cut spending

55. Policy prescriptions for each case Case d : Current account surplus and unemployment country is spending less than it should internally and externally, prescription is expansionary monetary and fiscal policy increase money supply reduce taxes and/or increase spending

56. Policy prescriptions for each case Case a : Current account deficit and unemployment externally country is spending more than it is earning internally country is not spending enough to maintain full employment. With fixed rates, there is no real solution. expansionary policy worsens deficit and reduces unemployment contractionary policy worsens unemployment and reduces current account deficit

57. Policy prescriptions for each case Case a : Current account deficit and unemployment externally country is spending more than it is earning internally country is not spending enough to maintain full employment. If country can change exchange rate, then solution may be to lower its currency’s value (raise foreign exchange rate) and use limited expansionary policy to lower unemployment (currency lowering can do much of the work for this case)

58. Policy prescriptions for each case Case c : Current account surplus and inflation externally country is spending less than it is earning internally country is spending more than it is producing, causing prices to rise. With fixed rates, there is no real solution. expansionary policy worsens inflation but reduces current account surplus contractionary policy worsens current acount surplus but reduces inflation

59. Policy prescriptions for each case Case c : Current account surplus and inflation externally country is spending less than it is earning internally country is spending more than it is producing, causing prices to rise. With fixed rates, there is no real solution. If country can change exchange rate, then solution may be to raise the value of its currency (lower foreign exchange rate) to get rid of excess demand externally, and use limited contractionary policy to lower inflation

60. Internal and external balance For an open economy, there are two targets that require balancing. Therefore two instruments are needed Adjustments to an exchange rate can be one of the instruments used to achieve balance. In 1963, (a time of fixed exchange rates) Swan put together a model to show how these work for internal and external balance

61. The next slide is Swan’s grahical analysis of the internal external balance, and how imbalances could be fixed using the exchange rate Mundell (chapter 25) presented a model with monetary and fiscal policy in a fixed rate system that made this model somewhat obsolete quickly Therefore, the next slide is for interest only. You don’t need to learn it.

62. Swan model