Economics of International Finance Econ. 315

Economics of International FinanceEcon. 315 Chapter 5 The Income Adjustment Mechanism and Synthesis of Automatic Adjustments

Income Determinants in a Closed Economy • The equilibrium level of national income and production (Y) is equal to the planned flow of consumption and investments Y = C (Y) + I • Where I is exogenous, while C is a dependent of income. • Look at figure 1 and recall your background about • Consumption function • Saving function • Investment function • Marginal propensities Multiplier in a closed economy Another equilibrium point ΔI = ΔS = MPS ×ΔY So that ΔY = ( 1/MPS) ΔI ΔY = K ×ΔI therefore, the multiplier (k) is: K = ΔY/ΔI = 1/MPS = 1/1-MPC An rise in I  to a multiple rise in GDP depending on the value of K

FIGURE 1 National Income Equilibrium in a Closed Economy.

Income Determination in a Small Open Economy • Import Function: the relationship between nation’s imports and national income. • Marginal Propensity to Import: the change in imports (ΔM) associated with a change in income (ΔY). • Average Propensity to Import: the ratio of imports to income. • Income elasticity of imports: ηM = (% ΔM/% ΔY) = (ΔM/ΔY)/(M/Y) = MPM/APM Determination Of the Equilibrium National Income in a Small Open Economy • We include foreign trade. In an open economy, exports, just like investment, are an injection into the nation’s income stream, while imports are just like savings are leakages out of the income stream. Hence; X and I stimulate domestic production

FIGURE 2 The Import Function. (ΔM/ΔY)/(M/Y) ŊM=(150/1000)/(300/1000) = 0.5

X is taken as exogenous or independent of income of the nation. The export function is thus horizontal when plotted against income. In a small open economy the equilibrium condition is: I + X = S + M • By rearranging the terms of this equation we restate the equilibrium condition as: X – M = S – I • The nation could have a surplus in its trade balance equal to the excess of savings over domestic investments (net domestic leakage). • The deficit of the nation’s trade balance must be accompanied by an equal excess of I over S • By rearranging I from the right to the left hand side we get another useful form of equilibrium condition: I + (X – M) = S • X-M refers to foreign investments since X-M is an accumulation of foreign assets.

Graphical Determination of the Equilibrium National Income • Look at figure 3. The equilibrium level of national income • The equilibrium level of national income: Injections = Leakages I + X = S + M 150 + 300 = 150 + 300 450 = 450

FIGURE 3 National Income Determination in Small Open Economy. S’(y)-I (X-M’

Foreign Trade Multiplier • Another equilibrium level of national income is determined where: ΔI + ΔX = ΔS + ΔM * • Induced changes in savings and imports when income changes are given by: • ΔS = (MPS)(ΔY) • ΔM = (MPM)(ΔY) • Substituting in equation ( * ) we get • ΔI + ΔX = (MPS)(ΔY) + (MPM)(ΔY) • ΔI + ΔX = (MPS + MPM)(ΔY) • ΔY = (1/(MPS + MPM)) (ΔI + ΔX) • Where the foreign trade multiplier (k’) • K’ = 1/(MPS + MPM) • From the equilibrium point E, if exports rise exogenously from X=300 to X’=500 • K’ = 1/(MPS+MPM) = 1/(.25+.15) = 1/.4 = 2.5.

ΔY =(ΔX)(K’) = 200×2.5 = 500 • AE’ =YE + ΔY = 1000 + 500 = 1500 • ΔS =(MPS)(ΔY) = 0.25 × 500 = 125 • ΔM =(MPM)(ΔY) = 0.15 × 500 = 75 • At YE’. Changes in injections = changes in leakages ΔI + ΔX = ΔS + ΔM 0 + 200 = 125 + 75 200 = 200 • At the equilibrium level of income YE = 1500 exports exceed imports by 125 per period. The adjustment in BOP is incomplete • Note that the foreign trade multiplier is k’ = 2.5. is smaller than k (4), because in an open economy, income leaks into both savings and imports. This is a fundamental result of open economy macroeconomics.

Note that X = 500, while M = 375, hence X’-M =125. • Note also that the smaller MPS+MPM, the flatter is the S(Y) + M(Y) function and the increase in income for a given autonomous increase in investment and exports. • If I rises by 200 instead of X • ΔI + ΔX = ΔS + ΔM = 200+0 = 125 + 75 • And the nation faces a trade deficit = 75 equal to the increase in M (Δ X=0) • If there is an increase in saving by 200, the S(y) – I function shift upward by 200 and YE* = 500. X-M = 75 (surplus) • Finally if there is an autonomous increase in imports by 200, the X-M shifts downward by 200 and eq Y = 500, in this case the nation would have a trade deficit of X-M = -125. Note that the nation’s imports replace domestic production.

Foreign repercussions • Here we relax the assumption that a nation is small and consider the foreign repercussions. • In a two nation world, assume that there is an autonomous increase in nation 1 exports, and an equal autonomous increase in nation 2 imports. If the autonomous increase in imports of nation 2, replaces domestic production, its income will fall, thus neutralizing part of the increase in its imports. This also neutralizes part of the original autonomous increase in nation 1 exports. This represents a foreign repercussions on nation 1. • The foreign trade multiplier with foreign repercussions will be smaller than the foreign trade multiplier without repercussions. • The foreign trade multiplier of nation 1 with trade repercussions is K” = ΔY1/ΔX1 = 1/(MPS1+MPM1+MPM2(MPS1/MPS2)) • Example: if MPS1 = .25, MPM1=.15, MPS2 = .2 AND MPM2 = .10. The trade multiplier for nation 1 is • K” = ΔY1/ΔX1 = 1/(.25+.15+.10(.25/.2)) = 1/.535 = 1.90

Thus the original increase in X of nation 1 by 200 leads to an increase in Y1 by (200 × 1.9) = 380 with foreign repercussions, as compared to (200 × 2.5) = 500 without foreign repercussions. As a result; • ΔM1 = (ΔY1)(MPM1) = 380×.15 = 57 • ΔS1 = (ΔY1)(MPS1) = 380×.25 = 95 • At equilibrium; ΔI1 + ΔX1 = ΔS1+ ΔM1 = 0+ ΔX1 = 95 + 57 = 152. • Net increase in X1 = 152 with foreign repercussions (compared with 200). • Trade surplus (X-M) is 152-57 = 95 with foreign repercussion (compared with 125) • The foreign trade multiplier for nation 1 with foreign repercussions for an increase in investment is: K* = ΔY1/ΔI1 = (1+MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2)) • K* = ΔY1/ΔI1 = (1+.1/.2)/.525 = 1.5/.525 = 2.86 • Thus k* > k’ > k”

ΔY1=(200)(2.86) = 572 (instead of 500 in the absence of foreign repercussions). • ΔM = (ΔY1))MPM1) = (572)(.15) = 85.8 • ΔS = (ΔY1)(MPS1) = (572)(.25) = 143 with foreign repercussions. • Substituting into the eq. condition ΔI1 + ΔX1 = ΔS1+ ΔM1 = 200 + ΔX1 = 143+85.8 = 228.8 • The induced exports 28.8 • Now country 1 trade deficit is (85.8 – 28.8) = 57 with repercussions (compared with 75 without repercussions) • Note: foreign repercussions make trade deficit (surplus) less • If there is an autonomous increase in investment in nation 2, the foreign trade multiplier in nation 1 with foreign repercussions (k**) is • K** = ΔY1/ΔI2 = (MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2)) • Note K* = K**+ k’’

Absorption Approach • We saw before that a nation can correct for it BOP deficit by depreciation, which is based on the elasticity approach. Depreciation will stimulate exports and discourages imports, thus increasing domestic production and income. • But increasing income in the deficit nation will in turn, induces imports and neutralizes part of the original improvements in the BOP. • If the deficit nation is at full employment, the real domestic absorption (expenditures) is not reduced (e.g., by fiscal or monetary policies), the depreciation will lead to increasing domestic prices and thus completely neutralize the competitive advantage of the nation conferred by the deficit without any reduction in the deficit. Therefore, devaluation will work only if domestic absorption is somehow reduced.

The absorption analysis was introduced by Alexander (1952). He began with this identity Y = C + I + (X – M) • By letting A equals domestic absorption – expenditures - (C + I) and B equals trade balance (X – M), we have Y = A + B • Subtracting A from both sides we get Y – A = B • Hence domestic production (income) minus absorption (domestic expenditures) equals the trade balance. • For B to improve as a result of depreciation, Y must rise and/ or A must fall. If Y is at full employment, Y will not rise and the depreciation can only be effective if A fall either automatically or as a result of contractionary policies. • How depreciation automatically reduces A?

If it redistributes income from wages to profit earners (have higher MPS than wage earners) thus affecting AE. • It increases prices and reduces the real value of cash balances, to restore cash balances to the desired level, the public must reduce consumption, AE go down. • Rising domestic prices put people into higher tax brackets (as nominal income increases) and reduce consumption, AE go down. • Monetary Adjustments • The mechanism of automatic monetary price adjustment in the deficit nation can be explained as follows:

When the exchange rate is not freely flexible, a deficit tends to reduce the nation’s money supply as excess demand for foreign currency is obtained by exchanging domestic money balances for foreign exchange at the central bank. This induces interest rate to rise in the deficit nation. • The rise in interest rates discourages investment and national income and thus imports which reduces the deficit. • The rise in interest rates attracts foreign capital which helps to finance the deficit. • Reduction in money supply and income tends to reduce domestic prices in the deficit nation which improve further BOP in the deficit nation

Synthesis of automatic adjustments Now we integrate automatic price, income and monetary adjustments (a synthesis of automatic adjustments). • Under flexible exchange rate system and stable foreign exchange market, currency will depreciate until the deficit is entirely eliminated (price adjustment). But depreciation stimulates production and income which induces imports (income adjustment). This reduces part of the original improvement in BOP. This simply means that the depreciation required to eliminate the deficit is larger than if automatic income adjustment is not present. • Under managed floating full depreciation required to eliminate the deficit is not allowed (price and monetary adjustment).

Under fixed exchange rate system, devaluation is allowed only within narrow limits and adjustment must come from elsewhere. Deficit tends to reduce the nation’s money supply, (monetary adjustment) increasing interest rates, which in turn reduces investment and income in the deficit nation and attracts foreign capital. It also induces prices to fall thus helping further to improve the deficit. Most of the adjustments come from the monetary adjustments. • When all of these automatic price, income and monetary adjustments are allowed to operate, the BOP adjustment is likely to be more or less complete even under fixed exchange rate system. But automatic adjustments have serious disadvantages. • In real world changes in income, prices, interest rates, exchange rates and other variables change as a result of autonomous disturbance in one nation affects other nations with repercussions back to the first nation. It is very difficult to trace all of these effects in the real world.

Disadvantages of automatic adjustments • Disadvantages of freely flexible exchange rate system may be erratic fluctuations in exchange rates, which impose costly adjustment burdens that might be unnecessary in the long run. • Possibility of devaluation under fixed exchange rate system can lead to destabilize international capital flows. Fixed exchange rate system also forces the nation to relay primarily on monetary adjustments • Under managed floating, erratic fluctuation in exchange rate can be avoided but monetary authorities may manage exchange rate so as to keep domestic currency undervalued to stimulate domestic economy. Such policies proved to be very disruptive in damaging international trade during interwar period.

Automatic income changes can also have serious disadvantages, a nation facing a autonomous increase in its imports at the expense of domestic production would allow its income to fall, while countries facing an autonomous increase in exports would have to accept domestic inflation to eliminate the surplus. • Finally for automatic monetary adjustments to operate, the nation must passively allow it money supply to change, thus giving up its use of monetary policy to achieve domestic full employment without inflation.

Key Terms • Closed economy • Import function • Equilibrium level of national income (YE) • Marginal propensity to import (MPM) • Desired or planned investment • Average propensity to import (MPM) • Marginal propensity to consume (MPC) • Income elasticity of imports (ny) • Consumption function • Export function • Saving function • Foreign trade multiplier (k') • Marginal propensity to save (MPS) • Foreign repercussions • Investment function • Absorption approach • Multiplier (k) • Synthesis of automatic adjustments

Economics of International Finance Econ. 315