Get documents about "Chapter 24 National Income and the Current Account
Document Sample
Chapter 24: National Income
and the Current Account
• Someone left a calculator at the exam. I
have it here.
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.
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”
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
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
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.
Consumption function
C = a + b Yd
• b represents the marginal propensity to
consume
MPC = ΔC/ΔYd
• There is a similar propensity for savings:
MPS = ΔS/ΔYd
• Since all disposable income is either consumed
or saved….
MPC + MPS = 1
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
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
Consumption and Savings function
• We can also graph the consumption and
savings functions:
S
C
C = 500 + 0.9 Yd
0.90 S = -500 + 0.1 Yd
-500 0.10
500
Yd Yd
I
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.
I
Autonomous components
• Example:
I = 200
G = 500
I,G,T,X
T = 400 G = 500
500
X = 150 400 T = 400
200 I = 200
150 X = 150
Income, Y
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
Imports
M=M+mY
MPM = ΔM/ΔY
• 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)
= (ΔM/M) / (ΔY/Y)
= (ΔM/ΔY) / (M/Y)
= MPM / APM
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
Imports
• Example:
M = 40 + 0.15 Y
MPM = 0.15
Imports
(M)
M = 40 + 0.15 Y
0.15
40
Income or production (y))
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
Putting it together: Equilibrium Income
• We can look at equilibrium with the
expenditure equation.
E=C+I+G+X–M
Y=E 45o
• Graphically:
Desired E
spending, E
(C+I+G+X-M)
autonomous spending
Y
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)
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)
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)
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)
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
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.
Putting it together: Equilibrium Income
• Graphically:
Desired
spending, E
45o
(C+I+G+X-M)
E=C+I+G+X-M
0.7
600 = a –bT+I+G+X-M
0 2000 Y
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
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
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.
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.
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
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.
Injections and leakages approach
I+G+X=S+T+M
I + G + X,
S+T+M
S+T+M
q
I+G+X
0
Y1 Ye Y2 Y
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.
I + G + X,
S+T+M
S+T+M
q
I+G+X
0
Y1 Ye Y2 Y
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
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
S + T-G – I
X-M
S + T –G - I
Ye
0 Y
q
X-M
You do:
• Find the injections in the book example,
and the in-class example.
• Find the current account balance in the
two examples.
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
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
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.
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)
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)
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
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).
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.
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.
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….
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.
Y = f(Y”)
Income in foreign Y* = f(Y)
country Y*
Income in home country Y
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
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
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.
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.
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
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
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
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
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)
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
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
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
• 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.
Swan model
Case c : Current account
e surplus and inflation (for EB
curr too high for EB,
spending too high for IB
Case d : Current account
surplus and unemployment Case b : Current account
(foreign currency too high for deficit and inflation (foreign
EB, spending too low for IB) currency too low for EB,
spending too high for IB)
Case a : Current account
deficit and unemployment IB
C+I+G
Related docs
