Economics of International Finance Econ. 315

Economics of International Finance Economics of International Finance Prof. M. El-Sakka Prof. M. El-Sakka CBA. Kuwait University CBA. Kuwait University

Economics of International FinanceEconomics of International FinanceEcon. 315 Econ. 315

Chapter 5Chapter 5

The Income Adjustment Mechanism The Income Adjustment Mechanism and Synthesis of Automatic and Synthesis of Automatic

AdjustmentsAdjustments


Income Determinants in a Closed EconomyIncome Determinants in a Closed Economy

The equilibrium level of national income and production (Y) is equal to The equilibrium level of national income and production (Y) is equal to the planned flow of consumption and investmentsthe planned flow of consumption and investments

Y = C (Y) + IY = C (Y) + I Where I is exogenous, while C is a dependent of income. Where I is exogenous, while C is a dependent of income. Look at figure 1 and recall your background about Look at figure 1 and recall your background about 1.1. Consumption functionConsumption function2.2. Saving function Saving function 3.3. Investment functionInvestment function4.4. Marginal propensitiesMarginal propensities

Multiplier in a closed economyMultiplier in a closed economyAnother equilibrium pointAnother equilibrium point

ΔΔI = I = ΔΔS = MPS S = MPS ×× ΔΔYYSo thatSo that

ΔΔY = ( 1/MPS) Y = ( 1/MPS) ΔΔI I ΔΔY = K Y = K ×× ΔΔI I

therefore, the multiplier (k) is: therefore, the multiplier (k) is: K = K = ΔΔY/Y/ΔΔI = 1/MPS = 1/1-MPCI = 1/MPS = 1/1-MPC

An rise in I An rise in I to a multiple rise in GDP depending on the value of K 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 EconomyIncome Determination in a Small Open Economy

Import Function:Import Function: the relationship between nation’s imports and the relationship between nation’s imports and national income. national income.

Marginal Propensity to ImportMarginal Propensity to Import: the change in imports (: the change in imports (ΔΔM) M) associated with a change in income (associated with a change in income (ΔΔY).Y).

Average Propensity to ImportAverage Propensity to Import: the ratio of imports to income. : the ratio of imports to income. Income elasticity of importsIncome elasticity of imports: :

ηηMM = (% = (% ΔΔM/% M/% ΔΔY) = (Y) = (ΔΔM/M/ΔΔY)/(M/Y) = MPM/APMY)/(M/Y) = MPM/APM

Determination Of the Equilibrium National Income in a Small Open Determination Of the Equilibrium National Income in a Small Open EconomyEconomy

We include foreign trade. In an open economy, exports, just like We include foreign trade. In an open economy, exports, just like investment, are an injection into the nation’s income stream, while investment, are an injection into the nation’s income stream, while imports are just like savings are leakages out of the income stream. imports are just like savings are leakages out of the income stream. Hence; Hence; X and I stimulate domestic productionX and I stimulate domestic production


FIGURE 2 The Import Function.

((ΔΔM/M/ΔΔY)/(M/Y)Y)/(M/Y)ŊM=(150/1000)/(300/1000) = 0.5


X is taken as exogenous or independent of income of the X is taken as exogenous or independent of income of the nation. The export function is thus horizontal when plotted nation. The export function is thus horizontal when plotted against income. In a small open economy the equilibrium against income. In a small open economy the equilibrium condition is:condition is:

I + X = S + MI + X = S + M

By rearranging the terms of this equation we restate the By rearranging the terms of this equation we restate the equilibrium condition as:equilibrium condition as:

X – M = S – IX – M = S – I The nation could have a surplus in its trade balance equal to The nation could have a surplus in its trade balance equal to

the excess of savings over domestic investments (the excess of savings over domestic investments (net domestic net domestic leakageleakage).).

The deficit of the nation’s trade balance must be The deficit of the nation’s trade balance must be accompanied by an accompanied by an equal excess of I over Sequal excess of I over S

By rearranging I from the right to the left hand side we get By rearranging I from the right to the left hand side we get another useful form of equilibrium condition:another useful form of equilibrium condition:

I + (X – M) = SI + (X – M) = S X-M refers to foreign investments since X-M is an X-M refers to foreign investments since X-M is an

accumulation of foreign assets.accumulation of foreign assets.


Graphical Determination of the Equilibrium National Graphical Determination of the Equilibrium National IncomeIncome

Look at figure 3. The equilibrium level of national income Look at figure 3. The equilibrium level of national income The equilibrium level of national income:The equilibrium level of national income:

Injections = LeakagesInjections = Leakages

I + X = S + MI + X = S + M

150 + 300 = 150 + 300150 + 300 = 150 + 300

450 = 450450 = 450


FIGURE 3 National Income Determination in Small Open Economy.

S’(y)-I

(X-M’


Foreign Trade MultiplierForeign Trade Multiplier

Another equilibrium level of national income is determined where:Another equilibrium level of national income is determined where:ΔΔI + I + ΔΔX = X = ΔΔS + S + ΔΔMM * *

Induced changes in savings and imports when income changes are given Induced changes in savings and imports when income changes are given by:by:

ΔΔS = (MPS)(S = (MPS)(ΔΔY)Y) ΔΔM = (MPM)(M = (MPM)(ΔΔY)Y)

Substituting in equation ( * ) we getSubstituting in equation ( * ) we get ΔΔI + I + ΔΔX = (MPS)(X = (MPS)(ΔΔY) + (MPM)(Y) + (MPM)(ΔΔY)Y) ΔΔI + I + ΔΔX = (MPS + MPM)(X = (MPS + MPM)(ΔΔY)Y) ΔΔY = (1/(MPS + MPM)) (Y = (1/(MPS + MPM)) (ΔΔI + I + ΔΔX)X)

Where the foreign trade multiplier (k’)Where the foreign trade multiplier (k’) K’ = 1/(MPS + MPM) K’ = 1/(MPS + MPM) From the equilibrium point E, if exports rise exogenously from X=300 to From the equilibrium point E, if exports rise exogenously from X=300 to

X’=500 X’=500 K’ = 1/(MPS+MPM) = 1/(.25+.15) = 1/.4 = 2.5.K’ = 1/(MPS+MPM) = 1/(.25+.15) = 1/.4 = 2.5.


ΔΔY =(Y =(ΔΔX)(K’) = 200X)(K’) = 200××2.5 = 5002.5 = 500 AE’ =YAE’ =YEE + + ΔΔY = 1000 + 500 = 1500Y = 1000 + 500 = 1500 ΔΔS =(MPS)(S =(MPS)(ΔΔY) = 0.25 Y) = 0.25 ×× 500 = 125 500 = 125 ΔΔM =(MPM)(M =(MPM)(ΔΔY) = 0.15 Y) = 0.15 ×× 500 = 75 500 = 75

At YAt YEE’’. .

Changes in injections = changes in leakagesChanges in injections = changes in leakages

ΔΔI + I + ΔΔX = X = ΔΔS + S + ΔΔMM0 + 200 = 125 + 750 + 200 = 125 + 75

200 = 200200 = 200

At the equilibrium level of income YE = 1500 exports exceed imports by At the equilibrium level of income YE = 1500 exports exceed imports by 125 per period. The adjustment in BOP is incomplete 125 per period. The adjustment in BOP is incomplete

Note that the foreign trade multiplier is k’ = 2.5. is smaller than k (4), 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. because in an open economy, income leaks into both savings and imports. This is a fundamental result of open economy macroeconomics. This is a fundamental result of open economy macroeconomics.


Note that X = 500, while M = 375, hence X’-M =125.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) 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 function and the increase in income for a given autonomous increase in investment and exports. investment and exports.

If I rises by 200 instead of XIf I rises by 200 instead of X ΔΔI + I + ΔΔX = X = ΔΔS + S + ΔΔM = 200+0 = 125 + 75M = 200+0 = 125 + 75 And the nation faces a trade deficit = 75 equal to the increase in M (And the nation faces a trade deficit = 75 equal to the increase in M (ΔΔ

X=0) X=0)

If there is an increase in saving by 200, the S(y) – I function shift upward 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)by 200 and YE* = 500. X-M = 75 (surplus)

Finally if there is an autonomous increase in imports by 200, the X-M 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 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 have a trade deficit of X-M = -125. Note that the nation’s imports replace domestic production. domestic production.


Foreign repercussionsForeign repercussions

Here we relax the assumption that a nation is small and consider the Here we relax the assumption that a nation is small and consider the foreign repercussions. foreign repercussions.

In a two nation world, assume that there is an autonomous increase in 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. nation 1 exports, and an equal autonomous increase in nation 2 imports. If the autonomous increase in imports of nation 2, replaces domestic If the autonomous increase in imports of nation 2, replaces domestic production, its income will fall, thus neutralizing part of the increase in production, its income will fall, thus neutralizing part of the increase in its imports. This also neutralizes part of the original autonomous its imports. This also neutralizes part of the original autonomous increase in nation 1 exports. This represents a foreign repercussions on increase in nation 1 exports. This represents a foreign repercussions on nation 1. nation 1.

The foreign trade multiplier with foreign repercussions will be smaller The foreign trade multiplier with foreign repercussions will be smaller than the foreign trade multiplier without repercussions. than the foreign trade multiplier without repercussions.

The foreign trade multiplier of nation 1 with trade repercussions is The foreign trade multiplier of nation 1 with trade repercussions is K” = K” = ΔΔY1/Y1/ΔΔX1 = 1/(MPS1+MPM1+MPM2(MPS1/MPS2))X1 = 1/(MPS1+MPM1+MPM2(MPS1/MPS2))

Example: if MPS1 = .25, MPM1=.15, MPS2 = .2 AND MPM2 = .10. The Example: if MPS1 = .25, MPM1=.15, MPS2 = .2 AND MPM2 = .10. The trade multiplier for nation 1 istrade multiplier for nation 1 is

K” = K” = ΔΔY1/Y1/ΔΔX1 = 1/(.25+.15+.10(.25/.2)) = 1/.535 = X1 = 1/(.25+.15+.10(.25/.2)) = 1/.535 = 1.901.90


Thus the original increase in X of nation 1 by 200 leads to an increase in Thus the original increase in X of nation 1 by 200 leads to an increase in Y1 by (200 Y1 by (200 ×× 1.9) = 380 with foreign repercussions, as compared to (200 1.9) = 380 with foreign repercussions, as compared to (200 ×× 2.5) = 500 without foreign repercussions. As a result;2.5) = 500 without foreign repercussions. As a result;

ΔΔM1 = (M1 = (ΔΔY1)(MPM1) = 380Y1)(MPM1) = 380××.15 = 57.15 = 57 ΔΔS1 = (S1 = (ΔΔY1)(MPS1) = 380Y1)(MPS1) = 380××.25 = 95.25 = 95

At equilibrium;At equilibrium;ΔΔI1 + I1 + ΔΔX1 = X1 = ΔΔS1+ S1+ ΔΔM1 = 0+ M1 = 0+ ΔΔX1 = 95 + 57 = 152X1 = 95 + 57 = 152. .

Net increase in X1 = 152 with foreign repercussions (compared with 200).Net increase in X1 = 152 with foreign repercussions (compared with 200). Trade surplus (X-M) is 152-57 = 95 with foreign repercussion (compared Trade surplus (X-M) is 152-57 = 95 with foreign repercussion (compared

with 125)with 125) The foreign trade multiplier for nation 1 with foreign repercussions for The foreign trade multiplier for nation 1 with foreign repercussions for

an increase in investment is:an increase in investment is:

K* = K* = ΔΔY1/Y1/ΔΔI1 = (1+MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))I1 = (1+MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))

K* = K* = ΔΔY1/Y1/ΔΔI1 = (1+.1/.2)/.525 = 1.5/.525 = 2.86I1 = (1+.1/.2)/.525 = 1.5/.525 = 2.86

Thus k* > k’ > k” Thus k* > k’ > k”


ΔΔY1=(200)(2.86) = 572 (instead of 500 in the absence of foreign Y1=(200)(2.86) = 572 (instead of 500 in the absence of foreign repercussions). repercussions).

ΔΔM = (M = (ΔΔY1)Y1)))MPM1) = (572)(.15) = 85.8MPM1) = (572)(.15) = 85.8 ΔΔS = (S = (ΔΔY1)(MPS1) = (572)(.25) = 143 with foreign repercussions.Y1)(MPS1) = (572)(.25) = 143 with foreign repercussions. Substituting into the eq. conditionSubstituting into the eq. condition

ΔΔI1 + I1 + ΔΔX1 = X1 = ΔΔS1+ S1+ ΔΔM1 = 200 + M1 = 200 + ΔΔX1 = 143+85.8 = 228.8X1 = 143+85.8 = 228.8 The induced exports 28.8 The induced exports 28.8

Now country 1 trade deficit is (85.8 – 28.8) = 57 with repercussions Now country 1 trade deficit is (85.8 – 28.8) = 57 with repercussions (compared with 75 without repercussions)(compared with 75 without repercussions)

Note: foreign repercussions make trade deficit (surplus) lessNote: foreign repercussions make trade deficit (surplus) less

If there is an autonomous increase in investment in nation 2, the foreign If there is an autonomous increase in investment in nation 2, the foreign trade multiplier in nation 1 with foreign repercussions (k**) istrade multiplier in nation 1 with foreign repercussions (k**) is

K** = K** = ΔΔY1/Y1/ΔΔI2 = (MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))I2 = (MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))

Note K* = K**+ k’’Note K* = K**+ k’’


Absorption ApproachAbsorption Approach We saw before that a nation can correct for it BOP deficit by We saw before that a nation can correct for it BOP deficit by

depreciation, which is based on the elasticity approach. depreciation, which is based on the elasticity approach. Depreciation will stimulate exports and discourages imports, Depreciation will stimulate exports and discourages imports, thus increasing domestic production and income.thus increasing domestic production and income.

But increasing income in the deficit nation will in turn, But increasing income in the deficit nation will in turn, induces imports and neutralizes part of the original induces imports and neutralizes part of the original improvements in the BOP. improvements in the BOP.

If the If the deficit nationdeficit nation is at full employment, the is at full employment, the real domestic real domestic absorptionabsorption (expenditures) is not reduced (e.g., by fiscal or (expenditures) is not reduced (e.g., by fiscal or monetary policies), the depreciation will lead to increasing monetary policies), the depreciation will lead to increasing domestic prices and thus completely neutralize the domestic prices and thus completely neutralize the competitive advantage of the nation conferred by the deficit competitive advantage of the nation conferred by the deficit without any reduction in the deficit. Therefore, devaluation without any reduction in the deficit. Therefore, devaluation will work only if domestic absorption is somehow reducedwill work only if domestic absorption is somehow reduced. .


The absorption analysis was introduced by Alexander (1952). He began with The absorption analysis was introduced by Alexander (1952). He began with this identitythis identity

Y = C + I + (X – M)Y = C + I + (X – M)

By letting A equals By letting A equals domestic absorptiondomestic absorption – expenditures - (C + I) and B – expenditures - (C + I) and B equals trade balance (X – M), we haveequals trade balance (X – M), we have

Y = A + BY = A + B

Subtracting A from both sides we getSubtracting A from both sides we getY – A = BY – A = B

Hence domestic production (income) minus absorption (domestic Hence domestic production (income) minus absorption (domestic expenditures) equals the trade balance. expenditures) equals the trade balance.

For B to improve as a result of depreciation, Y must rise and/ or A must 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 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 only be effective if A fall either automatically or as a result of contractionary policies.contractionary policies.

How depreciation automatically reduces A?How depreciation automatically reduces A?


1.1. If it redistributes income from wages to profit earners If it redistributes income from wages to profit earners (have higher MPS than wage earners) thus affecting AE.(have higher MPS than wage earners) thus affecting AE.

2.2. It increases prices and reduces the real value of cash It increases prices and reduces the real value of cash balances, to restore cash balances to the desired level, the balances, to restore cash balances to the desired level, the public must reduce consumption, AE go down.public must reduce consumption, AE go down.

3.3. Rising domestic prices put people into higher tax brackets Rising domestic prices put people into higher tax brackets (as nominal income increases) and reduce consumption, (as nominal income increases) and reduce consumption, AE go down. AE go down.

Monetary AdjustmentsMonetary Adjustments

The mechanism of automatic monetary price adjustment in The mechanism of automatic monetary price adjustment in the deficit nation can be explained as follows:the deficit nation can be explained as follows:


1.1. When the exchange rate is not freely flexible, a deficit When the exchange rate is not freely flexible, a deficit tends to reduce the nation’s money supply as excess tends to reduce the nation’s money supply as excess demand for foreign currency is obtained by exchanging demand for foreign currency is obtained by exchanging domestic money balances for foreign exchange at the domestic money balances for foreign exchange at the central bank. This induces interest rate to rise in the central bank. This induces interest rate to rise in the deficit nation. deficit nation.

2.2. The rise in interest rates discourages investment and The rise in interest rates discourages investment and national income and thus imports which reduces the national income and thus imports which reduces the deficit.deficit.

3.3. The rise in interest rates attracts foreign capital which The rise in interest rates attracts foreign capital which helps to finance the deficit.helps to finance the deficit.

4.4. Reduction in money supply and income tends to reduce Reduction in money supply and income tends to reduce domestic prices in the deficit nation which improve domestic prices in the deficit nation which improve further BOP in the deficit nation further BOP in the deficit nation


Synthesis of automatic adjustmentsSynthesis of automatic adjustments

Now we integrate automatic price, income and monetary Now we integrate automatic price, income and monetary adjustments (a synthesis of automatic adjustments). adjustments (a synthesis of automatic adjustments).

Under flexible exchange rate systemUnder flexible exchange rate system and stable foreign and stable foreign exchange market, currency will depreciate until the deficit is exchange market, currency will depreciate until the deficit is entirely eliminated (entirely eliminated (price adjustmentprice adjustment). But depreciation ). But depreciation stimulates production and income which induces imports stimulates production and income which induces imports ((income adjustmentincome adjustment). This ). This reducesreduces part of the original part of the original improvement in BOP. This simply means that the improvement in BOP. This simply means that the depreciation required to eliminate the deficit is depreciation required to eliminate the deficit is largerlarger than if than if automatic income adjustment is not present.automatic income adjustment is not present.

Under managed floatingUnder managed floating full depreciation required to full depreciation required to eliminate the deficit is not allowed (eliminate the deficit is not allowed (price and monetary price and monetary adjustmentadjustment))..


Under fixed exchange rate systemUnder fixed exchange rate system, devaluation is allowed , devaluation is allowed only within narrow limits and adjustment must come from only within narrow limits and adjustment must come from elsewhereelsewhere. Deficit tends to reduce the nation’s money supply, . Deficit tends to reduce the nation’s money supply, ((monetary adjustmentmonetary adjustment) increasing interest rates, which in ) increasing interest rates, which in turn reduces investment and income in the deficit nation and turn reduces investment and income in the deficit nation and attracts foreign capital. It also induces prices to fall thus attracts foreign capital. It also induces prices to fall thus helping further to improve the deficit. Most of the helping further to improve the deficit. Most of the adjustments come from the monetary adjustments. adjustments come from the monetary adjustments.

When all of these automatic price, income and monetary When all of these automatic price, income and monetary adjustments are allowed to operate, the BOP adjustment is adjustments are allowed to operate, the BOP adjustment is likely to be more or less complete even under fixed exchange likely to be more or less complete even under fixed exchange rate system. But automatic adjustments have serious rate system. But automatic adjustments have serious disadvantages.disadvantages.

In real world changes in income, prices, interest rates, In real world changes in income, prices, interest rates, exchange rates and other variables change as a result of exchange rates and other variables change as a result of autonomous disturbance in one nation affects other nations autonomous disturbance in one nation affects other nations with repercussions back to the first nation. It is very difficult with repercussions back to the first nation. It is very difficult to trace all of these effects in the real world.to trace all of these effects in the real world.


Disadvantages of automatic adjustmentsDisadvantages of automatic adjustments

1.1. Disadvantages of freely flexible exchange rate system may Disadvantages of freely flexible exchange rate system may be erratic fluctuations in exchange rates, which impose be erratic fluctuations in exchange rates, which impose costly adjustmentcostly adjustment burdens that might be unnecessary in burdens that might be unnecessary in the long run.the long run.

2.2. Possibility of devaluation under fixed exchange rate Possibility of devaluation under fixed exchange rate system can lead to system can lead to destabilizedestabilize international capital flows. international capital flows. Fixed exchange rate system also forces the nation to relay Fixed exchange rate system also forces the nation to relay primarily on monetary adjustmentsprimarily on monetary adjustments

3.3. Under managed floating, erratic fluctuation in exchange Under managed floating, erratic fluctuation in exchange rate can be avoided but monetary authorities may manage rate can be avoided but monetary authorities may manage exchange rate so as to keep domestic currency exchange rate so as to keep domestic currency undervalued to stimulate domestic economy. Such policies undervalued to stimulate domestic economy. Such policies proved to be very proved to be very disruptivedisruptive in damaging international in damaging international trade during interwar period.trade during interwar period.


4.4. Automatic income changes can also have serious Automatic income changes can also have serious disadvantages, a nation facing a autonomous increase in its disadvantages, a nation facing a autonomous increase in its imports at the expense of domestic production would allow imports at the expense of domestic production would allow its income to its income to fallfall, while countries facing an autonomous , while countries facing an autonomous increase in exports would have to accept domestic increase in exports would have to accept domestic inflationinflation to to eliminate the surplus. eliminate the surplus.

5.5. Finally for automatic monetary adjustments to operate, the Finally for automatic monetary adjustments to operate, the nation must passively allow it money supply to change, thus nation must passively allow it money supply to change, thus giving upgiving up its use of monetary policy to achieve domestic full its use of monetary policy to achieve domestic full employment without inflation.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

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Economics of International Finance Econ. 315

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