Given the amount of planned investment expenditures, which is assumed to be the same for all levels of income, we can now draw a line representing total expenditures (C + I) for every level of income. In Figure 18.1a, we assume I = 30, and that amount is added vertically to the consumption function to give us the C + I line, also called the “aggregate expenditure function.” The equilibrium level of income is that level at which aggregate expenditure just equals the level of income as indicated by the 45° line. In Figure 18.1a, the C + I line intersects the 45° line at E, indicating an equilibrium level of income of 200. It is clear that only one such point exists: at lower levels of Y, aggregate expenditure (C + I) is above the 45° guideline; at higher levels of Y, aggregate expenditure is below the 45° guideline. The solution can also be obtained by substituting equation (7) into equation (1), setting I = 30, and solving, as follows: Y = C + I (1) C = 50 + 0.60Y (7) Y = (50 + 0.60Y)+I = (50 + 0.60Y)+30 Y = 0.60Y +80 Y – 0.60Y =80 Y(1 – 0.60) = 80 1 Y = 80 = 200 1 – 0.60 The equilibrium level of income may also be defined as the level at which intended investment just equals the amount of saving people are willing to take out of income. In Figure 18.1b, we show the saving function (S), obtained from the upper part of the diagram by taking the vertical difference between consumption at the 45° line at each level of income. The saving function can also be obtained by substituting equation (7) into equation (2), as follows: Y = C + S (2) C = 50 + 0.60Y (7) Y = (50 + 0.60Y)+S S = –50 + 0.40Y (8) The saving function shows that saving increases as income increases. Equation (8) indicates that 40 percent of any increase in income will be saved. The fraction, 0.40, is the marginal propensity to save, defined as s = ∆S (9) ∆Y As noted earlier, we assume that there are no taxes so that all income is either spent for consumption or saved. Thus it is clear that the marginal propensities to consume and save add up to 1.00, that is: c + s = 1 (10) 18 – Open macroeconomics with fixed exchange rates 407 In our example, of each $1.00 of additional income, $0.60 will be spent for consumption and $0.40 will be saved. The level of planned investment is shown in Figure 18.1b by a horizontal line at I = 30. The equilibrium level of income, at which S = I, is indicated by point E, where Y = 200. Algebraically, this solution entails substituting equation (8) into equation (3) and setting I = 30, as follows: S = I (3) S = –50 + 0.40Y (8) –50 + 0.40Y =30 0.40Y =80 1 Y = 80 = 200 0.40 The two parts of Figure 18.1 contain the same information and thus yield the same outcome, although the lower part is especially useful for the case of an open economy, as we will see. The multiplier in a closed economy We are now in a position to explain how a change in investment expenditure (actually, any autonomous change in expenditure) will affect the level of income, consumption, and saving. To continue the given example, suppose planned investment increases by 10. This change appears as an upward shift in the aggregate demand function) to (C + I′) in Figure 18.2a, and as an upward shift in the horizontal investment line (to I′) in Figure 18.2b. In both diagrams we see that the equilibrium level of income rises by 25, from 200 to 225. Thus income rises by a multiple of 2 1 ⁄2 times the initial increase in investment (25 Ϭ 10 = 2 1 ⁄2 ). The size of this multiplier is determined by the division of an increment to income between consumption and saving – that is, the value of the marginal propensities to consume and save. In this case, with c = 0.60, when investment rises by 10, thus generating an initial increase in income of 10, 60 percent of that increase in income is spent for consumption. Therefore the first-round increase in consumption is 6. That increase in consumer expenditure is income to those who produce and sell consumer goods, and they in turn spend 60 percent of their increased income, so in the second round ∆C = 6 ϫ (60%) = 3.6. This process generates a sequence: ∆Y = 10 + 10(0.60) + 10(0.60) 2 +… ∆Y = 10(1 + 0.60 + 0.602 + …) 1 ∆Y = 10 = 10(2.5) = 25 1 – 0.60 408 International economics More generally: 1 ∆Y=∆I 1 – c where c is the marginal propensity to consume. The multiplier is the expression in parentheses: 1 (11) k = 1 – c Since c + s = 1, we can replace (1 – c) in the denominator and write the multiplier as 1 (12) k = s 18 – Open macroeconomics with fixed exchange rates 409 C, I 200 200 225 200 225 100 100 50 0 Y Y E C S I C + I C + I ′ 45° (a) S , I 30 40 0 –50 (b) E′ E E′ I ′ 80 90 Figure 18.2 The multiplier in a closed economy. Continuing from the previous figure, if intended investment increases, C + I shifts up to C + I′ in the top half of the figure and I shifts up to I′ in the bottom half, both producing an increase in output which is based on the multiplier process. This is based on the marginal propensity to consume, which is the slope of the C line and therefore the C + I line. This last formulation focuses on the so-called leakage from the circular flow of income. When people use their income to buy goods and services, their expenditure represents income to the seller and is thus returned to the income stream. That part of income which is not spent, namely the part saved, causes subsequent increments to income to be smaller, and thus reduces the size of the multiplier. In equation (12), the larger the value of s, the smaller is the multiplier, k. If a government sector were included in the model, the marginal propensity to consume becomes lower because taxes make less of earned income available for consumption spend- ing. This, of course, lowers the size of the multiplier. Government expenditures become an additional source of exogenous demand, playing a role in the model which is very similar to that of investments. Government budget deficits, whether from expenditure increases or tax cuts, are expansionary and potentially inflationary. Budget surpluses produce the opposite impacts. An open economy To extend this analysis to an economy that is engaged in trade with the outside world, we must allow for an additional sector, the foreign sector. Thus we will now include a third category of final product – exports of goods and services – and a third use of income – imports of goods and services. Determination of the level of income The gross domestic product is still defined as the money value of all final products produced in a given period of time. Since we are still omitting the government sector, the gross domestic product can be divided into three categories, and we have the following definitional equations for the product: Y = C d + I + X (13) and for the disposition of income: Y = C d + S + M where X and M represent exports and imports of goods and services, respectively, and C d is consumption of domestically produced goods and services. In equation (13), we define Y as the value of final product produced domestically – that is, net of imports. In the case of consumption this is denoted by C d , with the subscript d serving as a reminder that we mean consumption of domestically produced goods and services. However, we are also assuming that I and X are net of imports. Now we can set equations (13) and (14) equal to each other and subtract C d from both sides, as before: C d + S + M = C d + I + X S + M = I + X (15) Equation (15) states that, ex post, saving plus imports (leakages) must equal investment plus exports (the exogenous injections of expenditure). Although this relationship is a 410 International economics definitional one, it has interesting and useful interpretations. For example, when written in the form S – I = X – M it indicates a necessary relation between the trade balance and domestic saving and investment. If domestic investment exceeds saving in any period, imports must exceed exports. Similarly, if a country has an export surplus, its domestic saving must exceed investment; it is making savings available to the rest of the world, or acquiring claims on the rest of the world in exchange for the excess exports. Note that this relationship can also be written as S = I +(X – M) (16) In Chapter 12 we observed that the balance of trade in goods and services (X – M) is equal to the change in the home country’s net creditor/debtor position relative to the rest of the world, which can also be regarded as net foreign investment. 1 Consequently, the familiar identity between saving and investment still holds, with investment including both domestic and foreign investment. That is: S = I d + I f where I f = X – M Now we are ready to explain how income is determined in an open economy. We assume that exports, like investment, are exogenous – that is, the level of exports does not depend on domestic income. Imports, on the other hand, are a function of income: an increase in income leads to an increase in imports. This gives us a relationship (an import function) such as the following: M = mY (17) where m represents the “marginal propensity to import,” the fraction of additional income that is spent for imports. That is: ∆M m = (18) ∆Y For the purposes of this example, we will assume that m is 0.20. The import function is then simply: M = 0.20Y (19) It is depicted in Figure 18.3, which shows how much is spent for imports (vertical axis) at various levels of income (horizontal axis). If it is assumed that exports are determined externally (on the basis of foreign levels of foreign GDP) and that the exchange rate is fixed, the graph shown in Figure 18.3 leads to Figure 18.4. The latter shows how the trade balance behaves as domestic GNP increases. With given exports and with imports rising by the marginal propensity to import times any increase in income, there is an inverse relationship between GNP and the trade balance. As can be seen, a trade surplus exists at low levels of income, but the surplus declines and becomes a deficit as the economy expands. 18 – Open macroeconomics with fixed exchange rates 411 412 International economics Y S 0 S, I 1 MPS –S S – I Y 0 S – I 1 MPS I i Figure 18.5 Domestic savings, investment, and the S – I line. Saving increases with income through the marginal propensity to save, which is the share of additional income that is saved and the slope of the S line. Intended investment is determined outside the model and is assumed to be fixed at the level indicated by the I i line. S – I is generated in the bottom half of the diagram by subtracting the fixed level of investment from the savings line in the top half. M M Y 0 ∆ M ∆ Y Slope = ∆ M ∆ Y Figure 18.3 The propensity to import, and the marginal propensity to import. Imports rise with income, the marginal propensity to import being the share of additional income which is spent on imports and the slope of the M line. Y 0 S – I X – M X – M 1 – MPM Figure 18.4 The trade balance as income rises. With a given level of exports, the trade balance declines as imports rise due to an increase in domestic incomes. Returning to Figure 18.2, we observe that we can derive Figure 18.5 by deducting the fixed level of investment from the savings line. An equation on page 411 expressed the following identity: S – I = X – M That expression can be presented graphically by combining two graphs derived previously. Figure 18.6 shows an equilibrium level of national income at which S = I and X = M; that is, the trade account is in balance so that domestic savings equals domestic investment. Figure 18.7 illustrates what would occur if the economy were to experience an internal shock in the form of an increase in domestic investment. The multiplier in an open economy If the economy had been closed, national income would have increased to Y′′, but because trade exists and imports increase with income, the resulting increase in national income is considerably smaller, as shown at Y′. An expansionary domestic shock produces both a trade 18 – Open macroeconomics with fixed exchange rates 413 Y 0 S – I S – I X – M X – M Figure 18.6 Savings minus investment and the trade balance with both at equilibrium. Putting the S – I and the X – M lines on the same graph produces an equilibrium point where they are equal. For the purpose of the illustration, they are both zero, but that does not have to be the case. Y Y 0 S – I S – I X – M S – I ′ Y ′ X – M M > X, I > S Y ′′ ∆ I Figure 18.7 The impact of an increase in domestic investment. If intended investment increases, S – I shifts down, producing a new equilibrium level of income at Y′ and a trade deficit. If the economy had been closed, output would have increased to Y′′ because there would have been no increase in imports to reduce the strength of the multiplier process. deficit and a smaller increase in GDP than would have occurred in a closed economy, or in an economy with barter trade where exports always equal imports. The smaller increase in GDP implies a smaller multiplier, inasmuch as imports are an additional leakage from the income stream. In a closed economy without a government sector, savings are the only leakage, so a marginal propensity to save of 0.20 implies a multiplier of 5. With an open economy and a marginal propensity to import of 0.20, total leakages become 0.40 and only 60 percent of marginal income is spent on domestically produced goods, so the multiplier falls to 2.5. The multiplier is now defined as follows: 11 K == MPS + MPM 1–MPC dom 414 International economics Box 18.1 Japan’s chronic current account surplus: savings minus investment During every year since 1980 Japan has run a current account surplus, and during the 1990s, these surpluses averaged about $100 billion per year. The reason for the surplus is straightforward: the Japanese save 30 percent of GDP, compared to 16 percent in the United States, and only 20 percent on average for the G-7 countries other than Japan. As a mature and highly industrialized country, it would be difficult for Japan to invest 30 percent of GDP in the domestic economy, so a huge and chronic current account surplus results. During the Japanese recession of 1998–9, investment in Japan was far from buoyant, but the savings rate has remained very high, so the current account surplus exceeds $100 billion per year. Complaints by the United States and other industrialized countries about Japanese protectionism as the reason for the surplus are simply wrong: as long as Japan saves such an enormous percentage of GDP, and cannot find profitable investment projects in the domestic economy to absorb that savings flow, a large current account surplus must result. Despite being a developing country with enormous needs for domestic investment, China is following the Japanese pattern. The citizens of China outdo the Japanese, saving 40 percent of GDP. Even with an investment rate of 35 percent of GDP, a current account surplus must result. China’s current account surplus averaged just about $10 per year in the 1990s, and if domestic investment ever slows, it will become larger, which will mean larger bilateral trade deficits for the United States with China and more complaints about Chinese protectionism, which are again irrelevant. Singapore is the apparent champion of excess savers: the savings rate has recently been as high as 51 percent of GDP when domestic investment was 37 percent, resulting in a current account surplus of 14 percent of GDP. What causes these enormous savings rates in East Asia is not clear, but as long as they continue, it will be very difficult for the United States, which has a current account deficit of over $400 billion per year, to return to current account equilibrium. Source: Adapted from The Financial Times, June 4, 1996, p. 16, and Table 13 of the World Bank’s Annual Development Report (Washington, DC) for 1998–9, p. 214. where MPS is marginal propensity to save, which would include the marginal tax rate on income if government were included; MPM is marginal propensity to import; MPC dom is marginal propensity to consume domestic goods and services. The marginal propensity to import in the United States is less than 0.20. Thus its impact on the multiplier is not large, but in a smaller and therefore more open economy such as that of Belgium, where the marginal propensity to import could be 0.40 or more, the so-called foreign trade multiplier would become quite small. The more open the economy, that is, the larger the marginal propensity to import, the smaller the multiplier. The fact that domestic investment can have an import component provides another reason for more stability in the domestic economy in response to domestic shocks. If, for example, 20 percent of US capital goods are imported, a decrease in machinery investment of $1 billion would reduce domestic demand by only $800 million in the first round of the multiplier process, with the other $200 million in lost output occurring abroad. The greater the percentage of domestic investment that consists of imported goods, the larger is this dampening effect. Another effect of trade in this model is that the domestic economy becomes vulnerable to external macroeconomic shocks that affect export sales. A recession abroad, for example, will reduce foreign demand for imports, which means declining exports for the home economy. A decline in export sales has the same effect on national income as does a decline in domestic investment (see Figure 18.8). The decline in exports, which resulted from a foreign recession, caused domestic GDP to decline. Therefore the home economy imported the recession. The trade balance did not deteriorate by as much as the decline in exports because the domestic recession caused imports to fall. A shift in export sales will be partially offset by a parallel change in imports, resulting from changes in domestic national income. Hence the trade balance will not fluctuate as sharply as export sales. The international transmission of business cycles An important conclusion of this chapter is that business cycles of major trading partners tend to be linked through trade under the assumption of fixed exchange rates. A recession that begins in one large importer will tend to spread to its trading partners through declines in their exports. Small countries do not export cycles, because their imports are not sufficiently 18 – Open macroeconomics with fixed exchange rates 415 Y 0 S – I S – I X – M X ′ – M X – M M > X, I > S Figure 18.8 The impact of a decline in exports. If exports decline, due to a recession abroad, X – M shifts down to X′ – M, producing a lower level of output and a trade deficit. The trade deficit is less than the decline in exports, however, because at a lower level of output and income, imports decline. important in the other countries’ economies to produce such an impact, but big importers such as the United States, Germany, and Japan certainly do export cycles. 2 The short-term business-cycle prospects of the large trading countries are therefore of intense interest around the world. A cyclical turn in any of the largest importers brings the likelihood of a parallel cycle in many other countries; accordingly, the large countries are expected to manage their economies in such a way as to avoid destabilizing other economies. When such a country does a poor job of managing its cycles, as when, for example, the United States had an excessively expansionary set of policies during the Vietnam War, other affected countries become displeased. In such cases considerable diplomatic pressure may be brought to bear on the country that is causing the problems to improve its performance. The United States has frequently been the target of such pressure, which is often exerted through international organizations such as the Organization for Economic Cooperation and Development (OECD) or the Bank for International Settlements (BIS). Governments often try to predict the cyclical behavior of their major trading partners in order to adopt timely domestic macroeconomic policies to offset their impacts. If, for example, the Canadian government believes that the United States will enter a recession within a year, it may prepare to adopt more expansionary fiscal or monetary policies to maintain GDP despite the loss of export sales. If Canada were to use a more expansionary monetary policy to increase domestic investment expenditures, the situation depicted in Figure 18.9 would occur. Although Ottawa was successful in avoiding the US recession, it did so at the cost of a larger trade deficit. A recession that originates in the United States can produce a difficult choice for Canada in a world of fixed exchange rates: it can avoid the recession at the cost of a serious deterioration of the trade account, or it can limit the trade balance deterioration by accepting the recession. Foreign repercussions This discussion has avoided one complication in its discussion of multipliers and of the transmission of business cycles from one country to another. That complication is bounce- back effects or repercussions. A recession in the United States, for example, will reduce Canadian exports and therefore Canadian GDP. The recession in Canada will reduce that 416 International economics Y 0 S – I S – I S – I ′ X – M X' – M X – M M > X, I > S Figure 18.9 Impacts of a decline in exports and an increase in domestic investment. A decline in export sales shifts X – M down to X′ – M, as in the previous graph. If an expansionary domestic macroeconomic policy is used to recapture the lost output, S – I shifts down to S – I′. The recession is avoided, but the resulting trade deficit is larger. [...]... Brookings Institution, 198 9 • Dornbusch, R., Open Economy Macroeconomics, New York: Basic Books, 198 0 • Filatov, V., B Hickman, and L Klein, “Long-term Simulations of the Project Macroeconomic Interdependence,” in R Jones and P Kenen, Handbook of International Economics, Vol II, Amsterdam: North-Holland, 198 5 • Mundell, R., International Economics, New York: Macmillan, 196 8 18 – Open macroeconomics with fixed... was reappointed Source: The Washington Post, Robert M Dunn, Jr., © 198 3, Op Ed page, June 22, 198 3 Reprinted with permission Box 19. 1 Canadian monetary policy in mid- 199 9 The Canadian dollar depreciated sharply in mid- 199 8, leading the Bank of Canada to raise interest rates by a full percentage point to defend the currency By early 199 9, the recovery of the Canadian dollar to almost 70 cents US was seen... Handbook of International Economics, Vol II (Amsterdam: North-Holland, 198 5), pp 1107–51 See also M Baxter, International Trade and Business Cycles,” in G Grossman and K Rogoff, eds, Handbook of International Economics, Vol III (Amsterdam: Elsevier, 199 5), pp 1801–64 See also S Norton and D Schlagenhauf, “The Role of International Factors in the Business Cycle: A Multi-Country Study,” Journal of International. .. Policy under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics, November 196 3 These articles can also be found in R Mundell, International Economics (New York: Macmillan, 196 8) See also A Takayama, “The Effects of Fiscal and Monetary Policies under Flexible and Fixed Exchange Rates,” Canadian Journal of Economics, May 196 9  19 The theory of flexible exchange rates Learning objectives By the... of the world in a world of fixed exchange rates? Suggested further reading • Argy, V., International Macroeconomics: Theory and Policy, New York: Routledge, 199 4 • Baxter, M., International Trade and Business Cycles,” in G Grossman and K Rogoff, Handbook of International Economics, Vol III, Amsterdam: Elsevier, 199 5 • Bryant, R., David A Currie, Jacob A Frenkel, Paul R Masson, and Richard Portes, eds,... of International Economics, Vol II, pp 1117– 19 Much of the original work on this subject was done by Robert Mundell in terms of comparisons between regimes of fixed and flexible exchange rates The latter regime will be discussed in the following chapter See R Mundell, “The Monetary Dynamics of International Adjustment under Fixed and Floating Exchange Rates,” Quarterly Journal of Economics, May 196 0,... rates on international transactions Opponents of flexible exchange rates have frequently expressed the fear that the abandonment of fixed parities would discourage trade and other international transactions Additional transactions costs (wider bid/asked spreads in exchange markets) and risks would encourage businesses to emphasize domestic activities and avoid international business Studies of international. .. hedging techniques made such avoidance possible for many transactions Open economy macroeconomics with a floating exchange rate Some of the most interesting aspects of the economics of floating exchange rates involve the domestic economy rather than international transactions Many important relationships in macroeconomics are altered by the adoption of flexible exchange rates, including the effectiveness... Reserve System in dramatically reducing the US rate of inflation during the last 3 years is largely the result of a 35 percent appreciation of the dollar during 198 1 and 198 2 This exchange rate change was also a major cause 438 International economics of the huge costs of this disinflation in terms of output and employment The appreciation had particularly harsh impacts on export sectors such as agriculture... however oversimplified, often seems to be a more realistic representation of what actually occurs in international capital markets 18 – Open macroeconomics with fixed exchange rates 4 19 Monetary policy The adoption of an expansionary monetary policy, which lowers interest rates, will encourage capital outflows If international capital market integration is close, as is certainly the case for the major industrialized . 1–MPC dom 414 International economics Box 18.1 Japan’s chronic current account surplus: savings minus investment During every year since 198 0 Japan has run a current account surplus, and during the 199 0s,. equilibrium. Source: Adapted from The Financial Times, June 4, 199 6, p. 16, and Table 13 of the World Bank’s Annual Development Report (Washington, DC) for 199 8 9, p. 214. where MPS is marginal propensity to. in international capital markets. 418 International economics Monetary policy The adoption of an expansionary monetary policy, which lowers interest rates, will encourage capital outflows. If international