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Lecture 18 NI & CA Balance - Income Approach

1) The document discusses the determination of national income and trade balance in an open economy using the income approach. 2) It presents equations to model consumption, imports, exports and aggregate expenditure as functions of national income. 3) It shows that national income and trade balance must be determined simultaneously by setting aggregate expenditure equal to national income and the trade balance equal to exports minus imports.

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Arka Das
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52 views14 pages

Lecture 18 NI & CA Balance - Income Approach

1) The document discusses the determination of national income and trade balance in an open economy using the income approach. 2) It presents equations to model consumption, imports, exports and aggregate expenditure as functions of national income. 3) It shows that national income and trade balance must be determined simultaneously by setting aggregate expenditure equal to national income and the trade balance equal to exports minus imports.

Uploaded by

Arka Das
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Theory of BOP

Lecture 18
Determination of National Income and Trade Balance:
Income Approach

Chapter 21
The accounting identities cannot be used as cause-and-effect relations.

study of cause-and-effect relations and determinations of national income in an


open economy require
actual or ex post values being replaced by plans of relevant economic agents.

Two main issues are discussed

1. how an equilibrium in an open economy evolves where the plans of all


economic agents are simultaneously realized: determination of NI and
Trade/CA balance

2. how the equilibrium national income and trade balance change when the
spending pattern of private economic agents as well as of the government
changes: Foreign Trade Multipliers and Expenditure Multipliers

These effects are discussed both in the absence and presence of


international transmission mechanisms by which a change in the
national income of a country affects the national incomes of its
trading partners and vice versa
The income approach based on the simple Keynesian effective demand analysis has some
simplifying assumptions

rates of exchange between national and foreign currencies are


assumed to be fixed and normalized to one

commodity prices are assumed to be constant (and normalized to one)


because of under-employed resources everywhere.

ePU
Pu = 1, Pi = 1, e = 1  p 1
Pi
Thus, the effective demand for goods produced in India, and its components, depends
only on the national income of India, Yi , and under international transmission possibility,
on the national income of the United States.
Hence, it is an income approach.

only transactions in the trade account—trade in goods and services—are


considered  GDP = GNP
Ci
Define, (1) C i  Ci (Yi ), 0  ci  1
Yi

M i
(2) M i M i (Yi ), 0  mi  1
Yi

(3) I i  I i , Gi  G i

Di  Ci (Yi )  I i  M i (Yi )
Di
(4) D i  Di (Yi ), 0  d i  1
Yi

(5) ci  d i  mi  1  si  d i  mi

(6) X i  M u  M u (Yu ), 0  mu  1
No International Transmission:

assume that the national income of the United States is constant and
thus, India’s exports are also exogenously given at the level M u

Recalling the definition of India’s GDP, the equilibrium condition can be specified as:

(7) Y i  Di (Yi )  G i  M u

 Y i  Ci (Yi )  I i  G i  M u  M i (Yi ) (8)

Using the definition of aggregate expenditure (E), this can further be written as

Y i  E i  Ei (Yi )  M u  M i (Yi )
Ei Ci
Y i  E i  Ei (Yi )  M u  M i (Yi ) (9) ei    ci
Yi Yi
Trade surplus or positive net exports is all that matters for augmenting aggregate
output and national income through trade.

Intuition?

Import demand for Indian goods by US citizens augments India’s output


and national income.
Thus, India’s exports of goods and services have favourable effects on
its effective-demand-determined output

India’s imports or consumption of US goods and services substitutes the


consumption of domestically produced goods.
imports mean a decline in the demand for Indian goods

So, a trade surplus or positive net exports means a net increase In demand for
domestically produced goods
Hence, only a trade surplus augments aggregate output and national
income .
Trade surplus, however, is not independently determined.

For any exogenously given US import demand (or India’s exports), India’s import
demand, and consequently a trade surplus or deficit, depends on India’s national
income level

From (9) Y i  E i  Ei (Yi )  M u  M i (Yi ) (9)


if all economic agents together spend less than they earn, India will have a trade surplus

This is the essence of what is known as the absorption approach to BOP.

A trade (or BOP) surplus and deficit essentially depends on a country’s total
absorption or aggregate expenditure (E) relative to its produced income (Y)

What emerges from all these is that national income and trade balance position
are interdependent and have to be determined simultaneously
Y i  E i  Ei (Yi )  M u  M i (Yi ) (9)

TB, Y - E

Y i  E i  Ei (Yi )

O Yi
Yi

TBi  M u  M i (Yi )
Case of TBi = 0 at the equilibrium

TB, Y - E

Y i  E i  Ei (Yi )

A
O Yi
Yi

TBi  M u  M i (Yi )
Net savings and Trade Balance

Y i  E i  Ei (Yi )  M u  M i (Yi ) (9)

S i (Yi )  I i  G i  TBi (10)

In presence of lump-sum income taxes:

Y i  Ti  Ci (Yi )  I i  G i  Ti  M u  M i (Yi )

 S i (Yi )  I i  (Ti  G i )  TBi (11)


Expenditure and Foreign Trade Multipliers

1. An Exogenous Increase in India’s Export or US Import Demand

M u  0
Recall, (7) Y i  Di (Yi )  G i  M u

at the initial income and the corresponding demand by Indian consumers for Indian
goods Di, this will proportionately raise the effective demand for Indian goods

India’s national income will thus rise proportionately Yi 0   M u  0


this rise in national income will now have subsequent demand augmenting effects
since larger incomes will enable Indian consumers to spend more on domestically
produced goods
Di 0  d i (Yi 0 )  0

Hence, Yi1  d i (Yi 0 )  d i ( M u )  0


This in turn again induces consumers to raise their spending on Indian goods
And consequently raise national income by

Yi 2  d i (Yi1 )   d i  ( M u )  0
2

Thus, the initial income increase induced by an exogenous increase in the US


import demand leads to a chain of subsequent increases in domestic demand for
domestic good (Di) and corresponding proportional increases in national income.

the marginal propensity to consume domestic goods (di) being strictly less than one,
the national income expansion in each round will be smaller than that in the previous
round

Yi  Yi 0  d i (Yi 0 )  d i2 (Yi 0 )  d i3 (Yi 0 )  d i4 (Yi 0 )  ....


1
 (1  d i  d i2  d i3  d i4  ....)Yi 0  M u
1  di
1
Yi  M u
si  mi

Trade Balance

At the initial NI, an exogenous increase in Foreign import demand (and hence, our
Exports) will improve our trade balance

Subsequent increase in NI will worsen our trade balance as it will augment our
imports

Overall, however, our trade balance will improve:


si
TBi  M u
si  mi

Prove it by the same chain adjustments


TB, Y - E

Y i  E i  Ei (Yi )

O Yi
Yi

TBi  M u  M i (Yi )

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