2 management - School of International Business and ...

Günter S. Heiduk
the effect of economic growth on trade of goods and services. 3 Changes in national income will
infl uence the amount of imports. Growth of the domestic economy leads to the increase in private
income and consumption. Part of the consumers’ increasing demand is spent on foreign goods.
The positive correlation between economic growth and the level of imports is modeled by the
marginal propensity to import (MPI): IM = mY. This hypothesis is based on the general assump-
tion that the consumers’ behavior - measured by the marginal propensity to consume (MPC) - is
determined by the income: C = mY. An autonomous increase in investment will lead to a smaller
positive effect on income in an open economy compared to a closed economy as the open econ-
omy multiplier (OEM) indicates:
Then, the open economy has reached the general equilibrium:
It is to be expected that consumers in the foreign country behave in the same way. Their increas-
ing demand will positively affect the domestic exports. Therefore, the relation of the growth rates
of the trading countries determines the current account balance. If the domestic economy is grow-
ing relatively faster than the foreign economy, then its imports will increase faster than its exports.
The current account turns toward a defi cit (respectively the net exports decline).
The relation of the monetary developments will also infl uence the current account balance. High-
er infl ation in the domestic economy increases the prices of its exports to a higher degree than
in the lower infl ation in the foreign country. The consumers in the latter country will substitute im-
ported goods whereas the consumers in the domestic economy will substitute domestically pro-
duced products by imports. The domestic economy’s current account turns to a defi cit because of
declining exports and increasing imports.
Empirical studies show that there are a number of other reasons that cause changes in the current
account balance. Technological leadership may result in higher productivity, thus creating compet-
itive advantages on the global markets. Emerging economies often experience at the beginning of
their catching-up development a current account defi cit which later turns into a surplus. The defi cit
is caused by increasing imports of industrial imports to build up the infrastructure. The surplus fol-
lows when the country successfully exploits its comparative advantage, e.g. low wages.
The capital account balance is primarily determined by differences in interest rates between the
domestic and the foreign economy. Relative higher interest rates in the domestic economy attract
3 The aggregate expenditure in an open economy with government activities is Y = C + I + G +(EX – IM).
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