Chapter 17 NATIONAL INCOME AND THE TRADE BALANCE

Chapter 17
NATIONAL INCOME AND THE TRADE BALANCE
This chapter presents the open-economy version of the Keynesian model. It adds a second
element, national income, to the exchange rate in the determination of the trade balance.
The domestic price level is fixed in terms of domestic currency (hence the label
"Keynesian"), and consumption and import demand are functions of national income.
Exchange rates are assumed fixed.
Multipliers, i.e. the quantitative effect on national income, and thus employment, from
various exogenous shocks including changes in policy variables, are at the heart of
Keynesian analysis. This chapter derives such multipliers for the open economy and
discusses how they are intuitively appealing extensions of the closed-economy multipliers
from standard macroeconomics. Because some of the change in aggregate demand spills
over into demand for foreign goods, the expansionary effect on domestic income from,
say, higher government spending is smaller for an open economy than for a closed
economy with the same savings rate. By how much it is smaller depends upon whether
the country is small or large.
In the Keynesian model, a country is defined to be small if it cannot affect the national
incomes of its trading partners. For the small country, income spent on foreign goods is
gone forever; its exports are exogenous, and more imports can only worsen the trade
balance. For the large country, there are repercussion effects. An exogenous shock such
as higher government spending causes higher imports, which in turn raises foreign income
and hence foreign demand for home exports, which raises home income, and so forth.
Thus the multiplier from an expansionary domestic shock will be larger for a large country
than for a small country. This helps explains why, when worldwide demand is low, the
largest countries may be asked to undertake a "locomotive" role, that is, to raise their
spending, which would raise their demand for imports and thereby raise other countries'
incomes.
The introduction of national income into the analysis means that a devaluation will have a
smaller effect on the trade balance than it did in the elasticities approach of Chapter 16.
Assuming the Marshall-Lerner conditions are met, a devaluation will still raise the trade
surplus, but the increase in income due to the export stimulus provokes additional import
spending, partly undoing the rise in the trade surplus.
The transfer problem, seen first in Chapter 4, is reconsidered in the context of the
Keynesian model. The key difference is that the marginal propensity to save is no longer
zero, but positive. Because the recipient country always saves a portion of the transfer,
the transfer is necessarily undereffected, i.e., the amount the recipient country spends on
additional imports will always be less than the transfer. Under fixed exchange rates, the
donor's current account (the trade balance minus the transfer) must deteriorate, creating
pressure for a devaluation to restore balance.

SHORT-ANSWER QUESTIONS
1. In the small-country Keynesian model, an increase in government spending leads to
a deficit in the trade balance. What does this suggest about the way that the
government finances its fiscal expansion? Can this situation last indefinitely? Why
or why not?
2. Define the repercussion effect in the two-country Keynesian model.
3. What is meant by the statement that the "transfer is undereffected"? If the transfer
is undereffected, does the transferor suffer a secondary burden, i.e. does the
transferor suffer a worsening of its terms of trade?
4. True or false:
A foreign marginal propensity to import of less than 1.0 means that, in a Keynesian
model, a transfer to the foreign country is necessarily undereffected.
5. True or false:
In the Keynesian model, a country is defined as small if it cannot affect its terms of
trade.
6. Explain the two ways in which a devaluation affects import demand.
7. If the marginal propensity to save, s, falls, what will happen to the trade balance?
PROBLEMS
1. Changing World Interest Rates - Another Reason for the 1980s Debt Crisis:
Some economists have asserted that the increase in world interest rates in the
1980s resulted in a transfer of income from debtor countries to lending countries.
The diagram below is a highly simplified illustration of a loan from the
industrialized countries to Latin America; ELA, and CLA are endowment and
consumption points of Latin America, and EI and CI are the equivalent points for
the industrialized countries.

(a) Suppose there is an exogenous increase in the world interest rate. Which
group of countries is unambiguously better off?
(b) Draw in the new consumption points of the two groups. Identify the
income and substitution effects resulting from the change in the interest
rate. Verify that the substitution effects for both countries work in the
same direction but that the income effects work in the opposite direction.
(Hint: See Chapter 3 for a review of substitution and income effects.)
(c) Do you agree that the change in interest rates is effectively a transfer of
income from the Latin American countries to the industrialized countries?
2. Multipliers in the Keynesian Model:
Derive the following multipliers:
(a) The effect on domestic income from a fiscal expansion in each of the
following models:
(i) The two-country Keynesian model.
(ii) A closed Keynesian economy.
(iii) A small and open Keynesian economy.
(b) Rank these multipliers from largest to smallest. Give an intuitive
explanation for the relative sizes of these multipliers.
(c) What is the relationship between home and foreign income in each of the
models? In other words, what is the multiplier in the home country from
an exogenous change in foreign income?
3. More on Multipliers:
Show that the small-country multiplier for, say, a rise in investment is really a
special case of the more general two-country multiplier.

4. The Effects of a Devaluation:
Suppose a small country devalues its currency. If the Marshall-Lerner condition
holds, what happens to domestic income in the small-country Keynesian model?
Show algebraically that the trade balance of the country improves.
5. Devaluation or Tariffs - The Pros and Cons:
(a) Recalling the lessons you learned from real trade theory, why might you
argue against a general policy of currency devaluation to achieve domestic
economic objectives?
(b) What are the arguments from the Keynesian model that would weigh in
favor of a devaluation?
(c) Suppose the government decides to restrict the level of imports. Under
what conditions will a quota accomplish the same goal as a tariff? Can you
think of circumstances when a quota would have more impact on the trade
balance than a tariff?
(d) In what sense are quotas, tariffs and devaluations "beggar-thy-neighbor"
policies?
6. Explaining the U.S. Trade Balance:
Figure 17.8 in the textbook shows the current account as a share of GNP for the
United States since 1946.
(a) Explain how each of the following may help to account for changes in the
U.S. current account. Consider the effects one at a time and discuss what
trends in the data seem to support each of the following explanations.
(i) Differences in the growth rate of the American economy relative to
its major trading partners.
(ii) Differences in the income elasticity of import demand of the United
States and its major trading partners.
(iii) Changes in world interest rates resulting in a redistribution of
income between the United States and its trading partners.
(b) What additional data would you like to have in order to evaluate these
hypotheses?