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Lecture 6 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham Macroeconomic Performance Internal Balance Full employment of labor and other resources Growth of output (hopefully per capita) Price stability External Balance Achievement of a reasonable, sustainable balance of payments with the rest of the world The official settlements balance equal to zero, at least on average, implying no change in official reserves. 2 Basic Framework for Analysis Short run Keynesian Price level is sticky in the short run Supply cannot fully respond Long run Monetarist or neoclassical Price level does respond fully to supply and demand conditions Price inflation depends upon the growth rate of the country’s money supply relative to its output growth (M=kPy) 3 Short-run Model Y = C + Id + G + (X – M) Recall that domestic expenditure (absorption) is E = C + Id + G G and T are based on fiscal policy decisions, and therefore are exogenous. Exports (X ) are not related to domestic macroeconomic conditions. Exports are related to the economic conditions in the countries buying the exports. 4 Consumption Consumption is based primarily on disposable income. Other variables like interest rates, household wealth, and expectations play a role, but income is the most important variable. Disposable income is income less taxes plus transfers, hence Y – T. So: C = C(Y – T) Therefore we can simplify as C = C(Y). Many taxes vary with income, so T = tY and T = T(Y). Typical linear form: C = C0 + cY c is the marginal propensity to consume (mpc) The mpc is the proportion of the last dollar earned that will be spent on consumer goods Since Y = C + S + T, then saving is S = S(Y) 5 Domestic Investment Investment: Id = Id (i) Business decisionmakers compare the cost of financing new plant and equipment and compare it to the expected revenue stream they will bring to the business. (IRR) So the interest rates is the most important variable. Note that S(Y) = I(i) 6 Imports M = M(Y) As incomes increase, people buy more of everything that they buy, including imported goods. Typical linear form: M = Mo + mY. m is called the marginal propensity to import (mpi) The mpi is the proportion of the last dollar of income that will be spent on imports 7 AE Model We assume interest rates are fixed. Y = AD(Y) = E(Y) + X – M(Y) Or, Y = E + X – M. Subtracting C and G from each side, we get: (Y - C - G) = (E – C – G) + (X – M) Which is S = Id + If or S – Id = If 8 AE Model AD 45° AD(Y) Intercept is autonomous expenditure slope is marginal propensity to make expenditures from income Y* AD(Y) = E(Y) + X – M(Y) Output, Y 9 Savings vs. Investment Recall that equilibrium occurs when S – Id = If . This example shows a situation with a current account deficit 0 Y* S - Id Y If = X - M 10 Spending Multiplier ΔY = ΔG + (1 – s – m)ΔY, or ΔY(1 – 1 + s + m) = ΔG, or ΔY/ΔG = 1/(s+m) which is the simple spending multiplier (small open economy) This assumes that our country’s imports (based on our incomes) do not affect foreign incomes. To the extent that our imports do affect foreign incomes, the true spending multiplier will exceed the simple one. 11 Multipliers (Continued) Note that s and m are fractions, and that s+m is something like 0.5. This means that 1/(s+m) is something like 2. This implies that for every dollar that the government increases its spending, GDP increases by 2 dollars. 12 Trade Repercussions US exports (X) rise U.S. spending up (G raised?) Foreign output (Yf) and spending rise Output (Y) rises US imports (M) rise 13