International_Economics_Tenth_Edition (1)

macroeconomic variables relative to another nation will induce a chain reaction in both nations' economies.

7.An automatic balance-of-payments adjustment mechanism has several disadvantages. Nations must be willing to accept adverse changes in the domestic economy when required for bal- ance-of-payments adjustment. Policy makers must forgo using discretionary economic policy to promote domestic equilibrium.

8.The monetary approach to the balance of payments is presented as an alternative, rather than a supplement, to traditional adjustment theories. It maintains that, over the long run, payments disequilibria are rooted in the relationship between the demand for and the supply of money. Adjustment in the balance of payments is viewed as an automatic process.

1.What is meant by the term balance-of-pay- ments adjustment? Why does a deficit nation have an incentive to undergo adjustment? What about a surplus nation?

2.Under a fixed exchange-rate system, what automatic adjustments promote payments equilibrium?

3.What is meant by the quantity theory of money? How did it relate to the classical price-adjustment mechanism?

4.How can adjustments in domestic interest rates help promote payments balance?

5.In the gold-standard era, there existed the socalled rules of the game. What were these rules? Were they followed in practice?

6.Keynesian theory suggests that under a system of fixed exchange rates, the influence of

income changes in surplus and deficit nations helps promote balance-of-payments equilibrium. Explain.

7.When analyzing the income-adjustment mechanism, one must account for the foreign repercussion effect. Explain.

8.What are some major disadvantages of the automatic adjustment mechanism under a system of fixed exchange rates?

9.According to the monetary approach, balance in a nation's payments position is restored when the excess supply of money or the excess demand for money has fallen to restore the equilibrium condition: Money supply equals money demand. Explain.

10.What implications does the monetary approach have for domestic economic policies?

13.1 The Asian Development Bank, based in the Philippines, promotes the economic and social progress of its developing member countries. It has extensive

reports and statistics on a number of Asian countries. Find it by setting your browser to this URL:

http://www.adb.org

Income Adjustment Mechanism

To illustrate the Keynesian theory of income determination, let us first assume a closed econ- omywith no foreign trade, with price and inter- est-rate levels constant. In this simple Keynesian model, national income (Y) isthe sum of consumption expenditures (C) plus savings (5):

Y=C+S

Total expenditures on national product are C plus business investment (I). This relationship is given by

y =C + I

Figure 13.2 on page 412 represents the familiar income-determination model found in introductory economics textbooks. Referring to Figure 13.2(a), consumption is assumed to be functionally dependent on income, whereas investment spending is autonomous-that is, independent of the level of income. The economy is in equilibrium when the level of planned expenditures equals income. This occurs at YE, where the 45-degree line intersects the (C + I) schedule. At any level of income lower (or higher) than YE, planned expenditure would exceed (or fall below) income and income would rise (or fall).

Combining these relationships yields the following:

Y=C+S=C+I

Chapter 13

The basic equilibrium condition can thus be stated as

5=1

or

5 -I =0

This equivalent condition for equilibrium income is illustrated in Figure 13.2(b). Like consumption, saving is assumed to be functionally related to income. Given a constant level of investment, the (5 -I) schedule is upward-sloping. Savings can be regarded as a leakage from the income stream, whereas investment is an injection into the income stream. At income levels below YE, 1exceeds 5, and the level of income rises. The opposite holds equally true. The economy is thus in equilibrium where 5 =1(or 5 -I =0). Figure 13.2(b) illustrates income determination in an open economy.

Suppose an economy that is initially in equilibrium experiences some disturbance, say, an increase in investment spending. This would bid up the level of equilibrium income. This result comes about through a multiplier process; that is, the initial investment sets off a chain reaction that results in greater levels of spending, so that income increases by some multiple of the initial investment. Given an autonomous injection of investment spending

411

': '

•' ;

m

into the economy, the induced increase in income is given by

LlY = kLlI

where k represents some multiplier.

Let's seehow the multiplier is derived for a closed economy. First, remember that in equilibrium, an economy will find planned saving equal to planned investment. It follows that any I must be matched by an equivalent 5 if the economy is to remain in balance. Because it has been assumed that saving is functionally

dependent on income, changes in saving will be related to changes in income. If we use s to represent the marginal propensity to save out of additional income levels, then 5 =sY. Given an autonomous increase in investment, the equilibrium condition suggests that

LlI = 65 = s6Y

From the preceding expression, the multiplier can be derived as

6 Y = 1 61 s

Suppose, for example, a nation finds that its marginal propensity to save (5) is 0.25, and there occurs an autonomous increase in investment of $100. According to the multiplier principle, the induced change in income stemming from the initial increase in investment spending equals the increase in investment spending times the multiplier (k). Because the 5 is assumed to equal 0.25, k =1/5=1/0.25 =4. The $100 increase in investment expenditure ultimately results in a $400 increase in the level of income.

Income Determination in

an Open Economy

Now assume an open economy subject to international trade. The condition for equilibrium income, as well as the formulation of the spending multiplier, must both be modified. In an open economy, imports (M), like savings, constitute a leakage out of the income stream, whereas exports (X), like investment, represent an injection into the stream of national income. The condition for equilibrium income, which relates leakages to injections in an open economy's income stream, becomes

5+M=I+X

Rearranging terms, this becomes

5-I=X-M

Assume that exports are unrelated to the level of domestic income. Also assume that imports are functionally dependent on domestic income-that is,

where m represents the marginal propensity to import. We are now in a position to derive what is known as the foreign-trade multiplier.

First, let the injections into and leakages from the income stream rise by the same amount, so that the induced change in income will be of equilibrium magnitude. This yields

t:15 + t:1M =t:1I + t:1X

Given that

t:15 =st:1Y

and

t:1M =mt:1Y

the induced change in income stemming from the changes in injections and leakages can be shown as follows:

(5 + m)t:1Y =t:1I + t:1X

Holding exports constant, (t:1X =0), the induced change in income is equal to the change in investment times the foreign trade multiplier, or

t:1y=(_1_) x t:1I s+ m

The preceding expression states that the foreign-trade multiplier equals the reciprocal of the sum of the marginal propensities to save and to import. In this formulation, an autonomous change in exports, investment remaining fixed, would have an impact on domestic income identical to that of an equivalent change in investment.

414 Balance-af-Payments Adjustments

Implications of the

Foreign-Trade Multiplier

To show the adjustment implications of the foreign-trade multiplier, we construct a diagram based on the framework of Figure 13.2. Remember that the (5 -I) schedule is positively sloped. This is because changes in savings are assumed to be directly related to changes in income, investment being unaffected. Subtracting investment from saving yields an upward-sloping (5 - I) schedule, as shown in Figure 13.3. Similarly, it has been assumed that changes in imports are directly related to changes in income, exports remaining constant. When imports are subtracted from exports, the result is a downward-sloping

(X - M) schedule. As before, the equilibrium condition of an open economy with no government is (X - M) = (5 -I).

Starting at equilibrium income level $1,000 in Figure 13.3,suppose a disturbance results in an autonomous increase in exports by, say, $200. This is shown by shifting the (X - M) schedule upward by $200, resulting in the new schedule (X' - M).The level of income rises, generating increases in imports and savings. Domestic equilibrium is established at income level $1,400, where (5 - I) =(X' - M).The trade account is no longer in balance; there is a trade surplus of $100. This trade surplus is less than the initial $200 rise in exports because part of the surplus is offset by increases in imports induced by the rise in income from $1,000to $1,400.

In this example, we can use the concept of a foreign-trade multiplier to determine the effect of the increase in exports on the home economy. Inspection of the (5 -I) schedule in Figure 13.3 reveals that the slope of the schedule, which represents the marginal propensity

to save, equals 0.25. The slope of the (X - M) schedule indicates that the marginal propensity to import also equals 0.25. The foreign-trade multiplier is the reciprocal of the sum of the marginal propensities to save and to importthat is, 1/0.50, or 2. An autonomous increase in exports of $200 thus generates a twofold increase in domestic income, and equilibrium income rises from $1,000 to $1,400.

As for the trade account effect, the $400 rise in domestic income induces a $100 increase in imports, given a marginal propensity to import of 0.25. Part of the initial export-led surplus is neutralized, lowering it from $200 to $100. Over time, the increase in imports generated by increased domestic expenditures will tend to reduce the trade surplus, but not enough to restore balance-of- payments equilibrium.

Consider another case that illustrates the national-income and balance-of-payments effects of a change in expenditures. Assume that, owing to improved profit expectations, domestic investment rises autonomously by $200. Starting at equilibrium level $1,000 in Figure 13.3, the increase in investment will displace the (5 -I) schedule downward by $200 because the negative term is increased. This gives usthe new schedule (5-I'). Domestic income rises from $1,000to $1,400, which stimulates a rise in imports, producing a trade deficit of $100. Unlike the previous case of export-led expansion, an autonomous increasein domestic investment spending (or government expenditures) increases domestic income but at the expenseof a balance-of-payments deficit. This should serve as a reminder to economic policy makers that under a system of fixed exchange rates, the impact of domestic policies on the balance of payments cannot be overlooked.

Case 1:

No foreign sourcing-all costs are denominated in dollars.

Table 14.1 illustrates the hypothetical production costs of Nucor, a U.S. steel manufacturer. Assume that in its production of steel, Nucor utilizes U.S. labor, coal, iron, and other inputs whose costs are denominated in dollars. In period 1, the exchange value of the dollar is assumed to be 50 cents per Swiss franc (2 francs per dollar). Assume that the firm'scost of producing a ton of steelis $500, which is equivalent to 1,000 francs at this exchange rate.

Suppose that in period 2, because of changing market conditions, the dollar's exchange value appreciates from 50 cents per franc to 25 cents per franc, a 100 percent appreciation (the franc depreciates from 2 to 4 francs per dollar). With the dollar appreciation, Nucor's labor, iron, coal, and other input costs remain constant in dollar terms. In terms of the franc, however, these costs rise from 1,000 francs to 2,000 francs per ton, a 100 percent increase. The 100 percent dollar appreciation induces a 100 percent increase in Nucor's francdenominated production cost. The international competitiveness of Nucor is thus reduced.

This example assumes that all of a firm's inputs are acquired domestically and that their costs are denominated in the domestic currency.

In many industries, however, some of a firm's inputs are purchased in foreign markets (foreign sourcing), and these input costs are denominated in a foreign currency. What impact does a change in the home-currency's exchange value have on a firm's costs in this situation?

Case 2:

Foreign sourcing-some costs denominated in dollars and some costs denominated in francs.

Table 14.2 on page 418 again illustrates the hypothetical production costs of Nucor, whose costs of labor, iron, coal, and certain other inputs are assumed to be denominated in dollars. However, suppose Nucor acquires scrap iron from Swiss suppliers (foreign sourcing), and these costs are denominated in francs. Once again, assume the dollar's exchange value appreciates from 50 cents per franc to 25 cents per franc. As before, the cost in francs of Nucor's labor, iron, coal, and certain other inputs rise by 100 percent following the dollar appreciation; however, the franc cost of scrap iron remains constant. As can be seen in the table, Nucor's franc cost per ton of steel rises from 1,000 francs to 1,640 francs-an increase of only 64 percent. Thus, the dollar appreciation worsens Nucor's international competitiveness, but not as much as in the previous example.

Period 1

$.50 per Franc (2 Francs = $1)

Dollar Cost Franc Equivalent

Period 2

$.25 per Franc (4 Francs = $1)

In addition to influencing Nucor's francdenominated cost of steel, a dollar appreciation affects a firm's dollar cost when franc-denominated inputs are involved. Because scrap-iron costs are denominated in francs, they remain at 360 francs after the dollar appreciation; however, the dollarequivalent scrap-iron cost falls from $180 to $90. Because the costs of Nucor's other inputs are denominated in dollars and do not change following the dollar appreciation, the firm's total dollar cost falls from $500 to $410 per ton-a decrease of 18 percent. This cost reduction offsets some of the cost disadvantage that Nucor incurs relative to Swiss exporters as a result of the dollar appreciation (franc depreciation).

The preceding examples suggest the following generalization: As franc-denominated costs become a larger portion of Nucor's total costs, a dollar appreciation (depreciation) leads to a smaller increase (decrease) in the franc cost of Nucor steel and a larger decrease (increase) in the dollar cost of Nucor steel compared to the cost changes that occur when all input costs are dollar-denominated. As franc-

denominated costs become a smaller portion of total costs, the opposite conclusions apply. These conclusions have been especially significant for the world trading system during the 1980s to 2000s as industries--e.g., autos and computers-have become increasingly internationalized and utilize increasing amounts of imported inputs in the production process.

Changes in relative costs because of exchangerate fluctuations also influence relative prices and the volume of goods traded among nations. By increasing relative U.S. production costs, a dollar appreciation tends to raise U.S. export prices in foreign-currency terms, which induces a decrease in the quantity of U.S. goods sold abroad; similarly, the dollar appreciation leads to an increase in U.S. imports. By decreasing relative U.S. production costs, a dollar depreciation tends to lower U.S. export prices in foreign-currency terms, which induces an increase in the quantity of U.S. goods sold abroad; similarly, the dollar depreciation leads to a decrease in U.S. imports.

Several factors govern the extent by which exchange-rate movements lead to relative price