Lecture 6
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Macroeconomic Performance
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Internal Balance
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Full employment of labor and other resources
Growth of output (hopefully per capita)
Price stability
External Balance
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Achievement of a reasonable, sustainable
balance of payments with the rest of the world
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The official settlements balance equal to zero, at
least on average, implying no change in official
reserves.
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Basic Framework for Analysis
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Short run
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Keynesian
Price level is sticky in the short run
Supply cannot fully respond
Long run
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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)
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Short-run Model
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Y = C + Id + G + (X – M)
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Recall that domestic expenditure (absorption) is
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E = C + Id + G
G and T are based on fiscal policy decisions, and therefore
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are exogenous.
Exports (X ) are not related to domestic macroeconomic
conditions. Exports are related to the economic conditions
in the countries buying the exports.
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Consumption
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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)
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Therefore we can simplify as C = C(Y).
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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)
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Domestic Investment
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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)
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Imports
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M = M(Y)
As incomes increase, people buy more of
everything that they buy, including imported
goods.
Typical linear form: M = Mo + mY.
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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
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AE Model
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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:
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(Y - C - G) = (E – C – G) + (X – M)
Which is S = Id + If or
S – Id = If
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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
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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
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Spending Multiplier
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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.
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Multipliers (Continued)
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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.
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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
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