Foreign trade multiplier

Postulations

The foreign trade multiplier based on the following:

1.There is full employment in the domestic economy.

2.There is direct link between domestic and foreign country in exporting and importing goods and the country is small with no foreign country.

3.It is on a fixed exchange-rate system, the multiplier is based in instantaneous process without time lag and the domestic Investment (id) remains invariable.

4.There is no accelerator and the analysis is applicable to only two countries.

5.There are no tariff barriers and exchange controls.

6.The government expenditure is constant.

Bathtub theorem

The bathtub theorem is an analogy that explains the effects of exports and imports on national income. According to the analogy used in the bathtub theorem, national income level is the water in the bathtub. Exports, government spending, or investments inject extra water in the tub, and thus raise the level, while imports, savings, or taxes cause leakages. According to the same analogy, there will be a neutral effect on the water (or national income) level if exports equal imports, an expansionary effect if exports exceed imports, and finally, a contradictory effect if imports exceed exports.

Three scenarios for net exports

1.Neutral effect: exports equals imports, thus GDP does not change. In bathtub terms, injections are equal to withdrawals keeping the water level the same.

2.Expansionary effect: exports are greater than imports, thus GDP increases. In bathtub terms, injections are greater than withdrawals raising the water level of the bathtub.

3.Contractionary effect: exports are less than imports, thus GDP decreases. In bathtub terms, injections are less than withdrawals lowering the water level of the bathtub.

Assumptions of the open-economy model

1.Imports depend on the level of national income. As the national income increases, so do domestic expenditures on imports. Thus, marginal propensity to import (MPM) is defined as:

MPM = change in imports / change in income

2.Exports have no relationship with the level of national income, thus they are independent.

Multiplier effect

1.With the assumptions described above, an increase in exports tends to raise domestic income, but the increased income also encourages some imports, which act as "leakages." These tend to reduce the full multiplier effect that would exist if imports remained constant.

2.Open economy`s allocation of income is MPC + MPS + MPM = 1. Thus, MPM is the fraction of any increase in income that "leaks" into imports.

3.The foreign trade multiplier is defined as the reciprocal of all the leakages, including imports.

Foreign trade multiplier = 1 / (MPS + MPM) = 1 / leakage

4.If MPS is constant then the MPM has an inverse relationship with MPC. As more imports are consumed, there are smaller amounts to be consumed for domestic goods.

5.Example: If the MPS = 0.15 and the MPM = .05, the total leakage is .20 . Therefore,

Foreign trade multiplier = 1/(0.15 + 0.05) = 5 One unit change in aggregate expenditure will have a five-unit change in GDP. In contrast, the simple multiplier for a closed economy is 1/.15 = 6.67.

Foreign Trade Multiplier Meaning

The foreign trade multiplier also known as the export multiplier operates like the investment multiplier of Keynes. It may be defined as the amount by which the national income of a nation will be raised by a unit increase in domestic investment on exports. As exports increase, there is an increase in the income of all persons associated with export industries. These in turn create demand for goods. But this is dependent upon their marginal propensity to save (MPS) and the marginal propensity to import (MPM). The smaller these two marginal propensities are, the larger will be the value of multiplier and vice versa.

Postulations

The foreign trade multiplier is based on the following:

1.There is full employment in the domestic economy 2.There is a direct link between domestic and foreign country in exporting and importing goods and the country is small with no foreign country 3.It is on a fixed exchange rate system The multiplier is based on instantaneous process without time lag and the domestic Investment (Id) remains invariable 4.There is no accelerator and the analysis is applicable to only two countries 5.There are no tariff barriers and exchange controls 6.The government expenditure is constant Illustration 36

Let us assume the following:

MPS = 0.4

MPM = 0.4

Δ X = $2,000 millions

Where MPS is Marginal Propensity to Save and MPM is Marginal Propensity to Import. Calculate the foreign trade multiplier

Solution

The formula to calculate the foreign trade multiplier is

Kf = 1 MPS + MPM

Where,

MPS = Δ S and MPM = Δ M Δ Y Δ Y Δ Y = 1 Δ X MPS + MPM = 1 * 2,000 0.4 + 0.4 = 1 * 2,000 0.8 = 2,500

It shows that an increase in exports by $500 millions has raised national income though the foreign trade multiplier to $2,500 millions, given the values of MPS and MPM.

Illustration 37

An economy is characterised by the following equations:

Consumption C = 120 + 0.9Yd

Investment I = 20

Government G = 20

Expenditure

Tax T = 0

Exports X = 40

Imports M = 20 + 0.05 Y

1.What is the equilibrium income? 2.Calculate trade balance 3.What is the value of foreign trade multiplier? Solution

1. National Income

Y = C + I + G + Nx = 120 + 0.9Yd + 20 + 20 + 40 – (20 – 0.05Y) = 120 + 0.9 (Y – T) + 20 + 20 + 40 – 20 – 0.05Y = 120 + 0.9Y – 0 + 60 – 0.05Y Y = 180 + 0.85Y Y – 0.85Y = 180 0.15Y = 180 Y = 180 / 0.15 Y = 1,200

2. Trade Balance

X – M = 40 – (20 + 0.05Y)

Substituting the value of Y, we have

Trade balance = 40 – [20 + 0.5(1,200)] = 40 – 20 – 60 = - 40

Trade balance is in deficit.

3. Value of foreign trade multiplier = 1

1 – b + m

Where b is marginal propensity to consumer and m is marginal propensity to import.

Foreign Trade Multiplier = 1 1 – 0.9 + 0.05 = 1 0.15 = 6.67

Illustration 38

Behavioural and Structural equations of an economy are given below:

C = 200 + b (Y – 100 – tY)

I = 100

G = 100

X = 20

M = 10 + 0.1Y

The marginal propensity to consume ‘b’ is equal to 0.8 and proportional income tax rate, t = 0.25.

1.Find the equilibrium national income 2.Find foreign trade multiplier 3.Find equilibrium value of imports 4.If equilibrium national income falls short of full employment income by $100, how much government should increase its expenditure to attain full – employment? Solution

1. Reduced form of the equation for equilibrium income is

Y = 1 (a - bT + I + G + X - Ḿ) 1 – b (1-t) + m

Substituting the values of the variables and parameters we have

Y = 1 (200 – (100*0.8) + 100 + 100 + 20 - 10) 1 – 0.8 (1-0.25) + 0.1 Y = 1 (330) 0.5 Y = 330 / 0.5 Y = 660

2. Foreign Trade Multiplier

= 1 1 – b (1-t) + m = 1 1 – 0.8 (1-0.25) + 0.1 = 1 = 2 0.5

3. Equilibrium value of imports can be obtained by substituting the equilibrium income 660 in the import function. Thus

M = 10 + 0.1Y M = 10 + 0.1(660) M = 10 + 66 = 76

4. Required increase in Government expenditures to attain $100 increase in income can be obtained as under:

Δ Y = Foreign Trade Multiplier * Δ G Δ Y = 2 * DG Or Δ G = Δ Y = 100 = 50 2 2

Illustration 39

The equations in the economy are given as:

C = 400 + bYd

I = 140

Tax T = 120

Government = 140

Expenditure G

Exports X = 40

Imports M = 20 + 0.1Y

Marginal Propensity to consumer b = 0.8.

1.Find the equilibrium level of income 2.The value of the foreign trade multiplier 3.The equilibrium level of imports Solution

The consumption function is

C = 400 + 0.8Yd C = 400 + 0.8(Y – T) C = 400 + 0.8(Y – 120)

The equilibrium condition is given as Y = C + I + G + X – M

Thus,

Y = 400 + 0.8(Y – 120) + 140 + 140 + 40 – 20 – 0.1Y Y = 400 + 0.8Y – 96 + 140 + 140 + 40 – 20 – 0.1Y Y = 604 + 0.7Y Y – 0.7Y = 604 0.3Y = 604 Y = 604 /0.3

Thus equilibrium level of income is 2,013.33.

2. Foreign Trade Multiplier

Δ Y = 1 Δ X 1 – b + m = 1 1 – 0.8 + 0.1 = 1 = 3.33 0.3

3. Imports at the equilibrium level

M = 20 + 0.1Y = 20 + 0.1 (2,013.33) = 20 + 201.333 = 221.333

The equilibrium level of imports is 221.333.