2. Imports and Exports Now we allow for international trade. Use the following i

Question

2. Imports and Exports Now we allow for international trade. Use the following information from problem 1: C- 200 (8/9) *DI I-500 G 800 T = (12)"Y Suppose that exports are constant at X 300. In addition, let imports be a fraction of real income: M (1/9) * Y a. Explain why imports are positively related to national income. b. Suppose that national income increases by $1. How much will spending on imports increase (the marginal propensity to import)? c. Compute the equilibrium level of national income under international trade. d. Suppose that government spending increases by $400. i) Compute the new equilibrium national income. ii) Based on (i), what would you guess would be the value of the multiplier? ii) Compute the new government spending multiplier. Compare to Problem 1.c. (v). e. Mr. X: "In an open economy with international trade, govenment spending is much more effective at fighting recessions than in a closed economy." Evaluate.

Explanation / Answer

We have the following information

Consumption = C = 200 + (8/9) x DI

Investment = I = 500

Government Spending = G = 800

Taxes = T = (1/2) x Y

Exports = X = 300

Imports = M = (1/9) x Y

Y = National Income

DI = Disposable Income = (Y – T)

Part a) The reason why imports are positively related to income is that people spend their income not only on domestically produced goods but also on imported goods. Since, the cost of imported goods is most of the time higher than domestically produced goods so at lower income people demand lower level of imported goods. However, as income of individuals increases they increase their demand for imported goods as they can now afford them.

Part b) Marginal propensity to import is the change in imports for a unit change in national income.

M = (1/9) x Y

M/Y = 1/9

So, the marginal propensity to import is 1/9. So, when income increases by $1 the imports increases by $(1/9).

Part c)

Y = C + I + G + (X – M)

Y = (200 + (8/9) x DI) + 500 + 800 + (300 – (1/9)Y)

Y = [200 + (8/9)(Y – 1/2Y)] + 1600 – (1/9)Y

Y = 200 + (8/9)Y – (4/9)Y + 1600 – (1/9)Y

Y = 1800 + (8/9)Y – (4/9)Y – (1/9)Y

Y = 1800 + (3/9)Y

9Y = 16200 + 3Y

Y = $2700

Part d)

Now it is given that government spending has increased by $400. So, the new G is $1200

Y = C + I + G + (X – M)

Y = (200 + (8/9) x DI) + 500 + 1200 + (300 – (1/9)Y)

Y = [200 + (8/9)(Y – 1/2Y)] + 2000 – (1/9)Y

Y = 200 + (8/9)Y – (4/9)Y + 2000 – (1/9)Y

Y = 2200 + (8/9)Y – (4/9)Y – (1/9)Y

Y = 2200 + (3/9)Y

9Y = 19800 + 3Y

Y = $3300

So, the national income has increased by $(3300 – 2700) = $600

The value of multiplier is following

Multiplier = 1/1 – c(1 – t) + m

c = marginal propensity to consume

t = tax rate

m = marginal propensity of imports

C = (200 + (8/9) x DI)

C = [200 + (8/9)(Y – 1/2Y)]

C = 200 + (8/9)Y – (4/9)Y

C = 200 + (4/9)Y

So, the marginal propensity to consume is (4/9)

Tax rate is (1/2)

Marginal propensity to import is (1/9)

Multiplier = 1/1 – (4/9)(1 – (1/2)) + (1/9)

Multiplier = 1/1 – 0.5(1 – 0.44) + 0.11

Multiplier = 1/1 – 0.5 + 0.22 + 0.11

Multiplier = 1/1 – 0.168

Multiplier = 1.203

The value of multiplier will remain the same before and after increase in government spending, as the government spending is an exogenous variable with fixed value.

Part e) The statement is not correct, reason being in the presence of international trade any increase in government spending will not be fully absorbed in the domestic economy; there will be some leakages. This is because in the presence of international trade people will spend a part of their income on imports. This will reduce the value of multiplier.

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