DETERMINATION OF NATIONAL INCOME IN OPEN ECONOMY

Surinder meena

Pantea Rodd

Pradeep tahilyani

Tasleem ali

INTRODUCTION

An open economic is conceptually one which has economy transactions with the rest of the world

Open Economy - an economy that engages in transactions with other countries; the transactions involve goods and services, assets and transfers

It has no economic transactions with any other world

Foreign trade and transactions of a country affect its macro variables,& thereby the equilibrium level of its national income ,especially when foreign transactions account

Foreign transactions involves two kind of flows (1) commodity flows (2)financial flows

Financial flows are of two kinds(i) Financial flows resulting from commodity flows(ii) Autonomous flows

EXPORT, IMPORT AND THE AGGREGATE DEMAND

Lets us begin by looking at the export and import functions, their determinants and how they affect the aggregate demand and the national income.

EXPORT FUNCTION AND EXPORT MULTIPLIER

The demand for consumer goods (C), investment goods(I)and the government purchases(G)originate within the economy, and is called domestic demand . but, the demand for exports originates outside the economy. it is therefore called the external demand. Let us look at the determinants of exports and the export function

EXPORT FUNCTION

Export of a country are a function of a number of external and internal factor

External determinants of exports are (i) domestic price of exports in relation to those in

importing country (ii) income of a importing countries (iii) importers income-elasticity for imports (iv) tariffs and trade policy (v) ex-change rate policy and foreign exchange

restrictions

Internal determinants of exports are(i)Export policy of the exporting country(ii)Exports duties and subsidies(iii)Availability of exportable surplus(iv) Trade and tariffs agreement with other

countries (v)International competitiveness of domestics goods

EXPORTS AND AGGREGATE DEMAND

Exports result inflows of income from abroad. Some part of income is consumed and a part saved. The increase in consumption due to increase in exports affects the economy in the same manner as the increase in consumption due to increase in income

Exports constitute a part of the aggregate demand(AD)

AD = C +I + G + X --------(1) AD= Aggregate demand

C= consumer goods

I= investments goods

G=government purchase

X = Exports

When there is no imports Y = C+I+G+X---------(2) C =a+b(Y-T)-------(3)Putting value of C

EXPORT MULTIPLIER

If increase in export, X national income equilibrium eq can be rewritten as

Sub eq (4)from eq (5)

----------(6)

IMPORT FUNCTION

Imports are purchases of goods and services from abroad .payment for import are a leakage from the income stream because payments made for import make the domestic income flow out of the economy the level of imports determines the level of outflows of domestic income .

Major determinants of the imports of country are-(i) Prices of the foreign goods in relation to the domestic prices(ii) income level of the domestic economy (iii) income-elasticity of imports(iv) tariff rates and the imports policy of the government(v) Exchange rate policy and foreign exchange restrictions(vi) Taste and preference for foreign goods import function = M =M+mY M= constant m=marginal propensity

IMPORTS AND AGGREGATE DEMAND

The aggregate demand is reduced by the amount of payments for imports. This negative effect of imports on the aggregate demand is accounted for by including imports (M) as a negative value in the aggregate demand equation i.e. (X-M)

Thus the AD eq for the an open economy is : Y=C+I+G+(X-M)

If M>X the AD decreases X>M AD increases

NATIONAL INCOME EQUILIBRIUM IN A FOUR-SECTOR MODEL

The determination of national income in a four- sector model incorporating both X and M

four-sector model of income determination can be written as follows

Y=C+I+G+(X-M) where C= a+b (Y-T) M=M +mY by putting value Y= a + b(Y-T)+I+G+(X-M-mY)---------

(7)simplifying

GRAPHICAL PRESENTATION

Assumption (i) There is no transfer expenditure (GT)(ii) X is autonomous

As economy would be in equilibrium at point E2 without foreign trade. With the inclusion of foreign trade in the model (assuming M>X) the AD3 = C+I+G+X-M and equilibrium point shift to E1. It means that inclusion of foreign trade (M>X)causes a reduction in the equilibrium level of national income. In case X>M, the C+I+G+(X-M) schedule will shift upward above the AD3 =C+I+G schedule and equilibrium point will shift beyond point E2

FOREIGN TRADE MULTIPLIER

Let exports increase by X, all other variables remaining constant.

Eq 2 can be written as

Subtracting by 2-3

Rearranging eq (4)

Alternatively

Conclusion if b=m forign trade multiplier is equal to unity

b>m foreign trade multiplier is greater than unity & vice versa

A COMPLETE FOUR-SECTOR MODEL OF INCOME DETERMINATION

By four sector eq (7)we assume tax is constant i.e. T=T, and transfer payment GT=0

Y= a + b(Y-T)+I+G+(X-M-mY)---------(7)Lets assume T=T+tY---------------------------------(14) GT = GT >0------------------------------

(15) With assumption equilibrium level of national

income can be expressed as Y= C+ I + G + GT+ (X-M)----------------(16)

---------------(17) M=M+mY-----------(18)By substituting eq 17 through eq 18 in eq16

--19

THE FOREIGN TRADE MULTIPLIER (FM)WITH TAX FUNCTION

By eq (19) suppose country exports increase by X then the eq is

--(20)

Subtract eq (19) from eq(20)

TWO GAP THEORY

Y=C+I+X-M--------(a) Y=C+S---------------(b)Where, Y=income, C=Consumption,

I=investment M=ImportsEquating Eq (a)&(b) we get C+I+X-M=C+S(I-S)=(M-X)Investment-Saving gap equals current account

surplus

Y= GNP=GDP+NFI---------------------------(c)GDP=(PubExp + PubInv + PvtExp + PvtInv + X –

M )----------(d)Rearranging the terms of Eq (c)&(d) we get

Y= (PubExp + PubInv + PvtExp + PvtInv + X -M) + NFI --------(e)

or, Y-(PvtExp + PvtInv)= \\ (PubExp + PubInv) + (X-

M+NFI)----(f)Or, Y-(PvtExp + PvtInv+T)= (PubExp + PubInv-T) + (X-M+NFI)----

(g)

Three Gaps theory

Or, (X-M+NFI)=[Y-(PvtExp + PvtInv + T)] + [T-(PubExp + PubInv)]

Current account balance = (X-M+NFI)

Private sector balance = Y-(PvtExp + PvtInv + T)

Public sector balance = T - (PubExp + PubInv )

Thus we get Current account balance = Private sector balance + Public sector balance

IMPACT OF BOP ON BUSINESS

Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies that leads to a worsening of the balance of payments. This has further effects on the economy as a whole

(i) Reductions in demand in the circular flow:  There will be a net fall in AD because more money is leaving the circular flow of income (through imports) than is coming in from exports. An inward shift of AD would lead to a contraction along the SRAS curve.

(ii) Lost jobs: There will be a loss of employment if exporting industries require less labour and we import more product from outside

(iii) Dip in business confidence and investment: A fall in business confidence and a decline in capital investment spending by country exporting firms whose order books are less full and whose profits take a hit from a fall in demand from overseas

(iv) Reductions in inflationary pressure: Lower inflation because imports coming into the country are cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary pressure might then persuade the central to reduce interest rates to provide a boost to macroeconomic activity.

The exchange rate and the balance of payments Changes in the exchange rate can have a big effect on

the balance of payments although these effects are subject to uncertain time lags. When sterling is strong then India exporters found it harder to sell their products overseas and it is cheaper for India consumers to buy imported goods and services because the pound buys more foreign currency than it did before.

The Balance of Payments and the Standard of Living A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In the short term if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards may decline.