The International Sector and Planned Aggregate Expenditure
Recall the aggregate expenditure framework that we developed in order to examine the effects of changes in consumption (C), investment (I), and government spending (G) on the economy. Let us now add the foreign sector to this framework.
With the foreign sector, net exports are added to our definition of aggregate expenditure. Net exports of goods and services (EX - IM) consists of exports (EX) minus imports (IM). Thus, aggregate expenditure is defined as:
AE = C + I + G + EX - IM
To keep things simple for now, let us assume that exchange rates are fixed. (Do not worry, we will get to flexible exchange rates soon enough.) With fixed exchange rates, what could cause a change in the level of imports?
Think of what happens to consumption with an increase in income (Y). The marginal propensity to consume (MPC), you will recall, is the additional consumption resulting from an increase in income. Back in Chapter 20 (33), we had not yet introduced the foreign sector. As a result, the additional consumption was only on the domestically produced goods. Now, however, some of the additional consumption will be for imported goods. The marginal propensity to import (MPM) is the change in imports for a $1 change in income.
Now let us incorporate the foreign sector into our aggregate expenditure diagram. Let us assume for now that exports are fixed at a certain level (we will relax this assumption later). Starting with the consumption function, we will add investment (I), government spending (G), and exports (EX). This is shown in Figure 21.1 (33.1) in the text.
If no imports exist in this economy, we would be finished at this point. Recall that the equilibrium level of aggregate output (Y) is given by the intersection of the planned aggregate expenditure line and the 45 degree line. In Figure 21.1 (33.1) this occurs at an income level of 400.
We have yet to include imports (IM) into our analysis. From our discussion above, we know that imports increase with increases in income. At an income level of zero, there are no imports. The higher the level of income, the higher the amount of imports there will be. However, unlike exports that add to the planned aggregate expenditures in the economy, imports count as a negative. The value of imported goods will reduce the level of real GDP for an economy. As a result, we must subtract the value of imports from aggregate expenditure. This is shown by the dashed line in panel b of the figure above. Notice that the equilibrium level of income is now 200.
You will notice that aggregate expenditures including imports (C + I + G + EX - IM) is lower than the aggregate expenditure line we derived without imports. In addition, the higher the level of income, the farther it is from our earlier aggregate expenditure line. The reason that the new line rotates away from the earlier line is that imports increase as income (Y) increases. Thus, we are subtracting more from planned aggregate expenditures at higher levels of income.
The equilibrium level of aggregate output (Y) is lower with imports than without them. Notice that in this diagram, equilibrium output occurs at 200 (rather than 400 as was the case in the earlier diagram). With the presence of the foreign sector, the simple multiplier that was developed in earlier chapters needs to be modified (remember, this was 1/(1 = V MPC) or 1/MPS). With the presence of imports, the open-economy multiplier becomes:
Because the presence of the import market reduces the value of equilibrium output from what it would be otherwise, the value of the open-economy multiplier is less than the simple multiplier.
Let us use the values of MPC and MPM given in the text to see how the value of the multiplier is changed. Recall that when we developed the simple multiplier earlier, we used a value of 0.75 for MPC. This yields a value of 4 [1 / (1 - 0.75) = 1 / 0.25 = 4]. With a value of 0.25 for MPM, the value of the open-economy multiplier becomes 1/(.75 - .25) = 1/.5 = 2.
Why is the open-economy multiplier smaller? The reason is that, with a sustained increase in spending and a resulting rise in income, some of the increased consumption (stemming from the income rise) will be spent on imports rather than on domestic products. Recall that the multiplier works because of the extra income stemming, for example, from an increase in government spending, which is spent and respent in the economy. To the extent that some of this spending is on imported goods, it lessens the value of the multiplier. Imports represent another leakage and exports are an injection; therefore if imports exceed exports there is more leakage than injection!
This has implications for the effectiveness of fiscal policy. We discussed earlier that the presence of the money market reduces the effectiveness of expansionary fiscal policy because of rising interest rates as the economy begins to expand. We also know that the effectiveness of fiscal policy is further reduced because of rising prices, the presence of excess capital and labor, and other factors. Now we have another reason why the value of the multiplier is lower than the value given by the simple formula 1/(1-MPC). The presence of the import market reduces the value of the multiplier and the effectiveness of fiscal policy. We will also see later in this lecture that adding the effects of changing exchange rates on net exports reduces the effectiveness of fiscal policy even further.