TOPIC 6: Theory of Multiplier.

Foreign trade multiplier: Meaning, working and assumption.

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 country
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 properties are, the larger will be value of the multiplier, and vice versa.
It’s working:
The foreign trade multiplier process can be explained like this. Suppose the exports of the
country increase. To begin with, the exporters will sell their products to foreign countries and
receive more income. In order to meet the foreign demand, they will engage more factors of
production to produce more.
This will raise income of the owners of factors or production. This process will continue and the
national income increases by the value of the multiplier. The value of multiplier depends on the
value of MPS and MPM, there being an inverse relation between the two propensities and the
export multiplier.
The foreign trade multiplier can be derived algebraically as follows:
The national income identity in an open economy is
Y=C+I+X–M
where Y is national income, C is national consumption, I is total investment, X is exports and M
is imports.
The above relationship can be solved as:
Y – C = I + X -M
Or,
S=I+X–M (S = Y – C)
S+M=I+X
Thus at equilibrium levels of income the sum of savings and imports (S + M) must equal the sum
of investment and exports (I + X).
In an open economy the investment component (I) is divided into domestic investment ( Id) and
foreign investment (If).
I=S
Id + If = S………… (1)
Foreign investment (If) is the difference between exports and imports of goods and services.
If = X – M…………. (2)
Substituting (2) into (1), we have
Id + X – M = S
Or
Id + X = S + M
which is the equilibrium condition of national income in an open economy. The foreign trade
multiplier coefficient (Kf) is equal to:
Kf = ∆Y / ∆X
And
∆X = ∆S + ∆M
Dividing both side by ∆Y, we get
∆X / ∆Y = ∆S + ∆M / ∆Y
Or
∆Y / ∆X = ∆Y / ∆S + ∆M
Or,
Kf = ∆Y / ∆S +∆M (because Kf = ∆Y / ∆X)
Kf = 1 / ∆S/∆Y + ∆M/∆Y (because dividing by ∆Y)
Hence Kf = 1 / MPS + MPM (because MPS = ∆S/∆Y, therefore MPM = ∆M/∆Y).
Illustrating with an example,
Suppose MPS = 0.3, MPM = 0.2 and ∆X = Sh 1000, we get
Kf = ∆y / ∆X = 1 / MPS + MPM
∆Y = 1 / MPS + MPM ∆X
= 1/ 0.3 + 0.2 X 1000 = Sh 2000.
It shows that an increase in exports by Sh 1000 has raised national income through the foreign
trade multiplier by Sh 2000, given the values of MPS and MPM.
It’s assumptions
The foreign trade multiplier is based on the following assumptions.
1. There full employment in the domestic economy
2. There is direct link between domestic and foreign country in exporting and importing goods.
3. The country is small with no foreign repercussion effects
4. It is on a fixed exchange rate system
5. The multiplier is based on instantaneous process without time lags
6. There is no accelerator
7. There are no tariffs barriers and exchange controls
8. Domestic investment (Id) remains constant.
9. Government expenditure is constant
10. The analysis is applicable to only two countries

Balance of trade (or trade balance).

The balance of trade is the difference between the value of a country’s imports and exports for a
given period. The balance of trade is the largest component of a country’s balance of payments.
Economists use the BOT to measure the relative strength of a country’s economy. The balance of
trade is also referred to as the trade balance or international trade balance.
A country that imports more goods and services than it exports in terms of value has a trade
deficit. Conversely, a country that exports more goods and services than it imports has a trade
surplus.
The formula for calculating the BOT can be simplified as the total value of exports minus the
total value of imports, e.g., if a country imported Ksh.1.5 trillion goods and services in 2017, but
exported only Kshs. 1 trillion in goods and services, then the country had a trade balance of –
Kshs 500 billion, or a Kshs 500 billion, trade deficit.
Kshs 1 trillion in exports – Kshs 1.5 trillion in imports = Kshs 500 billion trade deficit.
A balanced budget amendment, is a constitutional rule requiring that a state cannot spend more
than its income. It requires a balance between the projected receipts and expenditures of the
government.
In its simplest form, a balanced budget amendment would add a budget rule to the constitution
that would require federal spending not exceed federal receipts. The amendment would make it
unconstitutional for the federal government to run annual budget deficits.
A balanced budget, (particularly that a government) is a budget in which revenues are equal to
expenditures…. Most economists agree that a balanced decreases interest rates, increases saving
and investment, shrinks trade deficits and helps the economy grow faster in the longer term.
A balanced budget amendment could, allow the government to increase spending and lower
taxes when times are good and force cutbacks during ---- precisely when doing so would weaken
economic activity and worsen the recession. Deficits tend to increase as a result of economic
activity.
∆Y / ∆G = 1 / (1-c) Govt multiplier
∆Y / ∆T = - c / (1 – c) Tax multiplier
∆Y / ∆G + ∆Y / ∆T = 1 / (1-c) + -c / (1 + c) = (1- c) / (1- c) = 1 Balanced budget multiplier.

When the government spending increases are matched with equal size increases in taxes, the
change ends up being equal to the change in government spending. Why? ∆G x 1 = ∆G
If both taxes and govt spending change by the same amount, they don’t cancel each other out-
spending will always have the bigger impact on the economy. E.g., The G increases spending by
$ 20 million while at the same time raising taxes by $ 20 million,
$ 20 x 1 = $ 20
GDP will increase by $ 20 million.
Tax Multiplier
∆Y = - MPC / 1-MPC / 1-MPC, ∆T
Or,
∆Y/ ∆T = MPC / 1-MPC or, Kt = - MPC / MPS.