The 2 gap model

Guido Lorenzo

Universidad de Buenos Aires

November 15, 2019

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 The external constraint Capacity utilization

1 The external constraint

Capacity utilization
Trade balance

2 The double role of foreign investment

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 The external constraint Capacity utilization

Aggregate Demand

Macroeconomic equilibrium:

Y =C +I +X −M (1)

Consumption
C = cY (2)
, with 0 < c < 1
Savings = (1)-(2):

S = Y − C = (1 − c)Y = sY (3)

Imports:
M = mY (4)
Investment (I ) and Exports (X ) are determined exogenously

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 The external constraint Capacity utilization

Equilibrium Output and Potential Output

Replacing (4) and (3) in (1):

Y − C = S = sY = I + X − mY
I +X
Y = (5)
s +m
We define Y0 as Potential Output, the highest level of output that
can be achieved (i.e. GDP consistent with full utilization of labor and
capital).
Y and Y0 are not are not necessarily equal. Thus, we need to define
the capacity utilization:
Y
u= (6)
Y0
with 0 < u < 1

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 The external constraint Capacity utilization

Output gap I

We define the investment to potential output ratio as i:

I
i= (7)
Y0
Analogously, define x for exports:
X
x= (8)
Y0
For simplicity, set Y0 = 1, so
I
i= =I (9)
Y0
X
x= =X (10)
Y0
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 The external constraint Capacity utilization

Output gap II

Divide (5) by Y0 and replace (9) and (10) to get:

i +x
u= (11)
s +m
Set u = 1, i.e. Y = Y0 :

i =s +m−x (12)

Equation (12) yields the possible combinations of investment and

exports, given the preference and technological parameters s and m,
to achieve full employment.

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 The external constraint Capacity utilization

The exports-investment trade-off

Graphically, eq (12)

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 The external constraint Capacity utilization

The model

The triangle between points 0AB yields the feasible combinations of

investment and exports.
The AB line represents the full employment combination of
investment and exports
Outside the OAB triangle, e.g. point Z, demand exceeds the potential
output (inflationary pressures).
If economy is at point D, inside the triangle, then the actual GDP is
lower than the potential output. There are many ways to take the
economy from D to the AB line:
increase x
increase i
or increase both x and i
decrease s
decrease m
or decrease both s and m
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 The external constraint Capacity utilization

Assessing the double role of investment

However, increases in x and increases in i have different effects.

Investment not only rises aggregate demand, but also rises the
potential output by increasing the capital stock. Recall

Kt = It + Kt−1 (1 − δ)

and
Y0 = F (K ; L)
Assuming that the potential output is constrained by the level of
capital (may be true for development countries), then the investment
times the capital productivity (a) gives us the expansion of the
potential output
∆Y0 = aI (13)

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 The external constraint Capacity utilization

Invest or export?

Dividing both sides of (13) by Y0 we get:

∆Y0
= ai
Y0
∆Y0
Y0 represents the rate of growth of Y0 , that we shall call g . Finally:

g = ai (14)

On the other side, increasing x also leads to higher aggregate demand

but has no effect on the potential output.
Why exporting?

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 The external constraint Trade balance

Introducing the trade balance

So far, we’ve been focusing in just the internal equilibrium condition,

i.e. eq (1) which states that the aggregate supply must equal
aggregate demand.
We should include the trade balance equilibrium condition (X = M)
into the model
X = M = mY
Dividing by Y0 on both sides

x = mu (15)

Replace (11) in (15):

i +x
x =m (16)
s +m

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 The external constraint Trade balance

x(s + m) = mi + mx
x(s + m) − mx = mi
x(s + m − m) = mi
m
x= i (17)
s
Eq. (17) can be placed in the same diagram as eq (12). Geometrically, it
will look like a ray from the origin and the slope given by the ratio ms

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 The external constraint Trade balance

The trade balance graph

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 The external constraint Trade balance

The red ray divides the graph into two zones:

the points below the line represent trade deficit
the points above the line represent trade surplus
An economy can remain below the line until international reserves are
exhausted
Hence, incorporating the trade balance into the model, we see that
economic growth may be hindered by two restrictions:
the feasibility condition
the trade balance equilibrium condition
The equilibrium is now defined by the system given by eq. (12) and
eq.(17) and can be solved graphically.

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 The external constraint Trade balance

The system

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 The external constraint Trade balance

Finding equilibrium

Both the feasibility constraint and the trade balance condition end up
defining the triangle 0AP0 as a sustainable area.
below the u = 1 line, the product is lower or equal to the potential
output (feasible)
above the x = ms i line, there is trade surplus.
The points inside the 0P0 B triangle are technologically attainable but
are not sustainable as the trade balance can’t run deficit for ever.

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 The external constraint Trade balance

Dynamics I

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 The external constraint Trade balance

Dynamics II

Assume the economy is at point J

The idea of achieving full employment by just increasing investment
(from iJ to i2 ) will take us to point Q, which is not sustainable (trade
deficit).
On the other hand, if we just increase the exports (from xJ to x1 ), we
will end up in point T: full employment and trade surplus.
Is point T the best scenario?
Too much investment sacrifice over the trade-off u = 1 line (recall the
double role).
The highest level of investment in the sustainable area will be i0 ,
given by the point P0 that emerges from the intersection of the full
employment line and the trade balance line
The point P0 , or equivalently the pair (i0 , x0 ) is the solution to the
system of equations (12) and (17)
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 The external constraint Trade balance

The equilibrium

Formally, the system is solved when there is full employment and trade
balance equilibrium. Recall eq (12)

i =s +m−x

The trade balance equilibrium condition (x − m = 0) implies:

i0 = s (18)

x0 = m (19)
The underdeveloped economies have shown several difficulties to achieve
the x0 level of exports. The growth of the agricultural activities
(comparative advantage) tends to be slower than the growth of the
manufacturing sector (net importer sector).

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 The external constraint Trade balance

The unbalanced productive structure (UPS)

Assume that the exports decreases to xJ , lower than the x0 needed for full
employment equilibrium.
To achieve trade balance equilibrium the investment must be limited
up to iJ .
The economy is then located at point J (below the u = 1 line) and
the capacity utilization decreases to uJ :
iJ + xJ
uJ = <1 (20)
s +m
From eq (17) we can rearrange to get iJ as a function of xJ .
s
iJ = xJ (21)
m

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 The external constraint Trade balance

The unbalanced productive structure (UPS)

Replace (21) in (20):

xJ
uJ = (22)
m
External restriction: The low level of exports impose a constraint over
the capacity utilization and the investment ratio.

When the economy suffers from UPS, the growth of exports is not a mere
alternative for the development of the economy but a necessary condition
for the economic growth take-off.

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 The external constraint Trade balance

The unbalanced productive structure (UPS)

We can rearrange to express the investment as a function of the exports

gap:
s
i0 = x0
m
Then i0 − iJ :
s s
i0 − iJ = x0 − xJ
m m
s
i0 − iJ = (x0 − xJ )
m
Recall that in equilibrium i0 = s, then solving for iJ :
s
iJ = s − (x0 − xJ ) (23)
m
The external restriction emerges when x0 − xJ > 0

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 The external constraint Trade balance

The unbalanced productive structure (UPS)

Analogously, we can rearrange to express the capacity utilization as a

function of the exports gap
x0 − xJ
uJ = 1 − (24)
m

Eq (23) and Eq (24) tell us that when exports equal x0 , then the
investment equal savings and the economy operates at full capacity.
When the external constraint emerges, each missing dollar decreases
the investment by ms dollars.
When the external constraint emerges, each missing dollar decreases
the output by m1 dollars.

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 The external constraint Trade balance

The dynamics of the external constraint

How does the insufficient level of foreign currency constraints investment

and output?
1 The missing dollars results in quantitative restrictions to import
intermediate inputs and machines that the local economy can not
provide.
2 Tight monetary policy: when the economy is overheating, i.e.
approaching to a point above the u = 1 line, the Central Bank usually
hikes the interest rate in order to stabilize the demand and prices.

In the UPS economies, this overheating usually happens in the 0P0 B

triangle. The demand is excessive not in terms of the productive
capacity, but in terms of the external balance.

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 The external constraint Trade balance

Exchange rate inflation

What happens if the policy makers doesn’t react to the overheating?

For every point inside the 0P0 B triangle, it is true that there is an
excess of demand for foreign currency.
This induces a depreciation of the local currency (or dollar
appreciation in the local economy).
This depreciation should promote net exports, taking the economy to
the trade balance. But in the UPS economies, the exporting sector
are supposed to have very low sensibility to exchange rate movements
(primary sector).
At the same time, the higher exchange rate raises the cost of living
(UPS economies tend to export food).
If the workers refuse to accept the new set of prices, they will fight for
higher wages (DANGER: inflationary spiral).

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 The double role of foreign investment

Opening the capital account

So far the economy was open to trade inflows but nothing was said
about capital inflows.
The international financial movements play a significant role in the
UPS economies business cycles.
The Latin America’s 80’s debt crisis
Tequila effect in the 90’s
The 2008 Subprime crisis propagation.
Let’s introduce the foreign capital into the model, studying it’s double
role: as a source of foreign currency and as real investment.

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 The double role of foreign investment

Foreign capital as foreign currency

Let’s call F the contribution of foreign capital, so the balance of
payments equation is:
B =X −M +F (25)
F
Set B = 0 for external balance and define f = Y0 to get:
0 = X − mY + F = x − mu + f
Replacing (11) for u:
i +x
0=x −m +f
s +m
Multiplying both sides by (s+m):
0 = x(s + m) − m(i + x) + f (x + m)
Solving for x: m m
x= i− f −f (26)
s s
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 The double role of foreign investment

Eq (26) poses a challenge, as x is now defined as a function of i and f .

Graphically we should go for a 3D chart ... but there’s a way to keep the
dynamics within our x-i diagram.

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 The double role of foreign investment

Now the external balance will be a family of functions: one line

(combination of x and i) for each possible value of f . In fact, we can
think that we’ve been working so far with the special case f = 0.

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