Ragan: Macroeconomics

Seventeenth Canadian Edition

Chapter 7
Adding International
Trade to the Simple
Macro Model

Part II

Copyright © 2023 Pearson Canada Inc. 22 - 1

 Introducing Foreign Trade
 AE = C + I + G + X – IM

 X: Exports of goods and services

 IM: Imports of goods and services

 Why subtracting IM?

2
 Measures of economic openness to international trade:

 ,


The
The Choice
Choice Between
Between Domestic
Domestic and
and Foreign
Foreign Goods
Goods 𝑃
∗
𝑒𝑃

Price of Canadian
goods in Canadain
dollars (P)
Price of U.S.
goods in U.S.
dollars (P*)
Price of U.S. goods
in Canadian dollars
(eP*)
 Exchange Rate

 The exchange rate is the number of units of domestic currency

required to purchase one unit of foreign currency.

 For example, today, Canadian-US exchange rate is 1.35

 it takes $1.35 CDN to purchase one USD.

 Another definition of an exchange rate:

 The price of foreign currency in terms of domestic currency

 Example:

 1$ C = $0.75 US
 Exchange
Exchange Rate
Rate Regimes
Regimes

•Exchange rate policies vary from country to country

• Flexible exchange rates: Canada, U.S., Japan, U.K.,

Euro countries

• Fixed exchange rates: Hong Kong, Panama, Qatar,

Saudi Arabia
 A flexible exchange rate is an exchange rate that is left free to
be determined by the forces of demand and supply on the free
market, with no intervention by central banks.

 A fixed exchange rate: A system in two or more countries

maintain a constant exchange rate between their currencies
• Revaluation of domestic currency corresponds to
a fall in the exchange rate under a fixed exchange rate system

• Devaluation of domestic currency corresponds to

an increase in the exchange rate under a fixed exchange
rate system
The
The Choice
Choice Between
Between Domestic
Domestic and
and Foreign
Foreign Goods:
Goods: Relative
Relative Prices
Prices

𝑃
 P=s ∗
𝑒 𝑃
 P* = Foreign price levels
 e = Exchanged rate

 A rise in Canadian prices relative to foreign prices

 This could be caused by:

 Changes in exchange rate

 Changes in domestic price levels
10

 Equilibrium Level of Output: Introducing
International Trade

1. The Actual supply of goods and services (GDP) = Desired AE

Y = AE = C + I + G + X - IM

X: exports
IM; imports

2. Leakages = Injection
S + T + IM = I + T + X
 Expanding the Goods Market to
Incorporate Foreign Trade

AE
AE == C
C ++ II ++ G
G –– IM
IM ++ X
X

IM : Imports
X: Exports

Domestic Demand: C + I + G

Domestic Demand for Domestic Goods: C + I + G - IM

Demand for Domestic Goods: C + I + G – IM + X

 AE = C + I + G + X - IM

 Determinants of Exports (X)

 Foreign Income - An increase in our foreign trading partners’

GDP increases quantity of Canadian goods demanded by foreign
countries.
𝑃
∗
 Changes in Relative International Prices 𝑒𝑃

 P* = Foreign prices
E = 13

 𝑃
∗
𝑒 𝑃

 The most important cause of a change in international relative prices is a change in the
exchange rate.

 Depreciation of a currency ($) – A depreciation of the CDN$ means that

foreigners must pay less of their money to buy one CDN$, and Canadian residents
must pay more CDN$ to buy foreign currency

 A reduction in the value of the Canadian dollar (higher e) will make country’s
goods less expensive in other countries.

𝑃
∗
Increases exports
𝑒 𝑃
 Appreciation of the Canadian dollar - A reduction in the value of the
Canadian dollar (lower e) will make Canadian goods more expensive
and

𝑃
∗
𝑒𝑃

 Reduces exports
 Other considerations: Barriers to trade – tariffs, quotas,
regulations, etc.

 Mad cow disease, lead paint on toys.

 Taste – trade promotion, ‘buy American’

16
 Canada’s exports are autonomous with respect
to Canadian GDP

X
X ==

X
X == $72bn
$72bn
 Determinants of Imports

 Imports are influenced by many factors:

 For simplicity we group these determinants of imports into TWO

categories:

 Income (Y)

 Non-income factors.

18
 IM
IM == M
M00 ++ mY
mY

 Domestic Income - An increase in domestic income results in an increase in

imports

 m is the marginal propensity to imports - The amount by which

imports rise when income rises by $1 ( )

 We assume that 0 < m < 1

 Non-income factors:

𝑃
 Changes in Relative International Prices
∗
𝑒𝑃

 Trade barriers -- Barriers to trade – tariffs, quotas, regulations, etc.

 IM
IM == M
M00 ++ mY=
mY= 30
30 ++ 0.1Y
0.1Y Y Imports (IM)
300 40
Imports 400 50
600 70
900 100

IM
50
40
Autonomous
imports
300 400 Y
 Change in Relative International Prices 𝑃
∗
𝑒 𝑃

 A rise in foreign prices makes imported goods more expensive and

reduces imports.
𝑃
∗
𝑒 𝑃

 Canadians will see imports from foreign countries become more

expensive relative to the prices of Canadian-made goods.

 A rise in domestic prices makes imported goods cheaper and increases

imports.
𝑃
∗
𝑒𝑃
 The depreciation of a currency ($) - A reduction in the value of the
Canadian dollar (higher e) will make foreign country’s goods more
expensive and reduces imports
𝑃
∗
𝑒 𝑃

 Canadians will see imports from foreign countries become more expensive
relative to the prices of Canadian-made goods.

 This reduces23imports
23
A Keynesian Model of Output Determination

AE
AE == CC ++ II ++ G
G ++ XX -- IM
IM

 Consumption expenditure
C
C == C
C ++ mpc(Y
mpc(Y–– T)
T)

II ==
 Investment expenditure

G
G ==
 Government expenditure

TT ==
 Exports: X
X ==

 Imports:
IM
IM == M
M00 ++ mY
mY

m: marginal propensity to import

M0: Autonomous imports

 Equilibrium output (Y) Y

Y==AE
AE == C
C ++ II ++ G
G ++ X
X -- IM
IM
25
  Canada’s exports are autonomous with respect to Canadian
GDP

 Increase in our trading partners’ GDP increases demand

for domestic goods, exports grow

 For imports, we assume:

IM
IM == M
M00 ++ mY
mY
 The increases in Y increases imports

26
 Trade Balances
 In
In an
an open
open economy:
economy:AE
AE == CC II ++ G
G ++ (X
(X -- IM)
IM)

 The trade balances (or net exports) is the difference between total
exports and total imports.

X – IM

 Trade surplus: When X>IM

 Trade deficit: When IM>X

 X, IM
IM
Y X IM X - IM
80 Trade deficit
300 72 40 32 -8
72 X

620 72 72 0 10
Y
NX 300 620 700
700 72 80 -8
62

0
-8 Y
Trade deficit
NX
 29

 The relationship between Y and NX is shown by the trade

29 balances (net export) function.

 Changes in income (Y) lead to changes in net exports (NX):

 Y NX (= X – IM ) NX

Copyright © 2011 Pearson Canada Inc.

 X, IM
IM
NX
NX == X
X –– (M
(M00 ++ mY)
mY)
80
NX
NX == (X
(X ++ M
M00 )) -- mY
mY
72 X

10
Y
NX 300 620 700
62

0 Y

NX
 Equilibrium Level of Output

 Equilibrium occurs when:

 Supply of goods = Demand for goods

 Actual
ActualYY== Desired
DesiredAE
AE == CC ++ II ++ G
G ++ (X
(X -- IM)
IM)

31
 Equilibrium level of output
AE
AE == C
C ++ II ++ G
G Y = AE
AE

A AE = C + I + G

C+I
C
Autonomous
Govt spending Slope=MPC
Autonomous
investment

Autonomous
consumption
45o
3.32
Y
AE
AE == C
C ++ II ++ G
G -- IM
IM IM
IM == 30
30 ++ 0.1Y
0.1Y
33
AE
AE = C + I + G

AE = C + I + G - IM

Domestic Demand: C + I + G

Domestic Demand for Domestic Goods: C + I + G - IM

 AE
AE == C
C ++ II ++ G
G –– IM
IM ++ X
X
34
AE
AE = C + I + G
AE = C + I + G – IM + X
AE = C + I + G - IM
X

Y
 Y
Y==AE
AE == C
C ++ II ++ G
G –– IM
IM ++ X
X
35
AE Y = AE

A
AE = C + I + G – IM + X

45o
Y
Y
The Determinants of Equilibrium Level of Output

 The equilibrium level of output is determined by the

desired level of aggregate expenditure

 AE = C + I + G + X - IM

 Any changes in export and imports affects AE, setting

in motion the multiplier process that tends to increase
equilibrium national income.
AE Y =AE

C+ I + G + (X – IM)
520

45o
Y
520 620
Net exports (NX)

Trade surplus

Trade deficit
0 +10
3.37
Y
 How Does an Increase in Our Trading Partners’ GDP Our Economy (Y
38 and Trade Balances?

 An increase in our trading partner’s income (YUS)

 YUS IMUS X

Y
Y==AE
AE == C
C ++ II ++ G
G ++ (X
(X –– IM)
IM)

 AE Y
YY==520,
520,XX==72,
72,IM
IM==62
62 AE Y = AE
Trade
Tradebalance
balance==++10
10
AE
520

45o
Net exports (NX)
520

Trade surplus

10
0 3.39 Y
 AE Y = AE
AE
AE
520
ΔX = 9

45o

520 550
NX
ΔX = 9

19 B
16 C
10 A
0 Y
3.40
 What would be the effect of higher exports on Canada’s
trade balances [ NX (= X – IM)]?
 An increase in foreign income results in an increase in Canadian
exports = ΔX = 9

 An increase in exports an increase Y (ΔY = 30)

 An increase in Y an increase in imports (import ΔIM =

3

 NX (= X – IM )

 An increase in NX (trade surplus goes up from 10 to 16

How Does a Depreciation of Canadian Dollar Affect Canada’s GDP?

 A depreciation of currency ($) - A reduction in the value of the Canadian

dollar (higher e) make foreign country’s goods more expensive relative to
domestic made goods
𝑃
∗
𝑒 𝑃

 Canadians will see imports from foreign countries become more expensive
relative to the prices of Canadian-made goods.

 This reduces4343
imports
 The depreciation of a currency ($) will make that country’s goods
cheaper in other countries.

 Foreigners will see Canadian-made goods become less expensive

relative to the prices of their own-made goods.

 This increases exports

 Y Imports (IM)
300 40
400 50
600 70
Imports 900 100

IM A Depreciation of
50 IM’ Canadian dollar

40 Lower imports

Autonomous
imports
300 400 Y
Exports

X’
72 X

Y
400 700 900
47

 The NX (=X - IM )

 Trade balance would improve

 48

IM

Imports and Exports

48 Illustration of a
depreciation of Canadian IM´
B
dollar X´
A
X
𝑃 C

∗
𝑒𝑃 Actual National Income

How does a decline in the

Net Exports
value of Canadian dollar
affect Canada’s trade
balances (X – IM)? A
Y
(X - IM)´
(X - IM)
Higher NX would improve trade balance and stimulate
economic growth

 NX Y

 Why?

 Y = AE = C + I + G + NX

49
 An AE Y = AE
Animprovement
improvement
in
intrade
tradebalances
balances AE
(NX)
(NX) AE
A
520
ΔX = 9
 NXNX increases
increases
from
from1010to
to19
19

45o
 This
Thisshifts
shiftsthe
the
AE
AEupwards
upwards 520 550
NX
ΔX = 9
 Leading
Leadingtoto
higher B
higherYY 16 C
10 A
0 Y
3.50
How Does an Appreciation of Canadian Dollar Affect Canada’s GDP?

 An appreciation of currency ($) - A reduction in the value of the

Canadian dollar (higher e) make foreign country’s goods cheaper
expensive relative to domestic made goods
𝑃
∗
𝑒 𝑃

 Canadians will see imports from foreign countries become ceaper relative
to the prices of Canadian-made goods.

 This increases
51 imports
51
 The depreciation of a currency ($) will make that Canadian-made
goods more expensive in other countries.

 Foreigners will see Canadian-made goods become more expensive

relative to the prices of their own-made goods.

 This reduces exports

53

 The NX (=X IM )

 Trade balance would deteriorate

 AE = C + I + G + (X –IM)
A Keynesian Model of Output Determination

 AE = C + I + G – IM + X

 Consumption expenditure C
C == C
C ++ mpc(Y
mpc(Y–– T)
T)

 Investment expenditure II ==

 Government expenditure G
G ==

 Taxes
TT ==
 Imports: IM
IM == M
M00 ++ mY
mY

 m: marginal propensity to import (The amount by

which imports rise when income rises by $1)( )

 Exports: X
X ==

 Equilibrium output (Y)

Y
Y==AE
AE == C
C ++ II ++ G
G ++ X
X -- IM
IM
55
 AE
AE == C
C ++ II ++ G
G IM
IM ++ X
X
56

AE
AE == C
C00 ++ mpc
mpc (Y
(Y–– )) ++ ++ (M
(M00 ++ mY
mY++

AE
AE == C
C00 ++ mpcY
mpcY–– mpc
mpc )) ++ ++ –– M
M00 mY
mY++

AE
AE == [C
[C00 –– mpc
mpc ++ ++ ++ ]] ++ mpcY
mpcY-- mY
mY

AE
AE == [C
[C00 –– mpc
mpc ++ ++ ++ X
X ]] ++ (mpc
(mpc –– m)Y
m)Y
 *
57
AE AE=Y

AE= C + I + G + IM + X

Slope: (mpc –m)

[C
[C00––mpc
mpc++ ++ +]
+]

45o Y
Y0

Slope of AE: the marginal propensity to spend on domestically-made

goods and services
 Equilibrium
Equilibrium level
level of
of output:
output:YY==AE
AE

Y
Y== [C
[C00 –– mpc
mpc ++ ++ ++ X
X ]] ++ (mpc
(mpc –– m)Y
m)Y

Y
Y–– mpcY
mpcY++ mY
mY=[C
=[C00 –– mpc
mpc ++ ++ ++ X
X ]]

Y(1
Y(1 –– mpc
mpc ++ m)
m) == [C
[C00 –– mpc
mpc ++ ++ ++ X
X ]]

Y = ( ) [C0 – mpc + + + X ] 58
59
Y = ( ) [C0 – mpc + + + X ]

Y = ( ) [C0 – mpc + + + X ]

(mpc – m): the marginal propensity to spend (z) on domestic

output.

Higher marginal propensity to import (m), lower would be the size

of multiplier.
Main Features of the Keynesian Macroeconomics:

 The equilibrium level of output is determined by the desired

level of aggregate expenditure ( C + I + G – IM + X )

 Any changes in autonomous spending has a multiplying

effect on output(Y)

3.60
 *
61
AE=Y
AE
AE= C + I + G + IM + X

Slope: (mpc –m)

[C
[C00––mpc
mpc++ ++ +]
+]

45o Y
Y0

Changes in autonomous spending (Co or I or G or X or Mo) will cause

the AE curve to shift
How does an increase in government expenditure affect GDP?

ΔG = 40

Y = ( ) [C0 – mpc + + + X ]

ΔY = ΔG

ΔY = 20 = [2] 20 = 40

62
 Government expenditure multiplier: open
versus closed economy

 Open economy:

 ΔY = ΔG

 Closed economy:

 ΔY = ΔG
63
 How does an increase in our trading partners’ GDP
affect our economy?

 Foreign Income - An increase in our foreign trading partner’s income

results in an increase in Canadian exports

Y = ( ) [C0 – mpc + + + X ]

ΔY = ΔX
64
 An Increase in export
65 AE AE=Y

AE1
AE0 = C + I + G + NX

ΔX

[C
[C00––mpc
mpc++ ++ ++]] ΔY
45o
Y
Y0 Y1
A Keynesian Model of Output Determination Under a More Complex
Tax System
 AE = C + I + G – IM + X

 Consumption expenditure C
C == C
C ++ mpc(Y
mpc(Y–– T)
T)

 Investment expenditure II ==

 Government expenditure G
G ==

 Taxes TT == tY
tY
 Imports: IM
IM == mY
mY

 Exports: X
X ==

 Equilibrium output (Y)

Y
Y==AE
AE == C
C ++ II ++ G
G –– IM
IM ++ X
X

67
 AE
AE == C
C ++ II ++ G
G IM
IM ++ X
X
68

AE
AE == C
C00 ++ mpc
mpc (Y
(Y–– tY)
tY) ++ ++ (M
(M00 ++ mY
mY++

AE
AE == C
C00 ++ mpc(1
mpc(1 –– t)Y
t)Y++ ++ –– M
M00 mY
mY++

AE
AE == [C
[C00 ++ ++ ++ ]] ++ mpc(1
mpc(1 –– t)Y
t)Y–– mY
mY

AE
AE == [C
[C00 ++ ++ ++ X
X )])] ++ [mpc(1
[mpc(1 –– t)t) –– m]Y
m]Y
 *
69
AE AE=Y

AE= C + I + G + IM + X

Slope: [(mpc(1 – t) –m]

[C
[C00++ ++ +]
+]

45o Y
Y0

Slope of AE: the marginal propensity to spend on domestically-made

goods and services
TT ==
AE
AE == [C
[C00 –– mpc
mpc ++ ++ ++ X
X ]] ++ (mpc
(mpc –– m)Y
m)Y

TT == tY
tY
AE
AE == [C
[C00 ++ ++ ++ X
X )])] ++ [mpc(1
[mpc(1 –– t)t) –– m]Y
m]Y
 Equilibrium National Income

 Highermarginal propensity to import (m), lower would be the size of

multiplier.

 Higher the tax rate (t),71 lower would be the size of multiplier.
Figure 7-3 The Aggregate Expenditure Function (
How does an increase in government expenditure affect GDP?

ΔG = 40

Y = ( ) [C0 + + + X ]

ΔY = ΔG

ΔY = 20 = 20 = [1.5]20 = 30

73
 An Increase in government purchase
74 AE AE=Y

AE1
AE0 = C + I + G + NX

ΔG

[C
[C00––mpc
mpc++ ++ +]
+]
ΔY
45o
Y
Y0 Y1
 Multipliers: Open Economy

Government exp enditure multiplier  1

1[ mpc (1  t )  m ]

Investment multiplier  1
1( mpc (1  t )  m ]

MULTIPLIERS: CLOSED ECONOMY

Government exp enditure multiplier  1
1[ mpc (1  t ) ]

MULTIPLIERS: CLOSED ECONOMY WITH NO GOVT.

Government exp enditure multiplier  1
1 mpc

75
 Imports, Taxes, and the Multiplier
The income-expenditure multiplier is impacted not only by the marginal
propensity to consume (mpc) but also by

the marginal propensity to import (m) and

the economy-wide marginal tax rate (t)

Marginal Propensity to Import

The amount by which imports rise when income rises by $1

The larger the marginal propensity to import is, the smaller the income-
Ch8-76
expenditure multiplier
Economy-wide Tax Rate (t)

The amount by which tax rises when income rises by $1

The larger the economy-wide tax rate is, the smaller the
income-expenditure multiplier
 Equilibrium level of output

 Equilibrium occurs when:

1. Supply of goods = Demand for goods

Y = Desired AE = C + I + G + X – IM

2. Injections = leakages

I + G + X = S + T + IM
78
Introducing government and foreign trade: Injection = Leakages

 The second approach to examine the influence of foreign trade on domestic output:

 I + G + X = S + T + IM

 I = S + (T – G) + (IM – X)

 I = S + Sg + Sf
Where T – G = government saving
IM – X = foreign saving

 (I - S) + (G - T) + ( X - IM) = 0
79
 The government sector surplus or deficit is equal to net
taxes, T, minus government expenditure on goods and services
G

 The private sector surplus or deficit is saving, S, minus

investment, I.

 Net exports is equal to the sum of government sector balance

and private sector balance:

 NX = (T – G) + (S – I)
 NX = (Sg + S ) – I
 Two Interpretations of Trade Balances

I. Y = C + I + G + X – IM or X – IM = Y – [C + I + G]

II. X - IM = (Sg + S ) – I

 What does a trade deficit imply?

 Y
Y==AE
AE == C
C ++ II ++ G
G ++ X
X -- IM
IM

X
X -- IM
IM ==Y
Y–– (C
(C ++ II ++ G)
G)

(C
(C ++ II ++ G):
G): domestic
domestic demand
demand

Trade
Trade surplus
surplus (NX>0)
(NX>0) Y
Y>> (C+
(C+ II ++ G)
G)

Trade
Trade deficit
deficit (NX<0)
(NX<0) Y
Y<< (C+
(C+ II ++ G)
G)

Balanced
Balanced trade
trade (NX=0)
(NX=0) Y
Y== (C+
(C+ II ++ G)
G)
 N – IM = NX = (Sg + S ) – I

 NX>0 implies that (Sg + S ) > I

 NX<0 implies that (Sg + S ) <I

83