t depends upon the marginal propensity to import which measures the change in
imports resulting from a given change in income.
Import Function
M0
M1
Y0 Y1
Real imports
Real Y
FIG ONE
FIG 1 illustrates how imports might be expected to vary with national income - an increase from Y0 to
Y1 leads to an increase in imports from M0 to M1. The ratio of these changes (equivalent to the slope
of the import function) defines the marginal propensity to import. In general, the higher the
marginal propensity to import (i.e. the most elastic the curve) the more effective the expenditure
changing policy will be.
It is expected that a direct relationship would exist between imports and either income or expenditure,
since any expansion of domestic activity would tend to suck in imports of raw materials for industry,
3
and consumers are likely to spend a proportion of their extra incomes on imported goods. So if the government wishes to cure a deficit it would employ fiscal and monetary policies to contract domestic activity in order to reduce spending on imports. This could be done by lowering government spending, raising taxes, reducing the domestic money supply, raising interest rates, or any combination of these. National income will fall as a result through the Keynesian multiplier process and the trade balance should improve, depending upon the strength of the marginal propensity to import. In general the higher this propensity the more effective the expenditure changing policy will be. An alternative way to discuss this approach is by reference to what is known as the ‘absorption’ model. This emphasises the importance of using monetary and fiscal policies to reduce absorption (i.e. spending on domestic goods and services and imports) to correct a balance of payments deficit. The efficiency of this approach depends upon a multiplier process whose strength derives from the elasticity of import demand with respect to income. This approach starts from the national income model: Y = C + I + G + (X - M) If we allow total domestic absorption (A) to equal total domestic expenditure (C + I + G), then; Y = A + (X - M) Re-arranging, we find that the trade balance (X - M) is equal to national income less total domestic expenditure; Y - A = (X - M) Thus the trade balance is the difference between domestic income or production and domestic spending or absorption. If total domestic absorption exceeds total domestic output, by definition the country must be running a current account deficit, absorbing more than it produces and importing the difference. In this situation, the deficit could be cured by either increasing Y or reducing A. The specific approach chosen depends upon the state of the economy. If the economy is at full employment, increasing Y in the short-run will prove difficult and potentially inflationary. Consequently, under these circumstances, the brunt of the readjustment will tend to fall on A through expenditure-reducing policies. However, if all economic resources were not fully employed, Y could be increased with relatively few negative effects. The income adjustment model we have been using is a very simple one, based only on one country and some quite restrictive assumptions, including, firstly, fixed exchange rates and, secondly, an economy which is operating at less than full employment. Nonetheless, it is possible to make this model more complex within the general equilibrium framework (t
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