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Subject ECONOMICS

Paper No and Title 13 – INTERNATIONAL ECONOMICS

Module No and Title 28 – FOREIGN TRADE MULTIPLIER AND ITS

REPERCUSSIONS
Module Tag ECO_P13_M28

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Adjustment to equilibrium in closed economy
3.1 Equilibrium Output in closed economy
3.2 Multiplier in closed economy
4. Adjustment to equilibrium in a small open economy
4.1 Planned expenditure in small open economy
4.1.1 Import Function
4.2 Equilibrium Output in small open economy
4.3 Multiplier in small open economy or Foreign Trade Multiplier
with no repercussions
5. Foreign Repercussions or Feedback Effect
5.1 Feedback effect from autonomous change in exports
5.2 Feedback effect from autonomous change in investment

6. Summary

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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1. Learning Outcomes

After studying this module, you shall be able to

 Know the difference between closed economy multiplier and open economy
multiplier with and without foreign repercussions.
 Learn the working of foreign trade multiplier.
 Identify the global repercussions of foreign multiplier.
 Evaluate the impact of autonomous changes in export and import on national
income.
 Analyse in detail the automatic adjustment mechanism.

2. Introduction

Introduction to the adjustment mechanism

The equilibrium level in any economy is defined by the equation Y = C+I+G+(X-M). But
there might be autonomous changes in any of these parameters which creates
disequilibrium. In response to this disequilibrium, the automatic adjustment mechanism
works through the multiplier technique to bring induced changes in the level of national
income. The multiplier technique is an application of Keynes in which output changes by
a multiple of change in autonomous parameter. It is the most effective technique in
dealing with changes in planned investment or changes in exports upon national income.

In this chapter, we will begin with the study of adjustment to equilibrium in a closed
economy. We will then extend the concept to equilibrium in a small open economy. The
concept is then further extended to include foreign repercussions which arise when
nations are not small. When nations are not small, there is a feedback effect which creates
repercussions on the first nation.

3. Adjustment to equilibrium in closed economy

3.1 Equilibrium Output in closed economy

The equilibrium in an economy is defined at the point at which planned aggregate

expenditure is equal to aggregate output. To keep the analysis simple, we will not include
the role of government sector into the model.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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Planned expenditure is the total expenditure by households on consumption plus the

desired investment expenditure by firms i.e. Y = C + I. On the other hand, planned
aggregate output is either consumed or saved and this remains true even if we are out of
equilibrium i.e. Y = C + S.

If in equilibrium, planned expenditure is equal to planned output, the equilibrium

condition can be restated as : C+I = C+S

Which finally gives us , I = S.

Hence, the equilibrium level of income is determined at the level at which planned
savings is equal to planned investment. This also defines the level at which leakages out
of the economy in the form of savings is exactly equal to injections in the form of
investment. The equilibrium in a closed economy can be seen graphically as below-

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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(Figure 1)

In the first panel, 45˚ line serves as the reference line where output and expenditure are
equal. On that we have imposed planned expenditure line Y=C+I. The point at which the
two lines intersect represents the equilibrium level of income E.

In the second panel, savings and investment levels of the economy are represented and
the equilibrium level E in the above panel is translated into the below panel at the point
where S=I.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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The diagram above also helps us to understand the adjustment mechanism. Any deviation
from the equilibrium level would create disequilibrium and hence calls for adjustment. If
for any reason there is a change in planned investment, it will shift the equilibrium point.

Let us consider the case where planned investment by all the firms in the economy rises.
This will shift the planned expenditure line upwards in a parallel manner by the amount
of new investment. The new line is C+I’ which intersects the 45˚ line at E’. This point
can be seen in both the panels of the diagram.

Due to an increase in investment, the equilibrium output in the economy rises. When
output rises, people spend this increased output. The increased consumption spending by
consumers signals firms to accumulate more inventories and make more investment. This
generates more income which is spent further on goods. This cycle goes on till we reach
the new equilibrium point at which spending is just equal to the output produced. The
process does not go forever because every time income is increased, only a part of it is
spent. A part of increased income is saved too which acts as leakage until the equilibrium
is restored. This process of a unit increase in investment creates multiple rounds of
increase in income which is known as the multiplier.

3.2 Multiplier in closed economy

An increase in investment leads us to the new equilibrium where savings equalize to the
new level of investment. This additional savings created is equal to the additional
investment in the equilibrium i.e. ∆S = ∆I.

∆S = MPS X ∆Y (a fraction of income is saved)

∆Y = ∆S / MPS

Also, ∆Y = ∆I / MPS (since ∆S = ∆I)

Hence, multiplier (k) i.e. ∆Y/∆I = 1/MPS = 1/1-MPC

In the closed economy, multiplier is equal to the inverse of marginal propensity to save.
Any autonomous change in economy changes the output by the multiplier times the
autonomous change.

4. Adjustment to equilibrium in a small open economy

(We will first consider the case of small open economy where the small economy is small
enough to have any effect feedback effect on the national level of income. The analysis
will then be extended to include foreign repercussions.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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4.1 Planned expenditure in small open economy

For analyzing planned expenditure in open economy, we should include the goods and
services produced for the rest of the world i.e. exports and exclude those what we import
from the rest of the world. Exports are included because they represent domestic
production whereas imports are excluded because they are not a part of domestic output
produced.

The equation thus becomes- Planned Expenditure = C+I+G+X-M (X-M together

represent net exports)

4.1.1 Import Function

Imports are determined on the level of domestic national income. When income rises,
imports also rises since people spend their increased income on various goods and
services which also includes goods and services produced abroad. In this case, imports
become a function of national income and hence can be written as a function of national
income i.e. M = mY where m is the marginal propensity to import.

m, marginal propensity to import (MPM) is the change in imports caused by a unit

change in income i.e. m= ∆M/∆Y It is a positive umber less than one so that a unit
increase in income changes imports by less than one unit. We assume exports to be
exogenous for time.

4.2 Equilibrium Output in an open economy

Equilibrium is defined at the level where planned expenditure is equal to the total output,
where Y = C+I+G+X-M.

Retaining the assumption of no government role, the above equation can be restated as :
Y-C+M = I+X
S+M = I+X

This is the leakages = injections condition under open economy equilibrium.

Rearranging the above equation, we get S = I+(X-M). (X-M) represents net exports or net
foreign investment. Hence, total savings in the economy is equal to the domestic
investment plus foreign investment. If the term is negative, it means there is net import
which implies there is foreign disinvestment.

4.3 Multiplier in small open economy or Foreign Trade Multiplier with no

repercussions

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
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From the equilibrium condition, we know S+M = I+X.

Hence, the following will be true: ∆S+∆M = ∆I+∆X

We know ∆S = MPS (∆Y)

and ∆M = MPM (∆Y)

Substituting in the equation, we get MPS (∆Y) + MPM (∆Y) = ∆I + ∆X

(MPS + MPM) (∆Y) = ∆I + ∆X
∆Y = 1 (∆I + ∆X)
MPS + MPM

Hence, foreign trade multiplier with no repercussion effects (k’) i.e. ∆Y/ (∆I+∆X) =
1/MPS+MPM = 1/1-(MPC-MPM).

5. Foreign Repercussions or Feedback Effect

The above analysis was one of simple trade multiplier based on the assumption of
small open economy. But economies in international trade are linked to each other. A
nation’s exports or imports affect not only its domestic level of income but also other
nation’s income level.

We will analyse in detail the effect of any autonomous change on national income. We
will study the effect of change in exports and change in investment and what
repercussions it create in case of open economy. We restrict the analysis to two-nation
world - Nation 1 and Nation 2.

5.1 Feedback effect from autonomous change in exports

Suppose Nation 1 exports increases. This means Nation 2’s imports rises. This effect
works through two channels.

Channel 1 of feedback effect - Nation 1 exports increases. Its income increases and as
income increases, nation’s imports increases too. This increase in imports of Nation 1
means Nation 2’s exports have risen leading to an increase in Nation 2’s income which
causes its imports to rise. As Nation 2’s imports rises, it means Nation 1’s exports rises
creating another round of increase in income and increase in imports.

This process gets repeated between the two nations as described above.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
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Figure 2

Channel 2 of feedback effect- Initial increase in Nation 1 exports leads to rise in imports
of Nation 2. This leads to reduced incomes and hence reduced imports of Nation 2. As
imports of Nation 2 decreases, Nation 1’s exports decreases reducing its income and
further imports. Decline in imports means corresponding decline in exports of Nation 2
and decline in its income and imports. This process also gets repeated back and forth
creating repercussions of an initial change in demand.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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Figure 3

From the above account, it is seen that an initial increase in exports of Nation 1 creates
repercussion effects which feeds back into itself.

Channel 1 works at increasing income which is reduced by the negative feedback effect
working through channel 2. The final effect is summarized in the following value of
multiplier-

k’’ = ∆Y1 = 1
∆X1 MPS1+MPM1+MPM2 (MPS1/MPS2)

MPS1 and MPS2 refer to marginal propensities to save of Nation 1 and Nation 2
respectively. Similarly, MPM1 and MPM2 are the values of marginal propensities to
import of Nation 1 and Nation 2.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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This value of foreign trade multiplier includes repercussions effects which is reduced due
to the negative feedback working reducing the total value of multiplier as compared to
the simple foreign trade multiplier k’.

5.2 Feedback effect from autonomous change in investment

Suppose Nation 1’s investment rises. An increase in investment leads to an increase in

income which increases its imports. There is only one feedback working in this case. As
imports of Nation 1 rises, Nation 2’s exports rises increasing its income and its imports.
An increase in imports of Nation 2 implies increase in Nation 1’s exports leading to its
increase in income and exports again. This process continues to work expanding exports,
incomes and imports in both nations.

Figure 4

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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The final value of multiplier changes in this case to be-

k = ∆Y1 = 1 + MPM2 / MPS2

∆ I1 MPS1+MPM1+MPM2 (MPS1/MPS2)

Here again MPS1 and MPS2 refer to marginal propensities to save of Nation 1 and Nation
2 and MPM1 and MPM2 are the values of marginal propensities to import of Nation 1 and
Nation 2 respectively.

Since there is a positive feedback working only in this case, the multiplier effect of initial
increase in investment would be higher than in the case of simple trade multiplier and the
feedback model of exports. Feedback model of exports had a contractionary effect
simultaneously working to reduce the national incomes in Nation 1 and Nation 2.

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS
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6. Summary
 The automatic adjustment mechanism works through the multiplier technique to
bring induced changes in the level of national income in case of disequilibrium.
 The equilibrium in an economy is defined at the point at which planned aggregate
expenditure is equal to aggregate output.
 Planned expenditure is the total expenditure by households on consumption plus
the desired investment expenditure by firms i.e. Y = C + I. On the other hand,
planned aggregate output is either consumed or saved and this remains true even
if we are out of equilibrium i.e. Y = C + S.
 In the closed economy, multiplier is equal to the inverse of marginal propensity to
save. Any autonomous change in economy changes the output by the multiplier
times the autonomous change.
 Planned Expenditure equation in the open economy changes to C+I+G+X-M.
 Imports are determined on the level of domestic national income. When income
rises, imports also rises.
 Foreign trade multiplier with no repercussion effects (k’) i.e. ∆Y/ (∆I+∆X) =
1/MPS+MPM = 1/1-(MPC-MPM).
 In open economy, the nation feeds back onto itself and creates repercussions.
Considering these repercussion effects, the value of multiplier changes.
 Feedback model of exports has both expansionary and contractionary effect
leading to a reduction in the value of multiplier to k’’ = ∆Y1 =
1
∆X1 MPS1+MPM1+MPM2 (MPS1/MPS2)
 Feedback model of investment has only expansionary effect working which raises
the value of multiplier higher than the simple trade multiplier to
k’’ = ∆Y1 = 1 + MPM2 /MPS2
∆ I1 MPS1+MPM1+MPM2 (MPS1/MPS2)

ECONOMICS Paper 13 – INTERNATIONAL ECONOMICS

Module 28 – FOREIGN TRADE MULTIPLIER AND ITS
REPERCUSSIONS