\"Starting from an initial position of equilibrium with X – M =0, an economy exp
ID: 1194881 • Letter: #
Question
"Starting from an initial position of equilibrium with X – M =0, an economy experiences income growth. If this growth is due to an autonomous increase in investment, then the balance of trade will move into a deficit, while if it is due to an exogenous increase in exports then the balance of payments will display a surplus, although the surplus will be less than the initial increase in exports.”
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Explanation / Answer
According to the fact that disposable income is either saved or consumed we have the Y = C + S + T.Now the aggregate spending in the economy is given by Y = C + I + G + (X - M).Thus equilibrium requires aggregate spending must be equal to income.Hence
C + S + T = C + I + G + (X - M)
Solving we get
X - M = (S - I) + (T - G).
The above identity clearly states that a trade deficit is one to one reflected in an internal deficit or an internal deficit(public G>T or private I>S) is one to one reflected via the trade deficit.
Thus when income increases through an increase in investment while savings , goverment spending and taxes remaining same this creates an internal deficit which needs to be reflected via a deficit in balance of trade.Thus the balance of trade which was intially in balance nows shows a deficit.
However if rise in income is due to a rise in autonomous exports , the balance payments will clearly depict a surplus as X - M is positive.However imports are not autonomous , rather they are always in proportion to income(M = A + mY where A is the autonomous component and m is the marginal propensity to import) .Thus higher income emplies a higher level of imports .Hence the (X - M) rises due to a hike in exports but as imports also rise due to a rise in income the surplus in balance of payments is lesser than the initial increase in autonomous exports.
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