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Foreign Trade Multiplier
Welcome friends to the 13th lecture of our course International Business. So, in the lastclass, we started discussing about a new concept called Multiplier Effect. Now, what isthis effect? If we have like we try to understand, multiplier effect is a very simpleconcept which says that whenever there is a case of depression or a potential recessiongoing to come and the economy is not doing well. Then, as per Keynes, he suggested thatthe government should interfere and inject money invest money into the system.So, that when the government invests right. So, when the money comes into the system,it has a multiplying effect. Now, why is the multiplying effect happens? Because forexample, if the government spends money on roads, construction of roads, let us say youknow construction of buildings and real estate development etc.So, automatically, the people start getting more jobs right and as people start gettingmore jobs and even you know the companies start producing the raw materials that thecomponents and all required for the real estate business example or the auto componentbusiness etc.(Refer Slide Time: 01:47)So, what happens is on two fronts; one side the people start getting more wages right oryou know their income grows right and other side, the plants start functioning which alsogives rise to employment right employment. So, in total; so, the employment comesthrough wages. The wages comes through employment only.So, because of this increase in this income of people. So, now, the people tend to spendthis income in some other ways. For example, they spend in going watching a movie,they spend in buying snacks, you know which earlier they would not have done. So, asthis money is spent.So, automatically, this to the demand for products rises right. So, as the demand for theproduct rises, there is automatically a good sign for the company’s right, who areproducing these products. For example, if more if the government gives us when the letus say the pay commission happens and we get a bonus or you know an extra money. So,most of the time, it has been seen that there is suddenly rise in the sales of cars of twowheelers and even refrigerators, consumer durable items.So, what happens is because of the extra disposable income, people tend to spend it onitems and goods that they feel are necessary for them and as a result, the company startproducing and they in the in their turn start buying raw materials and entire you know thewhole economic cycle becomes more active and it runs more faster right.On the other hand, when the economy is in a state of recession or depressed. So, in suchcondition, what happens? People become more scared and they try to save the moneyand they thinking that it might be required in the future.So, the future is uncertain. So, what they do is they try to save the money as much aspossible. And as a result of it, what happens? The money does not circulate and as themoney does not circulate, the demand for production goes down and as the demand forproduction goes down, the companies do not feel any need to produce the inventory.Because then it they understand it would be only you know hoarding of or waste of theinventory since it is not getting sold. So, for example, right now at the moment, when Iam discussing you must be knowing that in India, many of the auto companies. Forexample, Mahindra has announced that it would shut its plant for 17 days right. Someother auto component plants have shut their operations for since the last 10-15 days. Oneof them is the Jamna auto what I am saying.So as a result, in this condition, when the economy is in a dim state, so the governmentneeds to Keynes had suggested that the government needs to interfere and inject moneyso that people have more disposable income with them and they can start consumingmore. And more the marginal propensity to consume, the MPC, higher is the multipliereffect and when the marginal propensity to save is more, then lower is the multipliereffect right.(Refer Slide Time: 05:11)So, in the last class, we also discussed about the employment multiplier given by Kahn.So, and the next was we are discussing about the Foreign Trade Multiplier. Foreign trademultiplier I had said was given by Leighton right. And he said, there are a fewassumptions while you talk about foreign multiplier.What is foreign trade multiplier? It is a amount by which the national income of acountry will be raised, will grow by an unit increase in the domestic investment onexports. Now, suppose the government invests in the exports in improving the exports ofa of the country. Then obviously, we will get more money and this increase in flow ofmoney will help in increasing the national income right.So, this helps in the further you know running of the business and the economy becomesmore stronger right. So, this is called as an export multiplier. Now, the concept of foreigntrade multiplier was given by Leighton as I said and it is based on following assumptionswhich we discussed in the last class just to brief you again. The assumptions are it saysthere is already full employment in the domestic economy. So, if employment is notthere full, why it is being said? If there is no full employment in the domestic economyand people are; so the point is that how do you put in invest make investments in theexports right.Because you need to first understand that theevery person in a in the country is employedand he is having such some source of income. It also says that there is a direct linkbetween domestic and foreign country right which we have discussed about in themobility theory and trade theory right in exporting and importing goods. So that means,there is a free you know, trade you can understand that way.So, it is then he says it is a fixed or a static exchange rate system and not a dynamic orvolatile right which is again not true because the money, the in the market the moneymarket it changes so rapidly right. So, all the time the Dollar and the Rupee, the Yen andall they change their value very very fast right.So, it is it cannot be all that is a fixed exchange rate system; but for the to make itsimpler and easy to understand, it has been assumed to be fixed which is not exactly true.It says there are no tariff barriers, but again that is wrong. There are tariff barriers; thereare lot of tariff barriers, where tariff and non tariff barriers to have a control right, to savesometimes a domestic business people. The domestic industries and all and it assumesthe government expenditure is constant. But again, that is not true, that changes; all thesealways a fluctuating.(Refer Slide Time: 07:54)So, how does this foreign trade multiplier work? As exports increase, there is an increasein the income of all the people associated with the export industries and that createsdemand for the goods right.So, when you know the export increases, people get more income. They want to youknow consume something more, they want to spend this money on something, someother items right and this creates a demand for the for those goods; as I said refrigeratorright, computers, today laptops, mobiles you know. So, mobiles, car, maybe twowheelers, so, two wheelers right.But, this is dependent upon their marginal propensity to save, what it is based on; what itdepends upon? How much they want to save now and the marginal propensity to import.Now, there are two things if you see; save, now if the idea behind saving which is largelythere in India. For example, the Indian you know mindset of the Indian economy runsbasically largely on a saving mindset. So, we tend to save.So, you must have I am not talking about the black money and the hoarding of money;but I am saying in a simple plain if a normal human being also an Indian would like tosave the money as much as possible and try to reduce its consumption as far as possible.They do not want to spend too much because they feel it is a waste of money; butactually economics does not say that; economics says the more you tend to save, the lessthe money flows into the economy and therefore, there will be lesser demand of goodsand services. And thus, there would be lesser production and this lesser production, thenthis lesser production will require lesser employment and lesser employment againcomes down to lesser income right. So, if you are saving, in one way you are hurtingyourself that is what is a chain reaction right. When the value of these two marginalpropensities. The other one is the propensity to import and how much you want to importand when does one import?One would import when one wants to have some items which are not available in thelocal market and or it is cheaper in the other market. So, they would like to import thoseitems right. what it says is when the value of these two marginal propensities are smallthat means, the marginal propensity to save, you do not save much and the marginalpropensity to import. So, you do not want to import much, when these two are small;then, the value of the multiplier will be large that means, if export is sufficiently morethan import and consumption is more than saving, then this will be have a largermultiplier effect ok.(Refer Slide Time: 10:42)The foreign trade multiplier is equal to the reciprocal of marginal propensity to saveright plus the marginal propensity to import; now this one. So, what it is saying? It is thereciprocal, 1 by the marginal propensity to save MPS divided plus the marginalpropensity to import MPM right. It shows an indirect relationship that smaller the valuesof marginal propensity to save and marginal propensity to import right leads greater thevalue of foreign trade multiplier. So, we understood. So, the more you want to save, thelesser the money goes into. So, similarly, if you if you export more than more moneywill flow in and if you import, then the money will go out. It is as simple as that.So, the lesser the money goes out and the lesser is the money is saved and not consumed,then it and then consumed, then higher is the multiplier effect right foreign trademultiplier effect. Now, what is this MPS? We have already understood MPS is thechange in saving divided by the change in income right. So, change in saving divided bythe change in income and what is MPM? The marginal propensity to import is thechange in imports divided by the change in income ok.(Refer Slide Time: 11:58)Now, let us do this. Let us give an example. Calculate the foreign trade multiplier, ifMPS=0.2 and MPM=0.2 and second case MPS=0.3 and MPM=0.2. Now, just do it onyour notebook, using this formula. Just do it and tell me what is the result right ok.(Refer Slide Time: 12:19)(Refer Slide Time: 12:25)Now, this is what happens. So, the multiplier foreign trade multiplier is 1 by 0.2 plus 0.2;so, that is 2.5, right. In the second case, you see when the marginal propensity to savewas higher, when people started the tendency to save became higher. Obviously, thetrade multiplier effect although this was constant, the trade multiplier effect waschanging low. Now, let us take a third case. For example, the marginal propensity to saveMPS is equal to 0.3 and MPM also becomes 0.3. So, what is the change now?So 1 by 0.3 plus 0.3 that is equal to 1 by 0.6. That is equal to how much? So, six ones are6 (Refer Time: 13:12) six sevens are almost 6 6. So, 1.67. So, you see that again comesdown right and as the foreign trade multiplier comes down, that means, it is not a veryhealthy sign right.(Refer Slide Time: 13:23)Now, there are two conditions when the economy is a closed economy or when theeconomy is an open economy. So, what is a closed economy condition? A closedeconomy condition is when the domestic players are given more importance and the youknow the tendency to of the government and the trade policies are more stringent, youcan say stringent or more closed, you can understand that way.So, what it says in the closed economy, you know the policies are more restrictivepolicies. In a closed economy, the total national income is equal to the sum total of theprivate spending right.So, private spending is the C + I, I have explained everything, let me go through it andthe government spending. It represents the expenditure of the total national income of thecountry. So, algebraically, total national income the national income is equal to the totalconsumption expenditure right C + total investment expenditure right I, then thegovernment expenditure right; so, three things. So, my income right income is equal toconsumption expenditure + investment expenditure + government expenditure rightgovernmental expenditure.(Refer Slide Time: 14:46)Now, these three things will totally tell me my income. But the problem is in the closedeconomy the government does not follow the rules of economics right. So, there is nofree trade and all in a closed economy, its role is omitted. This is a very important line.The government’s role is removed from there. Hence, the national income will be equalto Y= C + I because G is equal to is 0, it does not exist now.Saving function expresses the functional relationship between saving and the level ofincome which is a function of Y. S is equal to saving is a function of Y. So, how you aresaving it will depend on how much you have you are earning right, your income, what isyour income.So, saving is defined as the excess of income over consumption right. So, how much youhave you are earning and income minus what is your consumption that is your saving,that is what you saved right. So, symbolically, S is equal to Y-C, income minusconsumption.So, what it is saying is generally as the level of income increases right. So, the income isincreasing, saving also increases and vice versa. So, if the income is increasing, myconsumption remains the same, consumption is not. Hoping that consumption remainsthe same, then my savings also increases.(Refer Slide Time: 16:16)But if my consumption also changes, then saving also will accordingly change.Algebraically, you can see Y = C, consumption + investment expenditure and on theother hand, Y = consumption + saving. Now, Y stands for the total national income, Cstands for the total consumption expenditure, I stands for the total investmentexpenditure, S stands for the saving.So, if I take these two equations, what do we get? Consumption + investmentexpenditure is equal to consumption + savings. So, if we strike off these two across theirboth the sides, then I = S. That means, my investment is equal to my saving. Keynesmultiplier depends upon the marginal propensity to consume. So, it largely focuses onthe marginal propensity to consume. How much you want to consume? How effective,how much the consumption is growing?(Refer Slide Time: 17:23)So, K the multiplier right is a function as per Keynes is a function of the marginalpropensity to consume right ok. So, let us take this numerical. If K the foreign trademultiplier, it says K foreign trade multiplier is the reciprocal of MPS right. So, MPS=delta S saving by the delta change in the income; change in saving divided by change inincome. K = 1 by MPS.So, if delta S change in my income saving is let us say 60 rupees, change in my incomeis let us say 100 rupees, then what is my MPS? Now, this by this; so, what is the foreigntrade multiplier? Now, delta S = 60, delta Y = 100. So, how much it is becoming? So,MPS MPS is equal to zero point sorry 60 upon 100. So, 0.6 right. Now, if this is my 0.6,MPS is my 0.6 right, then what is my what is the value of my MPC. Now, MPC + MPS= 1. So, if MPS is equal to 0.6, my MPC automatically becomes 0.4(Refer Slide Time: 18:42)So, now, that was a case of a closed economy right. Now, let us take this case of a openeconomy now, when the market the economy is more open and free right. So, thatnational income is equal to is Y = C + I. Now, what is C? C is my consumption, I is myinvestment expenditure, X is my export, minus M is my import. So, you see Y-C; if Ibreak it bring it this side is equal to how much? I plus it is I, I think it looks I + X-Mright. So, S is equal to since S is equal to Y-C right. So, S is equal to I + X-M right.So, S + M is equal to I + X. Now, what does it mean? That means, the savings plus theimports is equal to the investment expenditure plus the export expenditure. So, at aequilibrium level of income, the sum of savings and import, when it is a equilibriumcondition must equal the sum of investment plus the export right. So, this is againlooking like a 1. So, in an open economy the investment component is divided intodomestic investment and foreign investment.(Refer Slide Time: 20:22)So, this I, the I is now total I is equal to I d plus I foreign right. So, foreign investmentplus the domestic investment. Foreign trade multiplier coefficient is equal to now deltaY, the change in income upon the change in exports right in a open economy case anddelta X = change in exports = delta S + delta M, savings plus imports. We have seen that.You can go back to the slides, go back across and check it. So, delta S stands for changein savings, delta M stands for change in imports, delta Y stands for change in income anddelta X stands for the change in exports.(Refer Slide Time: 20:53)Let us take a numerical now to calculate the foreign trade multiplier. Let us assume thegiven data that marginal propensity to save is 0.4, the marginal propensity to import is0.4 and there has been a change in exports of rupees 2000 right. So, in this conditionright, calculate the foreign trade multiplier. Now, how do we do it? Try to do it on yourown and let us check then.(Refer Slide Time: 21:20)Now, the formula to calculate is Kf is given by 1/MPS + MPM right. Now, where MPSis my savings, change in savings / the change in income and my change marginalpropensity to import is my change in imports / change in income.So, change in income del Y = 1 / MPS + 1 / MPM into del X which is the change in theexports ok. So, that brings in 1 / 0.4 + 0.4 = 1 / 0.8 that is 1.25 multiplied by the 2000that you have seen here right, this 2000 right. So, that means, 1.25 into 2000 is equal to2500 rupees right, million rupees.So, it shows that an increase in exports by rupees 2000 million has raised the nationalincome through the foreign trade multiplier to rupees 2500 million right. So, and what isthe foreign trade multiplier in this case now? We have 1.25. So, my Kf is equal to Kf isequal to 1.25 and multiplied with the change in export, we get a value of rupees 2500right ok.(Refer Slide Time: 22:41)Now, let us take another problem in which is a case of a open economy case right andeconomy is characterized by the following equations. So, two equations are given; one isthe consumption equation, the other is the import right. So, what it saying consumption isgiven as 120 + 0.9 Y right. So, this is the only the representation form which is a form ofa regression equation. So, which is we say a + b of x right. So, instead of b, I am saying cbecause it is a consumption. So, c and x is my in the x is the independent variable in theregression equation, where here I am keeping the y; the y is the income right.So, 120 + 0.9Y. So, this is just to understand right. So, this is only to understand andsimilarly, I is 20 investment the government is making is the investment is 20, thegovernment expenditure is 20, the exports is 40 and imports is again given as a form in aregression form which is saying 20 + 0.05Y right. Now, 0.05 is again in that similar aform. So, this is not this is just to understand right these are understand. So, 0.05 is myslope. So, this is my slope 0.9 here and this is 0.05 here. Now, what is asking; what is theequilibrium income and what is the value of the foreign trade multiplier?(Refer Slide Time: 24:05)Now, let us go into it. Y = C which is my consumption expenditure consumption +investment expenditure zero point. So, this is consumption is 120 + 0.9 Y + 20 is myinvestment expenditure + G my government expenditure + X my you know exports andminus again 20 - 0.05 Y which is in the form of a equation.So, if I solve this equation, what am I getting? I am getting Y is equal to 180 + 0.85 Y.So, that means, what? Y is equal to if I solve this, I am getting Y, the value of Y myincome is equal to national income is equal to 1200 right. So, I have removed the unitsjust make it unit less.So, what is the value of the foreign trade multiplier in this case? Now, foreign trademultiplier = 1 / 1 - C. Now, C is what? Now, marginal propensity to consume plus themarginal propensity to import.Now, why I put it 1 - C because actually the equation looks something like this 1 /MPS +MPM right. So, but MPS we know = 1 - MPC right, since MPS + MPC is equal to 1. So,taking that into condition that condition, we are saying now the foreign trade multiplier =1 / 1 - C is 0.9 + M is 0.05. So, that gives me the value of 6.67. So, the foreign trademultiplier value is 6.67 right.(Refer Slide Time: 25:45)Now, this is another question. So, what is the value of change in income with the changein exports is rupees 1000 crore and MPS is given to you. Calculate Kf and similarly, 2 34, there are other questions, you can go through it right.(Refer Slide Time: 25:57)So, this is all about the foreign trade multipliers. So, what it is says as the governmenttends to increase the exports, automatically the income of the country will grow right andthat has got a multiplying effect. But foreign trade multiplier has some criticisms alsoagainst it. What are the criticisms? Some of the criticisms are given here, as you can see.The exports and investment which is considered assumes to be independent in theforeign trade multiplier case. Actually, is not true. The foreign trade multiplier is basedon the assumption that exports and investment are independent of changes in the level ofnational income; but in reality this is not so. A rise in export does not always lead toincrease in national income.It might not. So, you if you are if there is a rise in exports, it does not always necessarilysay that in the national income would grow. Full employment is only a ideal situation, autopian situation which is not realistic. This analysis based on the assumption of a fullemployed economy; but there is less than full employment in every economy. So, you goto the at most developed country, there is some unemployment always there also.So, thus the foreign trade multiplier does not find clear expression in a economy withless than full employment. So, that is one assumption which is again works as a criticismagainst state.Not applicable to more than two countries, we are talking about two countries there is arelationship trade between A and B, but the true is, the truth is the whole analysis isapplicable to a two country model. But if there are more than two countries which ishappens in the real life, it becomes complicated to analyze and interpret the foreignrepercussions of this theory because since there are 3 events, 3 countries.So, the you know the there are could be some effects which is not directly visible, butthat has an influence. So, that is not taken care of in the foreign trade multiplier theory. Itneglects trade restrictions, but trade restrictions are a truth that it is prevalent everywherein any type of businesses. So, foreign trade multiplier assumes that there are no tariffbarriers and exchange controls that is not possible. It is it is just an assumption which isnot true.So, this is a criticism again state right. It neglects the monetary fiscal measures. Thisanalysis based on the unrealistic assumption that the government expenditure is constantwhich is again not correct. But government always interferes through some other policieswhich affects the exports and imports and the national income. So, we cannot say that itis a constant effect right.(Refer Slide Time: 28:29)Finally, the effect of acceleration is ignored. It does not take into a consideration thechange in investment, as a result of the change in consumption. In fact, multiplier isinfluenced not only by the investment, but also by the consumption. So, we haveunderstood it very well now.So, it is not only the investment, but how much the people’s consumption pattern ischanging. If the people are going to save more, then the foreign trade multiplier valuewill not increase at all. It will not have a positive effect. If consumption expenditure isincreased, then only the multiplier will continue to work although no such investment isundertaken.Unnecessary importance to deficit financing, now deficit financing is a different conceptwhere we say that it is sometimes necessary to because to create this multiplier effect.The countries can go for a deficit financing and make investments, but this concept whatit is saying is concept of multiplier has given unnecessary importance to deficitfinancing. It says you need to invest.So, if necessary go for a deficit financing. But that minor might not hold true inpreference to many important and appropriate methods. There are other monetary policymethods which can be used to uplift the economy and create a better multiplier effect.So, all the time deficit financing might not be the best solution right. Relation betweenincome and consumption, the assumption of multiplier that MPC (Marginal Propensity toConsume) is less than unity and remains constant is also wrong you know assumption.Because, in fact, relationship between income and consumption is not as simple as it wasassumed by Keynes because it is it has been seen that for example, in the Giffen’sparadox that as the income of people increases, they sometimes move from the obviousgoods and they move into something which are called luxury goods. So, these kind ofrelationships exist which make it very complicated. So, the assumptions do not hold trueright.So, this is all we had today. So, we had today I hope you have understood the multipliereffect and how it affects the national income, how the government in a time ofdepression, recession can think of utilizing you know making investments injectingmoney into the economy create more jobs, more wealth so that you know it has acascading effect, it has a dominos effect and this chain effect will help in the overallgrowth of the economy.But yes, the you know the very the very notion that it should be done at any context at inall context in all conditions, by even go going for deficit financing might not hold trueand may not be the best policy that is available. So, this is all for the day.Thank you very much.