Question

Using the information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly. a) Opening the economy to trade tends to increase the multiplier because an increase in expenditure leads to more exports. b) A drop in domestic demand leads to a deterioration of the trade balance. c) A real depreciation leads to an immediate improvement in the trade balance. d) A fiscal expansion, all other factors equal, tends to increase net exports. A decline in income can lead to a decline in imports and thus a trade surplus

Answer 1

a).

The statement in “a” is “FALSE”.

The national income identity in close economy case is given by, “Y = C + I + G” and the multiplier is given by, “1/1-MPC, here MPC < 1. Now, the national income identity in open economy case is given by, “Y = C + I + G + X - M” and the multiplier is given by, “1/1+m-MPC, here MPC < 1 and “m” is “marginal propensity to import”. So, is we compare these values of the multiplier, we can see that the close economy multiplier is more compared to the open economy.

b).The statement in “b” is “FALSE”.

As the domestic demand decreases, => decrease in domestic income given that everything remain same, => given “X=export”, “I=import” will fall down, => “Trade balance” will improve.

c).

The statement in “c” is “FALSE”.

According to the Marshall Lerner condition, depreciation makes the domestic goods less expensive compare to foreign goods, so exports will increase and import decrease, causing an improvement in the trade balance. But, this will take some time. In the short run the relative increase in foreign prices makes the imports more expensive and the trade balance decreases

d).

The statement in “d” is “FALSE”.

“A fiscal expansion” leads to increase in “domestic income”, => given export, import will increase, => “Net Export” will fall.

e).

The statement in “e” is “TRUE”.

“A decline” in income leads to decrease in “import” given the export same, => “trade surplus”.