National Income Issues - Essay Example

Running Head: CHAPTERS 5 AND 12 SUMMARY Chapters 5 and 12 Summary In APA Style By Chapter 5 The national income account identity sums up total output in the economy as the total of consumption of domestic goods and services (C), investment in domestic goods and services (I), government expenditures on domestic goods (G) and services and net exports of domestic goods and services (NX or Export - Import). This equation also shows that the spending in an economy is not only comprised of domestic spending: if output exceeds domestic spending, the country exports the difference and net exports is positive; however, if the output falls short of domestic spending, the country is expected to import the difference and net exports is negative. Thus, net exports denote the difference what a country can produce and what it actually consumes. If the output it produces is insufficient to satisfy consumption, investment, and government expenditures, it will tend to source output from other countries. On the other hand, the net capital outflow is the difference between domestic savings and domestic investment while the trade balance is shown as the total amount that the country receives for its net exports. Through the national income identity discussed above, it can be seen that net capital outflow is always equal to the country's trade balance. If the trade balance and the net capital outflow is positive, the country is running a trade surplus which means that it is a lender in the international financial market and that its exports is greater than its imports. However, if it is negative, it is running a trade deficit which means that it is a borrower in the financial market and imports is greater than exports. Following from this, the impact of any policy on the balance of trade can be identified and assessed by considering its effect in the country's savings and investment. Logically, any policy which causes savings and investment to increase supports a trade surplus while one which causes decline in savings and investment will lead to a trade deficit. In order to facilitate transactions with other countries, exchange rates are used. Exchange rate can be simply defined as the price at which resident of each country trades with one another. There are two type of exchange rates: nominal which is the relative price of currency of two countries while real is the relative price of goods of two countries. These two are related in the sense that the real exchange rate is equal to the nominal exchange rate multiplied by the ratio of price levels in the two countries. Thus, if the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. On the other hand, if the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap. The real exchange rate is directly related to net exports in the sense that when real exchange rate is high and domestic goods are less expensive, it is expected that net exports will be greater as domestic goods will appeal more to other countries and exports are higher. Another determinant of real exchange rate is net capital outflow. It should be noted that the equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals to the net capital outflow. On the other hand, since the nominal exchange rate is determined by the prices of commodities in one country compared to the other, the price level is its most significant determinant. Empirical evidence shows that the high level of inflation which makes domestic goods priced higher will tend to cause a depreciating currency. Chapter 12 The Mundell-Fleming model has been recognized as a dominant policy paradigm for the study of open-economy monetary and fiscal policy. It is the same as the IS-LM Model in the sense that both emphasize the interaction between the goods and money market. Also, these models assume that price is fixed while showing what affects short-run fluctuations in aggregate income. The main difference is the assumption of IS-LM model of a closed economy while Mundell-Fleming model looks at an open economy with perfect capital mobility. The aim of this model is to show which factors causes fluctuations in income and exchange rate while holding the price level as constant. Under floating exchange rate (exchange rate is determined by market factors), the Mundell-Fleming model shows that fiscal policy does not affect the aggregate income in an economy. Looking at the repercussions of the policy, a fiscal expansion will tend to cause the local currency to appreciate thereby reducing net export. The decline in net exports however, offset the expected expansionary effect on the economy's income. However, under fixed exchange rate (exchange rate is pegged at a certain level, fiscal policy will be effective in manipulating demand. Alternatively, the Mundell-Fleming model shows that monetary policy will be unable to affect income when exchange rates are fixed. This is caused by the fact that even though the economy can evaluate and devaluate its currency, policy makers will still opt to maintain the announced exchange rate. Thus, any increase or decrease in the money supply will be useless. On the other hand, monetary policy will be effective in influencing the level of income in an economy which has a floating exchange rate. In summary, the Mundell-Fleming model stresses that the power of monetary and fiscal policies to affect the level of income is dependent on the exchange-rate regime that the economy chooses. The attractiveness of a country's currency is tied to the exected return of holding that currency. Investors might therefore be cautious of holding assets in a country because that country may exceed the world interest rate with a risk premium. According to the Mundell-Fleming model, a country with an increasing risk premium will tend to have a currency with higher interest rate. In the future, it is expected that the value of the currency will depreciate. The expectation that a currency will lose its value in the future will start to lose its value today. The Mundell-Fleming model also stresses the advantages and disadvantages of the two exchange rate regimes. Floating exchange rates enables monetary policy makers to pursue other economic objectives except exchange rate stability. On the other hand, fixed exchange rates may not enable policy maker to attain some economic objective but having a fixed exchange rate will mean the stability when undertaking international transactions. This analysis of Mundell-Fleming leads to a special implication for policy makers: it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. Thus, policy makers are resigned to choosing either one of the three options: free flows of capital in order to conduct an independent monetary policy which is currently pursued by the United States; allow free capital flows and to fix exchange rate which is best exemplified by Hong Kong; and to restrict international flow in and out of the country leaving interest to be determined by domestic factors which is the case of China. Read More