ts and
:BOP. Leson- 19
losses
o involve
vade the FOREIGN TRADE MULTIPLIER
1ere may
T, direct cONTENTS
and not
does not 19.0 Objectives
:to grips 19.1 Introduction
solution
le where 19.2 Working of Foreign Trade Multiplier
Ba BOP 19.3 Foreign Repercussion on Backwash Efect
ols.
9.4 Criticism
1sists of 19.5 Application of Foreign Trade Multiplier to UDCs
of policy 19.6 Summing up
enditure
Lve to be 19.7 Key Terms
19.8 Self Assessment Exercise
19.9 Suggested Readings
19.0 Objectives
After going through the lesson you will come to know:
About the working of the foreign trade multiplier,
About the backwas' effect, and
icies to
The application of the foreign trade multiplier to UDCs.
19.1 Introduction
The foreign trade multipier, also known' as the export
investment multiplier of Keynes. It-may be defined as the amount multiplier, operates ike the
income of a country will beTäised by a unit increase in domestic by which the national
investment on exports.
19.2 Working of Foreign Trade Muitiplier
As exports /ncrease, there is an increase in
export industries. These, in turn, create demand forthegoods.
income of all persons associated with
marginal propensity to saye MPS) and th¹ marginal propensity But this is dependent upon thèir
|hese two marginal propensities are the' larger will be the to import (MPM). The smaller
rersa. The foreign trade multiplier process can be explained value of the muitiplier, and vicë
the country increase. To begin with, the exporters will sell like this. Suppose the exports of
nd receive more income. In order to meet the foreign their products to foreign countrics
0f production to produce more. This will raise the demand, they will engage more factorj
income of the owners of façtors of
production. This procss will continue and the national income increases by the
uultiplier. The value of the multiplier depends on the valúe of MPS and MPM, value of the
averse relation betweeh the twopropensities and the export there being an
multiplier.
236
The foreign trade
multiplier can be derived algebraically as follows:
The national incomne,
identity in an open economy
y=C+ +6+X-M Y-C++X-M 5
where Yis national
exports and Mis imports. income, Cis national consumption, Iis total investment, Xie
The above
relationship can be solved as:
Y-C=I +X-M
S=I+X- M(: S= Y- C)
S+ M=|+X
Thus at
equal the sum ofequilibrium levels of income the
investment and export (1 + X). sum of savings and imports (S + M) mtst
n
1) and foreignopen economy the investment (D
investment () component is divided into domestic
investment
Foreign-investment (L) is the difference
services. between exports and
imports of goods and
I =X-M
Substituting (2) into (1), we have
...(2)
I,+X- M= S
which is the equilibrjum I, +X= S+ M
trade multiplier
coefficient (K) iscondition of
equal to national income in an open economy. The
AY foreign
K,=
AX
and
AX =AS+ AM
Dividing both sides by Y,
we get
AX AS + AM
AY
Or AY AY
AS + AM
4Y
K= AS+AM
AX
237
1
K,= AS AM (:: Dividing by aY)
AY AY
1
Hence
K=
MPS + MPM
Let us understand it with the help of an
example.
ust Suppose MPS = 0.3, MPM = 0.2 and AX (increase in exports)
Ra. 1000 crores, we get
AY 1
ent K=
AX MPS + MPM
1
or AY = AX
and MPS + MPM
1
x 1000 = Rs. 2000 crores
0.3 + 0.2
It shows that an incrase in
through foreign trade multiplier by [Link] by Rs. 1000 crores has raised
2000 crores, given tie values of MPS national income
ign Assumptions and MPM.
The foreign trade multiplier is based on
1. There is full employment in the following assumptions
the domestic economy.
2. There is direct ink between the
importing oods. domestic and the foreign country in exporting
and
3. The country is small with no
4. It is on a fixed foreign repercussion effects/Backwash effects.
exchange rate system.
5..The multiplier is based on
6. There is no instantaneous process without time lags.
accelerator.
7. There are no tariff barriers
8. Domestic investment (T) and,exchange controls.
remains constant.
9 Government expenditure
is constant.
Diagrammatle Explanation
Given these assumptions, the
where S(Yn is the' saving equilibrium level in the economy is showa in
function and
Tepresents domestic investment and I, + (SX + M)Y is th» saving plus import [Link] A,
|M)Y end I, +Xfunctions determine the exports plus domstic I
the equilibrium level of national investment. The (S +
Where savings equal doimestic income OY at point E,
investment and exports equal imports.
PAN EL A PANEL B
po &ive eltet (Nogalive eltet)
Savir
inprs inma
ldtx!
ÎNvestt duad
demad
(SnE
(snefA )}
MATIOWA L
If there is a shift in the ld+X function due to
increase in domestic
investment on exports, national income will increase from
Yo to Y1, The
change in the level of national income is more than
the change in level of
domestic investment on exports, it is due to positive
operation of multiplier
effect, it can be known from panel Aabove . Lesser
the marginal propensity to
imports (MPM) and more the marginal propensity to
consume (MPC), more
will be the effect of multiplier.
The functioning of multiplier in negative
(reverse) direction can
understand through panel B above. If there is a shift in the ld+X1 function
due
to decrease in domestic investment on
exports, national income will decrease
from Y1 to [Link] change in the level of national income is
more than the
change in the level of domestic investment on exports, it is
due to reverse
operation of multiplier effect.
239
would excèed savings by ds. The eyel of national incoth is reduced from oY to OY,
This is the reverse operation of the breign trade multiplier.
Tablo 1
County A Couty B
ational
income
by sd, and so on
ibrium
19.3 Foreign Repercussion or Backwash Efect
The above analysis of the simple foreign trade multiplier has been studied in the
case of one small country. But, in reality, countries are linked to each other indirectly
also. A country's exports or imports afect the national income of the other country
which, in turn, afects the foreign trade and national income of the first country. This
is known as the Foreign Repercussion or Backwash or Feedback Effect. The smaller the
country is in relation to other trading partner, the negligible is the foreign repercussion.
But the foreign-repercussion will be high in the case of a large country because a
change in the-national inccme of such a country will have significant foreign
repercussions or backwash effects. Assuming two large countrics A and B where A's
imports are B's cxports and vice versa. An increase in A's domestic investment will
cause a måltiplier increase in its income. This will increase its imports. This increase
in Å's imports will be increase in B's exports which will increase income in B through
B's foreign trade multiplier. Now the increase in B's income will bring an increase in
its imports from country A which will induce a second round increase in A' income,
and -so on. This is explained in Table 1. When autonomous domestic investiment
increases in county A, Its national income increases (+ Y), It induces country A to
L, + X import-more from country B. This increases the demand for country B's cxports (X+)
estrment
Consequently, the national income in country B increases (Y +). Now this country
imperts more (M + )from country A. As the demand for country A's exports incroascs
240.
(+X), its national income (+ Y) increases further and this country imports more M)
(+ M
from B country. This process will continue in smaller [Link] are the foreign r e i g n
repercussions or the backwash effects for country A which will peter out and dampen mpe
the effects increase in the original autonomous domestic investment 1
n country A.
The formula of foreign trade multiplier with foreign repercussions'
tor country A is
1 + (MPM,/MPS)
K, =
MPS, + MPM, + MPM, (MPS,/MPS)
The stages of foreign repercussions shown in the above table are explained in
Figure 4 Panel , II and III. In stage I. domestic investment in country A
increases from
, to in Panel I. This leads to an upward shift in the I, + X curve to
, + . As a
result, the new equilibrium point is at E. which shows an increase in the national
income from OY to 0Y, As the national income increases, the
demand for imports from
COuntry Balso increases. This means increase in the exports of
country B. This is
shown in Panel I when the I, + X schedule of country B
shifts, upwards as + X
Consequently, the national income in country B increases from OY, to OY' at the higher
cquilibrium level E: As country B's income increases; its demand for imports from
country A also increases. This, in turn, leads to the backwash effect in the form
of
increase in the demand for exports of country A. This is shown in Panel II
where the
La, t X curve (of Panel I) further shifts upwards to I,, + X, and
income increases further from OY, to OY,
consequently the national
.(S M) Y
EA-a+X Pánel lI
Country - B
(S+ M) Y Yor
E4 lg +X Panol
CountryA
Panel ul
Country A
YY. -
YY
Natlonal. fnicomo
FIG.4
This shows how the foreign repercussions in one country
afect its own national
income and that of the other country which, in turn, again
affects its own national
income through the backwash effects with greater force.
1. For students interested in working out the formula may consut Bo
Pp. 544-46, Sodersten and G. Reed, op. cit.,
241
Implications of Foreign
Repercussions
The following arc
M) the implications of foreign repercussion effects:
reign 1. The foreign repercussion cffects suuggest a mechanism for the transmission of
mpen ncome disturbances between trading countries. If a country
ry A. is small, it will be afteCtel
0y change in income of other countries, that will
A is alter the demand for lts exports. But
t Wll not be able to transmit its own
income disturbances to the latter. I a country
S large, 1t may transmit its own income disturbances to
De atfected by income disturbances in thenm. It other countries end, in turn,
implies that a boom or alump in one
cOuntry has repercussion on the incomes of other
cycles are likely to be internationally contagious, 'ascountries. Thus swings in business
ed in happened in the 1930a,
from 2. The repercussion effects also suggest that since
peter out, automatic income changes cannot the backwash cflects ultimately
As a eliminate completely the current account
ional BOP deficit or surplus-produced by an
automatic disturbancç.
from 3. The policy implications of the
is is policies raise national income in the backwash effects suggest that export promotio1
+ X,, increase in domestic investment. The trading partners at a lower rate than by an
igher via the simple foreign trade export promotion measures raise
rational income
from policies raise national income multiplier, whereas increase in domestic investment
effects. many times in multiplier
a of rounds,via the repercussion
: the
Cr
ional Criticism of Foreign Trade Multiplier
The two models of the
certain assumptions which foreign trade multiplier presented. above are
make the analysis based on
1. Exports and unrealistic.
trade multiplier is basedInvestment not Independent : The
and foreign) are on the assumption that exports and analysis of simple foreig11
this is not só. Aindependent of changes in inyestment (both domestic
rise in exports does-not the level of national income. But, in
On the contrary, always 'lead to reality,
national income. certain imports, of say,capital goods, haveincrease in national income.
the effect of
2. Lagle[s increasing the
process whereby itAnalysis :The foréign trade
supplies the inal [Link] is assumed to be an
3..Full Employment not Thus it involves no
lags and is
instantäneous
a fully employed Reallstic : The analysis is unrealistic.
economy.
Thus the foreign trade But there is less based on the
Dnal less than full muitiplier does not findthan full employment in
assumption of
i Dnal employment. clear expression in every economy
an economý
4. Not Applloable with
to a two-cOuntry to More thAn
model. If there are two Countrles : The whole
more than two analysis is applicable
countries, lt becomes
GomplcatGd
242
to analyse and nterpret the toreign repereussions of this theory
S. Neglects Trade Restrietions : The foreign trade multiplier asatumes that there
are no taritt bariers and exchange controls. In reality, such trade restrictions cxis : 19.
which restrict the operations of the foreign trade multiplier.
6. Neglects Monetary-Flscal Measures : This analysis is based on the unrealistig
fcct
assumpt0n that the government expenditure is constant. But governmenta alwaya the
intertere through monetary and fiscal policies which afect exports, imports and national pro
income.
19.
Despite these shortcomings, he forcign trade multiplier is a powerful tool of
eonomice analysis which helps in formulating policy meASUres.
19.5 Applicatiou of Foreign Trade Multiplier to Under-developed Countries (UDCs)
The foreign trade multiplier has important implications for UDCs. The value of 19
this multiplier helps in implementing various policies. It is particularly important in
those conomies where the contribution of foreign trade in national income is high. 19
1. Basis for Export Promotlon Polcies : The foreign trade multiplier supports
cxport related policies in UDCS, It is through the export multiplier that a country can
increase its national income many times. But it does not meen that imports should be
reduced to increase exports. Prof, Lewis opines in this context that to make the export
sector leading and developed, it is essential to adopt the policy of import substitution.
In this way, both the sectors are complementary to cach other.
2. Improvement in Balance of Payments : UDC are always faccd with the BOP
deficit. Under such a situation, the current account BOP can be improved by increasing
exports. Moreov"r, by increasing domestic investment, UDCs can bencfit through the
repercuseion or backwash effects.
3. Incentive for Domestic Industries : By providing incentives to domestic
industrics for exports, the government can increase income by multiplier times through
the export multiplier.
4. Encouragement to Foreign Investment : Mostly goods are imported from
abroad in UDCs. To cut down imports and manufactureiimport substitution goods, the
governments of such countries encourage foreign inyestment. Foreign investors set u
import substitution industries in UDCs which are also exported in the long [Link]
the increase in exports help in raising national income multiplier times in suclh
countries.
2 WA. Lewis. Tata Memorial Lecturs. 1973.
S. Panhaa
BATI (Eo Hons)