National Income Accounts and Income Determination in an Open Economy

National income accounts comprise a country’s key macroeconomic variables and provide a complete understanding of a country’s economic performance, income level, and international transactions. National income accounting involves measuring the value of goods and services produced in an economy and the income generated by the components of the economy.

GDP is the market value of all final goods and services produced within a given period of time by the factors of production within a country. GDP can be measured as the total amount of expenditures made by the main components of the economy (households, firms, government, and the rest of the world) during a given period.

In a closed economy (an economy without trade, i.e., exports and imports of goods and services), we have to add expenditures made by households, firms and the government to calculate GDP by expenditure approach. National income identity, formulaizes the calculation of GDP by expenditure approach for a closed economy. This identity indicates that in a closed economy, GDP is the sum of consumption expenditures (C), investment expenditures (I) and government expenditures (G).

Consumption expenditures (C), the largest proportion of GDP, includes goods (durable and nondurable) and household services purchases. In Türkiye, consumption expenditures accounted for 54.9 percent of GDP in 2021.

With the inclusion of interactions with the rest of the world,  national income identity for an open economy write as follows: GDP = C + I + G + X - M X stands for exports which is the purchase of goods and services made by foreigners, and M stands for imports which is the purchase of foreign-made goods and services in the domestic economy.

The Keynesian income model are determined of equilibrium national income in a closed economy. In addition to the closed economy assumption, this also assume that all prices and interest rates are constant and that the economy is not at full employment. The Keynesian income model reflects a short-run macroeconomic situation. In the Keynesian income determination model, the equilibrium level of national income is determined by aggregate expenditure (spending) in the entire economy (Appleyard & Field, 2014). Aggregate spending in a closed economy for a given period of time consists of consumption spending by households (C), investment spending by firms (I) and government spending by central and local government (G).

Keynesian theory of consumption, households increase consumer spending as their income increases, and the most important determinant of consumption spending (C) is income (Y).

In the simple Keynesian income model, investment and government spending are assumed to be autonomous, meaning these aggregate expenditure components are determined by factors other than income.

The equilibrium income level is defined as the equality between the aggregate expenditure (AE) and income (Y) levels of the economy. In order to determine the equilibrium level of income substitute aggregate expenditure (AE) in the equilibrium condition (AE=Y),

that is; Y = C + I + G

Y = a + bY_d + I₀ + G₀

Y = a + b (Y -T₀ + I₀ + G₀) 

Y = a + bY - bT₀ + I₀ + G₀

Collecting all the terms, including Y at the lefthand side; Y - bY = C₀ + I₀ + G₀ - bT₀

Knowing that b = MPC, the equilibrium level of income is;

Y = 1/[(1− b) (C + I₀ +G₀ −bT₀)]

AE0 = C₀ + I₀ + G₀ - bT₀ ,

b = MPC

Y* = 1/(1− MPC).AE₀

Autonomous expenditure multiplier is a key concept that describes how changes in autonomous expenditure (spending) can have a larger effect on income (Krugman & Obstfeld, 2006). From the equilibrium condition, we know that a change in one of the autonomous expenditures would cause a change in the equilibrium level of income. In order to explain the change in the equilibrium level of income after a change in autonomous expenditure, the multiplier concept is used. Autonomous expenditure multiplier, i.e., multiplier (k), is defined as the ratio of the change in the equilibrium level of income (ΔY*) to the change in an autonomous expenditure (ΔAE0).

In a closed economy, there are four multipliers: autonomous consumption multiplier, investment spending multiplier, government spending multiplier and tax multiplier. The autonomous spending multipliers (consumption, investment and government spending) altogether can be called “autonomous expenditure multipliers”.

The real exchange rate and income are two important factors determining a nation’s import level. Imports are negatively associated with the real exchange rate and positively associated with income. Holding the exchange rate fixed, an import function that increases in national income can be defined.

The change in imports associated with a change in income is the marginal propensity to import (MPM).

Exports are the foreign demand for domestic output and therefore, part of aggregate demand. Many factors affect the level of exports, including the relative price levels in exporting and importing countries, i.e., the exchange rate, political and economic relations between countries, tax on trade like tariffs, transportation costs, consumer preferences, etc. However, the main determinant for Turkish exports is the level of foreign income. From Türkiye’s point of view, foreign income and accordingly, demand for Türkiye’s exports are exogenous. Thus, in the simple Keynesian small open economy model, assuming price levels and all other factors are fixed, exports are taken as autonomous.

A low real exchangerate level means that a country’s currency is morevaluable and can buy more goods and services in the foreign country than the foreign country’s currency can buy in the domestic country. From the domestic country’s point of view, currency depreciation impliesan increase in the real exchange rate, and a unit of thedomestic currency will now buy less of the foreign country’s currency or foreign goods and services.Thus, the real exchange rate is a critical economic indicator affecting a country’s trade balance and competitiveness in international markets.

The Marshall-Lerner Condition is an economic concept that explains the conditions necessary for currency depreciation to improve a country’s trade balance.

According to the Marshall-Lerner Condition, depreciation of a country’s currency (an increase in the real exchange rate) will improve its trade balance if the combined price elasticity of demand for its exports and imports is greater than 1. In other words, the trade balance will improve if the sum of the percentage change in the volume of exports and imports exceeds the percentage change in the real exchange rate. The condition implies that if the demand for a country’s exports and imports is relatively insensitive to price changes (i.e., if the price elasticity of demand is low), currency depreciation will not significantly improve the trade balance.

The J-curve effect of a country’s currency depreciation is a concept that describes the short-term and long-term effects of this change on the country’s trade balance. Devaluation (or depreciation) of a country’s currency can improve its trade balance, but this effect is not immediate. J-curve refers to the short-term increase in a country’s trade deficit following a devaluation of its currency, followed by a subsequent improvement in its trade balance in the long run. The term “J-curve” describes the dynamic effect depicting the trade balance against time following currency devaluation or depreciation. In the short run, depreciation causes the price of imported goods and services to increase, i.e., the cost of imports increases. On the other hand, the price of exported goods and services does not change immediately, and they remain unchanged.In the short run, the quantities traded also remain unchanged since there might be lags between the changes in prices and changes in actual quantities exported and imported. Further, as the increase in the price of imports outweighs the increase in the price of exports; the trade balance initially worsens, leading to the first part of the J-curve (Figure 3.5). However, over time, the depreciation of the currency makes the country’s exports more competitive in the global market. Namely, the quantities traded will be adapted by economic agents to the changes in relative prices, and export demand will increase while demand for imported goods and services will decrease. As a result, in the long run, the trade balance starts to improve, leading to the second part of the J-curve. It is important to note that the timing and magnitude of the J-curve effect depend on various factors, including the elasticity of demand for imports and exports, the competitiveness of domestic industries, and the responsiveness of exchange rates to changes in trade balances. Additionally, the J-curve effect may not be observed in all cases of currency depreciation.

There are additional autonomous components of the aggregate demand in the open economy model, including exports and the autonomous component of imports. While autonomous expenditures are not directly determined by income, shifts in these affect the level of aggregate demand for a given level of national income and thus result in changes in the equilibrium level of income. In an open economy, when an increase in national income is brought about by an increase in an autonomous expenditure component such as G0, a part of this increased income is spent on imports of goods and services produced abroad instead of domestically produced ones. 
Moreover, this part of the income spent on imports does not increase national income. To see the multiplier effect, one needs to know how much of the increased domestic output is induced by the increased income. In other words, we need to know the marginal propensity to consume domestic goods. A change in autonomous government spending will have a direct effect on national income as well as an induced effect on domestic consumption with a further effect on income. The higher the value of marginal propensity to import, the smaller the induced effect on demand for domestic goods and, hence, the change in domestic income (Y). Accordingly, while domestic consumption is the consumption of all goods (C) minus imports (M), the marginal propensity to consume domestic goods is the marginal propensity to consume (all) goods (MPC) minus marginal propensity to import (MPM), i.e., MPC-MPM. 

The open economy multiplier is smaller than the multiplier in the closed economy case. For instance, the impact of an increase in autonomous government spending on equilibrium income is smaller in an open economy than in a closed economy. This is true because when there is an increase in income caused by an increase in government spending, consumption rises. However, some of this consumption increase goes to imports, i.e., foreign goods and services instead of domestically produced ones. As for the exports and autonomous component of imports, any increase in export demand induces an expansionary effect on equilibrium income, whereas an increase in autonomous imports will have a contractionary effect.