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Multiple Problems December 6, 2008

Posted by A Texan In Grad School in Economic Theories, Federal Debt.
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Here’s an interesting question on trade and Keynesian fiscal policy inspired by a post by Dani Rodrik:

The Keynesian multiplier is:

\frac{1}{1-c(1-t)+m}

where c is the marginal propesnity to consume, t is the tax rate, and m is the marginal propensity to import.  It is clear from this formula that m is inversely proportional to the multiplier.  So, if we decrease m, we will maximize the multiplier, in terms of m.  Therefore, raising import tariffs such that m=0 will give us high growth and employment for the same amount of government spending.  Also we eliminate our current account deficit.  Seems good all around…

Now, how can this be square with Ricardian theories of comparative advantage?  How can eliminating trade actually increase economic growth?

(My answer below the fold)

It doesn’t.  If we eliminate imports, then prices will go up on almost all of our goods.  This will decrease the marginal propensity to consume, which will drive down the multiplier.  Also one must consider the flip side of our current account deficit: our capital account surplus.  While we import a bunch of goods from say China, China in turn invests in our economy by buying our debt.  This keeps our interest rates low, which also keeps our marginal propensity to consume up.  Thus, eliminating these imports will attack the multiplier from two sides.

Update: Megan McArdle discusses Rodrick and Tyler Cowens response.  She astutely points to Smoot-Hawley.

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