CHAPTER

17 The Income Adjustment

Mechanism with Flexible
and Fixed Exchange Rates

.
Learning Goals:
 Understand how the equilibrium level of
income is determined in an open economy
 Understand the meaning of foreign
repercussions
 Describe how the absorption approach works
 Understand how all the automatic adjustments
work together in open economies
Content
 Introduction
 Income determination in a Closed Economy
 Income determination in a Small Open
Economy
 Foreign repercussions
 Absorption approach
 Monetary adjustments and synthesis of the
automatic adjustments
Introduction
 The income adjustment mechanism
relies on changes in the level of national
income of deficit and surplus nations to
adjust BOP
 The income adjustment mechanism is
Keynesian, while the price adjustment
mechanism is more traditional, or
classical
Assumptions
 Deficit or surplus arises in the current
account
 All prices, wages and interest rates remain
constant
 Nation operates under fixed exchange
system
 Nations operate at less than full
employment
Income Determination in a
Closed Economy
 Y = C + I + G (1) or Y = C+S+T (2)
Where:
Y: Total national income or output (GDP)
I: Total investment expenditure
C: Total consumption expenditure
 In a closed economy (No X, M, no government sector: G, T):
Y= C (Y) + I (3)
S (Y) = Y – C (Y) (4)
Income Determination in a Closed
Economy
 (3), (4) => C+I = C+S
 The equilibrium level of income is where:

S=I (5)
FIGURE 17-1
Income Determination in a Closed
Economy
 In 1936, John Maynard Keynes “The General
Theory of Employment, Interest, and Money”
 The Keynesian Multiplier (k): an increase in
C, I, or net G (gross government spending –
government tax revenue) raises the total
GDP by more than the amount of the
increase.

 Eg. if C increases by 10 units, the total GDP

will increase by more than 10 units.
Income Determination in a Closed
Economy
 Like consumption, saving increases with
income
 MPS (Marginal propensity to save) = (Change in
savings) / (Change in income) = ΔS / ΔY
 For an individual, MPS will reflect how much
they want to put extra income into different
forms of saving.
 Eg. Suppose an individual:
 receives a year-end bonus of $600 and
 spends $300 on goods and services
=> The MPS is (600 – 300) / 600 = 0.5.
Income Determination in a Closed
Economy
 Since S = I at equilibrium, then:
ΔY = (1/MPS)ΔI
 If k = 1/MPS, then ΔY = k ΔI (6)
k is the Keynesian (closed economy) multiplier
(6) => Any change in I will induce a multiplied
change in Y
Income Determination in a Closed
Economy
Example:
 MPS = ¼ so k = 1/MPS = 1/.25 = 4
 Income will increase by smaller and smaller
amounts until total increase is 400.
 When income has increased by 400, induced
savings will have increased by 100, and equilibrium
national income (S=I) will again be achieved.
Income Determination in a Small
Open Economy
 The equilibrium condition of Y in an open
economy will be as follows:
Y=C+I+X–M (8)
Or: I+X = (Y – C) + M (9)
 In an small open economy, the equilibrium
condition:
I+X=S+M (10) or X - M = S – I (11)
(11)
Income Determination in a Small
Open Economy
 In an small open economy, the equilibrium
condition:
I+X=S+M (10)
or X - M = S – I (11)

 I + X: injections. They bring increment to Y

 S + M: leakages. They leak out Y.
Foreign Repercussions
 A country’s exports or imports affect the
national income of the other country which, in
turn, affects the foreign trade and national
income of the first country.
 In a two-nation world, an autonomous increase in
exports in Nation 1 is equal to an autonomous
increase in imports in Nation 2.
 If Nation 2’s imports replace domestic production,
income falls, inducing Nation2’s imports to fall,
neutralizing part of autonomous increase in imports.
Foreign Repercussions

 This induces foreign repercussions on Nation 1,

neutralizing part of autonomous increase in exports.

 As a result, the foreign trade multiplier for Nation

1 with foreign repercussions is smaller than
corresponding trade multiplier without foreign
repercussions, and its trade balance will not improve
as much.
Domestic equilibrium
 The absorption approach integrates the effect of
induced income changes in the process of correcting a
BOP disequilibrium by a change in the exchange rate.

 Domestic equilibrium is given by:

Y = C + I + (X – M)
Absorption Approach
 Define A (domestic absorption) = C + I and
B (foreign absorption) = X – M. Then:
Y=A+B or Y–A=B
 A depreciation of the currency is expected to
increase B.
 This can only occur if A falls or Y increases.
 If the economy is at full employment, Y cannot
increase.
 Therefore, a depreciation must result in a fall in A.
Forces that lead to a fall in
domestic absorption (A)
 Income is redistributed from wages to profits.
 The depreciation increases prices and lowers
domestic expenditures.
 The depreciation pushes people into higher tax
brackets, lowering disposable income and
consumption.
Monetary Adjustments and Synthesis
of the Automatic Adjustments

 BOP deficits tend to reduce a nation’s money supply

which, unless neutralized, will increase interest rates.
 Higher interest rates discourage domestic
investment, and reduce national income, causing
reduction in domestic imports, which reduces deficit.
 Also attracts foreign capital, helping to finance
deficit.
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Synthesis of Automatic Adjustments
 For nation facing unemployment and balance of
payments deficit at equilibrium level of income.
 Fixed Exchange Rate System:
 Exchange rate can depreciate only within narrow limits allowed, stimulating
production and income.
 Imports rise, reducing part of improvement in trade balance resulting from
depreciation.
 Deficit reduces money supply, increases interest rates, reduces investment
and income, so imports fall, reducing deficit.
 Most of automatic adjustments come from monetary adjustments, unless
nation devalues currency.
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Synthesis of Automatic Adjustments
 For nation facing unemployment & BOP deficit at equilibrium
level of income.
 Freely Flexible Exchange Rate System:
 Currency will depreciate until deficit is entirely eliminated.
 Imports rise, reducing part of improvement in trade balance resulting
from depreciation.
 Depreciation required to eliminate deficit is larger than if automatic
adjustment mechanisms were not present.
 National economy is to large extent insulated from BOP disequilibria, and
most of adjustments take place through exchange rate variation
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Disadvantages of Automatic Price Adjustments
 Freely Floating Exchange Rates:
 Overshooting and erratic fluctuations in exchange
rates interfere with international trade and impose
costly adjustment burdens that may be unnecessary in
the long run.
 Managed Float System:
 Beggar-thy-neighbor monetary policies to stimulate
domestic economy are disruptive and damaging to
international trade.
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Disadvantages of Automatic Price
Adjustments
 Fixed Exchange Rate System:
 Possibility of devaluation can lead to destabilizing
international capital flows.
 Forces nation to rely primarily on monetary
adjustments.
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Disadvantages of Automatic Income Adjustments
 Nation facing autonomous increase in imports at the
expense of domestic production would have to allow
national income to fall in order to reduce trade deficit.
 Nation facing autonomous increase in exports from
full employment position would have to accept
domestic inflation to eliminate trade surplus.
Monetary Adjustments and Synthesis of the
Automatic Adjustments
 Disadvantages of Automatic Monetary
Adjustments
 Nation must passively allow money supply to
change as a result of balance of payments
disequilibria, giving up use of monetary policy
to achieve domestic full employment without
inflation.
Q&A