Lecture 6

The Income Adjustment

Mechanism and Synthesis of
Automatic Adjustments

Chapter 17 The Income Adjustment Mechanism

and Synthesis of Automatic Adjustments
17.1 Introduction
17.2 Income Determination in a Closed
Economy
17.3 Income Determination in a Small Open
Economy
17.4 Foreign Repercussions
17.5 Absorption Approach
17.6 Monetary Adjustments and Synthesis of the
Automatic Adjustments

17.1 Introduction

To examine how automatic income changes lead to

BOP adjustment

Assumptions
-All prices remain constant
-Under fixed exchange rate system
-Nations operate at less than full employment
-Marshall-Lerner condition is satisfied
-Deficit or surplus arises in the current account

17.2 Income Determination in a Closed Economy

Equilibrium National Income

Y C (Y ) I
SI

Multiplier in Closed Economy

I S MPS Y
1
Y (
)I
MPS

FIGURE171NationalIncomeEquilibriuminaClosedEconomy.

17.3 Income Determination in a Small Open

Economy

Equilibrium National Income

I X SM
X M S I
I (X M ) S

Foreign Trade Multiplier

Y
k'

1
(I X )
MPS MPM
1
MPS MPM

FIGURE 17-2 The Import Function

FIGURE 17-3 National Income Determination in a Small Open

Economy.

17.4 Foreign Repercussions

If the nation is large

Foreign repercussions make foreign trade

multiplier smaller and business cycles
propagate internationally

17.5 Absorption Approach

Domestic absorption

A=C+I
Y=C+I+(X-M)
Y-A=B

17.6 Monetary Adjustments and Synthesis of

the Automatic Adjustments
17.6a Monetray Adjustment
17.6b Synthesis of Automatic Adjustment
17.6.c Disadvantages of Automatic
Adjustments