Economics of International Finance
Econ. 315
Chapter 5
The Income Adjustment Mechanism
and Synthesis of Automatic
Adjustments
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Income Determinants in a Closed Economy
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1.
2.
3.
4.
The equilibrium level of national income and production (Y) is equal to
the planned flow of consumption and investments
Y = C (Y) + I
Where I is exogenous, while C is a dependent of income.
Look at figure 1 and recall your background about
Consumption function
Saving function
Investment function
Marginal propensities
Multiplier in a closed economy
Another equilibrium point
ΔI = ΔS = MPS × ΔY
So that
ΔY = ( 1/MPS) ΔI
ΔY = K × ΔI
therefore, the multiplier (k) is:
K = ΔY/ΔI = 1/MPS = 1/1-MPC
An rise in I  to a multiple rise in GDP depending on the value of K
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 1 National Income Equilibrium in a Closed Economy.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Income Determination in a Small Open Economy
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Import Function: the relationship between nation’s imports and
national income.
Marginal Propensity to Import: the change in imports (ΔM)
associated with a change in income (ΔY).
Average Propensity to Import: the ratio of imports to income.
Income elasticity of imports:
ηM = (% ΔM/% ΔY) = (ΔM/ΔY)/(M/Y) = MPM/APM
Determination Of the Equilibrium National Income in a Small Open
Economy
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We include foreign trade. In an open economy, exports, just like
investment, are an injection into the nation’s income stream, while
imports are just like savings are leakages out of the income stream.
Hence; X and I stimulate domestic production
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 2 The Import Function.
(ΔM/ΔY)/(M/Y)
ŊM=(150/1000)/(300/1000) = 0.5
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

X is taken as exogenous or independent of income of the
nation. The export function is thus horizontal when plotted
against income. In a small open economy the equilibrium
condition is:
I+X=S+M
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By rearranging the terms of this equation we restate the
equilibrium condition as:
X–M=S–I
The nation could have a surplus in its trade balance equal to
the excess of savings over domestic investments (net domestic
leakage).
The deficit of the nation’s trade balance must be
accompanied by an equal excess of I over S
By rearranging I from the right to the left hand side we get
another useful form of equilibrium condition:
I + (X – M) = S
X-M refers to foreign investments since X-M is an
accumulation of foreign assets.
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Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Graphical Determination of the Equilibrium National
Income
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Look at figure 3. The equilibrium level of national income
The equilibrium level of national income:
Injections = Leakages
I+X=S+M
150 + 300 = 150 + 300
450 = 450
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
FIGURE 3 National Income Determination in Small Open Economy.
S’(y)-I
(X-M’
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Foreign Trade Multiplier
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Another equilibrium level of national income is determined where:
ΔI + ΔX = ΔS + ΔM
*
Induced changes in savings and imports when income changes are given
by:
ΔS = (MPS)(ΔY)
ΔM = (MPM)(ΔY)
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Substituting in equation ( * ) we get
ΔI + ΔX = (MPS)(ΔY) + (MPM)(ΔY)
ΔI + ΔX = (MPS + MPM)(ΔY)
ΔY = (1/(MPS + MPM)) (ΔI + ΔX)
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Where the foreign trade multiplier (k’)
K’ = 1/(MPS + MPM)
From the equilibrium point E, if exports rise exogenously from X=300 to
X’=500
K’ = 1/(MPS+MPM) = 1/(.25+.15) = 1/.4 = 2.5.
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Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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ΔY =(ΔX)(K’) = 200×2.5 = 500
AE’ =YE + ΔY = 1000 + 500 = 1500
ΔS =(MPS)(ΔY) = 0.25 × 500 = 125
ΔM =(MPM)(ΔY) = 0.15 × 500 = 75
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At YE’.
Changes in injections = changes in leakages
ΔI + ΔX = ΔS + ΔM
0 + 200 = 125 + 75
200 = 200
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At the equilibrium level of income YE = 1500 exports exceed imports by
125 per period. The adjustment in BOP is incomplete
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Note that the foreign trade multiplier is k’ = 2.5. is smaller than k (4),
because in an open economy, income leaks into both savings and imports.
This is a fundamental result of open economy macroeconomics.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Note that X = 500, while M = 375, hence X’-M =125.
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Note also that the smaller MPS+MPM, the flatter is the S(Y) + M(Y)
function and the increase in income for a given autonomous increase in
investment and exports.
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If I rises by 200 instead of X
ΔI + ΔX = ΔS + ΔM = 200+0 = 125 + 75
And the nation faces a trade deficit = 75 equal to the increase in M (Δ
X=0)
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If there is an increase in saving by 200, the S(y) – I function shift upward
by 200 and YE* = 500. X-M = 75 (surplus)
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Finally if there is an autonomous increase in imports by 200, the X-M
shifts downward by 200 and eq Y = 500, in this case the nation would
have a trade deficit of X-M = -125. Note that the nation’s imports replace
domestic production.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Foreign repercussions
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Here we relax the assumption that a nation is small and consider the
foreign repercussions.
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In a two nation world, assume that there is an autonomous increase in
nation 1 exports, and an equal autonomous increase in nation 2 imports.
If the autonomous increase in imports of nation 2, replaces domestic
production, its income will fall, thus neutralizing part of the increase in
its imports. This also neutralizes part of the original autonomous increase
in nation 1 exports. This represents a foreign repercussions on nation 1.
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The foreign trade multiplier with foreign repercussions will be smaller
than the foreign trade multiplier without repercussions.
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The foreign trade multiplier of nation 1 with trade repercussions is
K” = ΔY1/ΔX1 = 1/(MPS1+MPM1+MPM2(MPS1/MPS2))
Example: if MPS1 = .25, MPM1=.15, MPS2 = .2 AND MPM2 = .10. The
trade multiplier for nation 1 is
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K” = ΔY1/ΔX1 = 1/(.25+.15+.10(.25/.2)) = 1/.535 = 1.90
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Thus the original increase in X of nation 1 by 200 leads to an increase in
Y1 by (200 × 1.9) = 380 with foreign repercussions, as compared to (200 ×
2.5) = 500 without foreign repercussions. As a result;
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ΔM1 = (ΔY1)(MPM1) = 380×.15 = 57
ΔS1 = (ΔY1)(MPS1) = 380×.25 = 95
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At equilibrium;
ΔI1 + ΔX1 = ΔS1+ ΔM1 = 0+ ΔX1 = 95 + 57 = 152.
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Net increase in X1 = 152 with foreign repercussions (compared with 200).
Trade surplus (X-M) is 152-57 = 95 with foreign repercussion (compared
with 125)
The foreign trade multiplier for nation 1 with foreign repercussions for
an increase in investment is:
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K* = ΔY1/ΔI1 = (1+MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))
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K* = ΔY1/ΔI1 = (1+.1/.2)/.525 = 1.5/.525 = 2.86
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Thus k* > k’ > k”
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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ΔY1=(200)(2.86) = 572 (instead of 500 in the absence of foreign
repercussions).
ΔM = (ΔY1)(MPM1) = (572)(.15) = 85.8
ΔS = (ΔY1)(MPS1) = (572)(.25) = 143 with foreign repercussions.
Substituting into the eq. condition
ΔI1 + ΔX1 = ΔS1+ ΔM1 = 200 + ΔX1 = 143+85.8 = 228.8
The induced exports 28.8
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Now country 1 trade deficit is (85.8 – 28.8) = 57 with repercussions
(compared with 75 without repercussions)
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Note: foreign repercussions make trade deficit (surplus) less
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If there is an autonomous increase in investment in nation 2, the foreign
trade multiplier in nation 1 with foreign repercussions (k**) is
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K** = ΔY1/ΔI2 = (MPM2/MPS2)/(MPS1+MPM1+MPM2(MPS1/MPS2))
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Note K* = K**+ k’’
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Absorption Approach
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We saw before that a nation can correct for it BOP deficit by
depreciation, which is based on the elasticity approach.
Depreciation will stimulate exports and discourages imports,
thus increasing domestic production and income.
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But increasing income in the deficit nation will in turn,
induces imports and neutralizes part of the original
improvements in the BOP.
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If the deficit nation is at full employment, the real domestic
absorption (expenditures) is not reduced (e.g., by fiscal or
monetary policies), the depreciation will lead to increasing
domestic prices and thus completely neutralize the
competitive advantage of the nation conferred by the deficit
without any reduction in the deficit. Therefore, devaluation
will work only if domestic absorption is somehow reduced.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The absorption analysis was introduced by Alexander (1952). He began with
this identity
Y = C + I + (X – M)
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By letting A equals domestic absorption – expenditures - (C + I) and B
equals trade balance (X – M), we have
Y=A+B
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Subtracting A from both sides we get
Y–A=B
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Hence domestic production (income) minus absorption (domestic
expenditures) equals the trade balance.
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For B to improve as a result of depreciation, Y must rise and/ or A must
fall. If Y is at full employment, Y will not rise and the depreciation can
only be effective if A fall either automatically or as a result of
contractionary policies.
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How depreciation automatically reduces A?
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
1.
If it redistributes income from wages to profit earners
(have higher MPS than wage earners) thus affecting AE.
2.
It increases prices and reduces the real value of cash
balances, to restore cash balances to the desired level, the
public must reduce consumption, AE go down.
3.
Rising domestic prices put people into higher tax brackets
(as nominal income increases) and reduce consumption,
AE go down.
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Monetary Adjustments
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The mechanism of automatic monetary price adjustment in
the deficit nation can be explained as follows:
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
1.
When the exchange rate is not freely flexible, a deficit
tends to reduce the nation’s money supply as excess
demand for foreign currency is obtained by exchanging
domestic money balances for foreign exchange at the
central bank. This induces interest rate to rise in the
deficit nation.
2.
The rise in interest rates discourages investment and
national income and thus imports which reduces the
deficit.
3.
The rise in interest rates attracts foreign capital which
helps to finance the deficit.
4.
Reduction in money supply and income tends to reduce
domestic prices in the deficit nation which improve
further BOP in the deficit nation
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Synthesis of automatic adjustments
Now we integrate automatic price, income and monetary
adjustments (a synthesis of automatic adjustments).
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Under flexible exchange rate system and stable foreign
exchange market, currency will depreciate until the deficit is
entirely eliminated (price adjustment). But depreciation
stimulates production and income which induces imports
(income adjustment). This reduces part of the original
improvement in BOP. This simply means that the
depreciation required to eliminate the deficit is larger than if
automatic income adjustment is not present.
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Under managed floating full depreciation required to
eliminate the deficit is not allowed (price and monetary
adjustment).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Under fixed exchange rate system, devaluation is allowed
only within narrow limits and adjustment must come from
elsewhere. Deficit tends to reduce the nation’s money supply,
(monetary adjustment) increasing interest rates, which in
turn reduces investment and income in the deficit nation and
attracts foreign capital. It also induces prices to fall thus
helping further to improve the deficit. Most of the
adjustments come from the monetary adjustments.
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When all of these automatic price, income and monetary
adjustments are allowed to operate, the BOP adjustment is
likely to be more or less complete even under fixed exchange
rate system. But automatic adjustments have serious
disadvantages.
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In real world changes in income, prices, interest rates,
exchange rates and other variables change as a result of
autonomous disturbance in one nation affects other nations
with repercussions back to the first nation. It is very difficult
to trace all of these effects in the real world.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Disadvantages of automatic adjustments
1.
Disadvantages of freely flexible exchange rate system may
be erratic fluctuations in exchange rates, which impose
costly adjustment burdens that might be unnecessary in
the long run.
2.
Possibility of devaluation under fixed exchange rate
system can lead to destabilize international capital flows.
Fixed exchange rate system also forces the nation to relay
primarily on monetary adjustments
3.
Under managed floating, erratic fluctuation in exchange
rate can be avoided but monetary authorities may manage
exchange rate so as to keep domestic currency
undervalued to stimulate domestic economy. Such policies
proved to be very disruptive in damaging international
trade during interwar period.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
4.
Automatic income changes can also have serious
disadvantages, a nation facing a autonomous increase in its
imports at the expense of domestic production would allow
its income to fall, while countries facing an autonomous
increase in exports would have to accept domestic inflation to
eliminate the surplus.
5.
Finally for automatic monetary adjustments to operate, the
nation must passively allow it money supply to change, thus
giving up its use of monetary policy to achieve domestic full
employment without inflation.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
•Closed economy
•Import function
•Equilibrium level of national income (YE)
•Marginal propensity to import (MPM)
•Desired or planned investment
•Average propensity to import (MPM)
•Marginal propensity to consume (MPC)
•Income elasticity of imports (ny)
•Consumption function
•Export function
•Saving function
•Foreign trade multiplier (k')
•Marginal propensity to save (MPS)
•Foreign repercussions
•Investment function
•Absorption approach
•Multiplier (k)
•Synthesis of automatic adjustments
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University