ANHUI UNIVERSITY OF FINANCE & ECONOMICS 1/21 The Income Adjustment Mechanism & Synthesis of Automatic Adjustments Chapter 17

ANHUI UNIVERSITY OF FINANCE & ECONOMICS 1/21

The Income Adjustment Mechanism & Synthesis of Automatic

Adjustments

Chapter 17


Key TermsKey Terms• Closed economyClosed economy• Quilibrium level of national incomeQuilibrium level of national income• Marginal propensity to consumeMarginal propensity to consume• Marginal propensity to importMarginal propensity to import• Consumption functionConsumption function• Saving functionSaving function• Investment functionInvestment function• Marginal propensity to saveMarginal propensity to save• MultiplierMultiplier• Import functionImport function• Export functionExport function


1 Introduction1 Introduction Review the concept and the determination of the equilibrium national income and the multiplier in a closed economy. Extend the concept and examine the determination of the equilibrium level of national income and multiplier in a small open economy. Further extend the presentation to include foreign repercussions that arise when the nations are not small. Examine the price and income adjustment mechanisms together. Discusse monetary adjustments and presents a synthesis of all automatic adjustments, pointing out the disadvantages of each automatic mechanism and the need for adjustment policies.


2 Determination of Equilibrium Nation2 Determination of Equilibrium National Income in Closed Economyal Income in Closed Economy

In a closed economy without a government sector, the In a closed economy without a government sector, the equilibrium level of national income and production (Y) is equilibrium level of national income and production (Y) is equal to the consumption (C) plus investment expenditurequal to the consumption (C) plus investment expenditures (I):es (I):

Y=C(Y)+IY=C(Y)+I Investment (I) is exogenous, or independent of the levInvestment (I) is exogenous, or independent of the level of national income.el of national income. Consumption expenditures, C(Y), are a function of, or Consumption expenditures, C(Y), are a function of, or depend on, the level of national income. That is, as incomdepend on, the level of national income. That is, as income (Y) rises, desired consumption (C) also rises. e (Y) rises, desired consumption (C) also rises. The change in consumption ( C) associated with a c△The change in consumption ( C) associated with a c△hange in income ( Y) is called the marginal propensity t△hange in income ( Y) is called the marginal propensity t△o consume (MPC). Since consumers save part of their inco consume (MPC). Since consumers save part of their income, the increase in consumption is less than the increasome, the increase in consumption is less than the increase in income so that MPC < 1. e in income so that MPC < 1.


The consumption function is shown by line C(Y). It equals 100 when income is zero and rises as income rises. The positive level of consumption (when income is zero) indicates that the nation lives off its past savings. The MPC= C/ Y = 4△ △50/600 = 3/4, or 0.75. The equation of this linear consumption function is then C = 100 + 0.75Y, where 100 is the vertical intercept and 0.75 is the slope.

2 Determination of Equilibrium Nati2 Determination of Equilibrium National Income in Closed Economyonal Income in Closed Economy


The total expenditure function C(Y)+I. The C(Y)+I function crosses the 45o line at E. Every point on the 45°line measures equal distances along the vertical and horizontal axes. At E, the total consumption and investment of 1000 equals the level of production of income of 1000. YE =1000 is the equilibrium level of national income.

2 Determination of Equilibrium Natio2 Determination of Equilibrium National Income in Closed Economynal Income in Closed Economy


At Y > 1000, expenditures are smaller than the output, firms have an accumulation of inventories of unsold goods, and they cut production. At Y < 1000, expenditures exceed production, there is a reduction of inventories, and production is increased. Thus, YE = 1000 is stable in the sense that at any other level of national income, it moves toward Ye = 1000.

2 Determination of Equilibrium Nati2 Determination of Equilibrium National Income in Closed Economyonal Income in Closed Economy


In the bottom, The level of In the bottom, The level of desired desired investment is exoginvestment is exogenous at I = 150enous at I = 150 regardless regardless of the level of income. On tof the level of income. On the other hand, desired savihe other hand, desired saving is a function of income, ng is a function of income, so that the saving function so that the saving function isis

S(Y) = YS(Y) = Y －－ C(Y)C(Y) Thus, when Y=0, C=100 Thus, when Y=0, C=100 (see the top) and S=(see the top) and S= －－ 100 100 (in the bottom). At Y=400, C (in the bottom). At Y=400, C = 400 and S=0 (point A in b= 400 and S=0 (point A in both panels). At Y=1000, C = oth panels). At Y=1000, C = 850 and S=150. Note that a850 and S=150. Note that as income rises, desired savs income rises, desired saving rises. ing rises.



The change in saving ( S) △The change in saving ( S) △is defined as the marginal is defined as the marginal propensity to save (MPS). propensity to save (MPS). Thus, the marginal propenThus, the marginal propensity to save, or MPS, equalsity to save, or MPS, equals S/ Y = 150/600 = 1/4. △ △s S/ Y = 150/600 = 1/4. △ △Since any change in incomSince any change in income ( Y) always equals the c△e ( Y) always equals the c△hange in consumption (Ahange in consumption (AC) plus the change in saviC) plus the change in saving ( S), MPC + MPS = 1, s△ng ( S), MPC + MPS = 1, s△o that MPS = 1 - MPC. In tho that MPS = 1 - MPC. In the above example, MPC + Me above example, MPC + MPS = 3/4 + 1/4 = 1, and MPS PS = 3/4 + 1/4 = 1, and MPS = 1 - 3/4 = 1/4. = 1 - 3/4 = 1/4.



In the bottom, investmenIn the bottom, investment is an injection into the st is an injection into the system because it adds to ystem because it adds to total expenditures and stitotal expenditures and stimulates production. Savimulates production. Saving is a leakage out of the ng is a leakage out of the system because it repressystem because it represents income generated bents income generated but not spent. The equilibriut not spent. The equilibrium level of income is the um level of income is the one at which one at which S = IS = I The equilibrium level of inThe equilibrium level of income is at point E in the come is at point E in the bottom panel. bottom panel.



Thus, the equilibrium level of national income is determined either at the intersection of the C(Y) + I function with the 45°line in the top panel or by the intersection of the S(Y) and I functions in the bottom panel. In either case, the equilibrium level of national income is YE = 1000, and we assume that it is smaller than the full-employment level of income.



3 Multiplier in Closed Economy3 Multiplier in Closed EconomyIf investment rises by 100 from I = 150 to I' = 250, the total expenditure function shifts up by 100 from C(Y) + I to C(Y) + I' and defines equilibrium point E' at Y’E=1400. An autonomous increase in investment causes the investment function to shift up from I = 150 to I'= 250 (in the bottom panel) and intersect the saving function at point E’ also defining the equilibrium level of national income at Y’E = 1400.


△I = S = MPS × Y△ △so that △Y = （ 1/MPS ）△ ITherefore, the multiplier (k): k = Y/ I = 1/MPS △ △ = 1/(1-MPC)

3 Multiplier in Closed Economy3 Multiplier in Closed Economy


The import function of a nation, M(Y), shows the relationship between the nation's imports and national income. A hypothetical import function is shown in Figure 17.2. Note that M = 150 when Y = 0 and rises as Y rises. When income is zero, the nation purchases 150 of imports by borrowing abroad or with its international reserves. Then as income rises, imports also rise.

4 Import Function4 Import Function


4 Import Function4 Import FunctionMPM = M/ Y= 150/1000 = 0.15△ △MPM = M/ Y= 150/1000 = 0.15△ △APM = M/Y = 300/1000 = 0.3APM = M/Y = 300/1000 = 0.3

APM

MPM

YM

YM

YY

MM

comechangeininpercentage

portschangeinimpercentagenY

/

/

/

/


5 Determination of Equilibrium NI in 5 Determination of Equilibrium NI in Small Open EconomySmall Open Economy

In an open economy, exports, like investment, are an In an open economy, exports, like investment, are an injection into the nation's income stream, while imports, injection into the nation's income stream, while imports, like saving, represent a leakage out of the income stream. like saving, represent a leakage out of the income stream. Exports and investment stimulate domestic production, Exports and investment stimulate domestic production, while imports and saving constitute income earned but while imports and saving constitute income earned but not spent on domestic output.not spent on domestic output. For a small open economy, For a small open economy, exports are also taken to be exports are also taken to be exogenousexogenous or independent of the level of income of the or independent of the level of income of the nation (just like investment). Thus, the export function, is nation (just like investment). Thus, the export function, is also horizontal when plotted against income. That is, also horizontal when plotted against income. That is, the the exports of the nation are the imports of the trade partner exports of the nation are the imports of the trade partner or the rest of the world and depend not on the exporting or the rest of the world and depend not on the exporting nation's level of income but on the level of income of the nation's level of income but on the level of income of the trade partner or the rest of the worldtrade partner or the rest of the world. On the other, . On the other, imports (like saving) are a function of the nation's income.imports (like saving) are a function of the nation's income.


In a small open economy, the equilibrium condition relating injections and leakages in the income stream is

I+ X= S + M Note that this condition for the equilibrium level of national income does not imply that the balance of trade (and payments) is in equilibrium. Only if S = I will X = M, and the balance of trade also be in equilibrium. By rearranging, we can restate the condition for the equilibrium level of national income as

X- M = S - I

5 Determination of Equilibrium NI 5 Determination of Equilibrium NI in Small Open Economyin Small Open Economy


X- M = S - I This points out that at the equilibrium level of national income, the nation could have a surplus in its trade balance (a net injection from abroad) equal to the excess of saving over domestic investment (a net domestic leakage). On the other hand, a deficit in the nation's trade balance must be accompanied by an equal excess of domestic investment over saving at the equilibrium level of national income. By transposing I from the right to the left side of Equation, we get:

I + (X- M) = S

5 Determination of Equilibrium NI 5 Determination of Equilibrium NI in Small Open Economyin Small Open Economy


5 Determination of Equilibrium N5 Determination of Equilibrium NI in Small Open EconomyI in Small Open Economy


6 Questions for Discussion What is meant by closed economy? What are a consumption function, a saving function, and an investment function? What do the MPC and MPS measure? How is the equilibrium level of national income determined in a small open economy? What is the value of foreign trade multiplier?


The End

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ANHUI UNIVERSITY OF FINANCE & ECONOMICS 1/21 The Income Adjustment Mechanism & Synthesis of Automatic Adjustments Chapter 17