Transcript 8.3 Absorption Approach

International Economics
Chapter 8
Balance of Payments
Adjustments
Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary Approach
8.1 Elasticities Approach

As a traditional approach to the balance of payments,
elasticities approach assumes that capital flows occur only
as a means of financing current account transactions.
 Derivation of the Demand for Foreign Exchange:
The quantity of a currency demanded in the foreign
exchange market is derived from the country’s demand
for imports.
8.1 Elasticities Approach
S
S
￥800
Spot Exchange Rate (￥/$)
Price of iPod
PI
B
￥700
A
DI
O
8
10
iPod Imports (in millions)
(a)
QI
8.00
8.00
B
7.00
7.00
A
D$
O
800
1000
Q$
Demand for dollars (in millions)
(b)
China’s Import Demand Curve and the Demand for dollar
8.1 Elasticities Approach
 Elasticity
of Import Demand and the Elasticity of
Foreign Exchange Demand.
S e
S
￥800
B’
Spot Exchange Rate (￥/$)
Price of iPod
PI
B
￥700
A
D I’
DI
O
6
8
10
iPod Imports (in millions)
(a)
QI
8.00
8.00
B’
B
7.00
7.00
A
D$
O
600
800
1000
D$’
Q$
Demand for dollars (in millions)
(b)
8.1 Elasticities Approach
Derivation of the Supply of Foreign Exchange
The supply of foreign exchange to a country results
from its exports of goods and services.
PT
￥80
￥70
O
e
ST
B
A
60
80
Toy Exports (in millions)
(a)
S$
S
Spot Exchange Rate (￥/$)
Price of Toy

QT
8.00
8.00
7.00
7.00
O
B
A
600
800
Supply of dollars (in millions)
(b)
Q$
8.1 Elasticities Approach
Elasticity of Export Supply and the Elasticity of Foreign
Exchange Supply
PT
e
ST
￥70
O
B
Spot Exchange Rate (￥/$)
￥80
B’
A
60
80 100
Toy Exports (in millions)
(a)
S$
S
ST ’
Price of Toy

QT
S$’
8.00
8.00
7.00
7.00
O
B
B’
800
1000
A
600
Supply of dollars (in millions)
(b)
Q$
8.1 Elasticities Approach

The elasticities approach centers on changes in the
prices of goods and services as the determinant of
a country’s balance of payments and the exchange
value of its currency.
a change in
the exchange
rate
the domestic
currency price of
goods and services
country’s balance
of payments and
exchange value
the quantity
of foreign
exchange
the quantity
of goods and
services
8.1 Elasticities Approach

The Current Account Deficit
e
S$
S$’
8.00
7.50
7.00
D$’
D$
0
600
700
800
900
1000
Q$
8.1 Elasticities Approach

The Role of Elasticity
The elasticities of the supply of and demand for
foreign exchange are fundamental determinants of
adjustment to a balance-of-payments deficit.
8.1 Elasticities Approach

The Marshall-Lerner Condition
The Marshall-Lerner condition specifies the necessary
condition for a positive effect of depreciation of
domestic currency on the balance of payments.
8.1 Elasticities Approach
Assumption

Capital flows occur only as a means of financing
current account transactions.
 Trade balance exclusively represents the current
account.
8.1 Elasticities Approach
CA in
domestic currency:
CA  PX  eP * M
dCA
dX
dM
P
 P * M  eP *
de
de
de

Derivate it with e:

Initial CA in equilibrium:

Then:

Rearrange it:

Finally:
eP * M
1
PX
dCA
eP * M dX
dM
P
 P * M  eP *
de
PX de
de
dCA
dX e dM e
 P*M (

 1)
de
de X de M
dCA
 P * M ( x  m  1)
de
(
x 
dX e
de X
, m   dM
e
de M
)
8.1 Elasticities Approach
A depreciation


So:
to improve CA:
dCA
0
de
x  m  1
Marshall-Lerner condition states that a depreciation
of domestic currency can improve a country’s balance
of payments only when the sum of the demand
elasticity of exports and the demand elasticity of
imports exceeds 1.
8.1 Elasticities Approach

J-Curve Effect
 A depreciation of
the domestic currency is unlikely to
immediately improve a country’s balance-of-payments deficit. It
is even possible that the depreciation could cause a country’s
balance of payments to worsen before it improves.
BP Surplus
0
t0
t1
A
e↑
B
BP Deficit
C
t2 Time
8.1 Elasticities Approach
Reasons
for J-Curve Effect:
 Recognition lags of changing competitive
conditions;
 Decision lags in forming new business connections
and placing new orders;
 Delivery lags between the time new orders are placed
and their impact on trade and payment flows is felt;
 Replacement lags in using up inventories and
wearing out existing machinery before placing new
orders;
 Production lags involved in increasing the output of
commodities for which demand has increased.
Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary Approach
8.2 Multiplier Approach

The multiplier approach is a modified and
extended version of the elasticity analysis.
The exchange rate is assumed fixed. The theory
is suitable to analyze the adjustment process
under a pegged regime.
The only possibility for BP adjustment in this
model is by changes in national income.
8.2 Multiplier Approach

Assumptions
 Underemployed resources;
 Rigidity of all prices;
 Absence of capital mobility;
 All exports are made out of current output.
8.2 Multiplier Approach

National income:
Y  C  I  G  (X  M )
C  C0  cY
I  I0
G  G0
X  X0
M  M 0  mY

Thus:
Y
1
(C0  I 0  G0  X 0  M 0 )
1 c  m
8.2 Multiplier Approach

An expansionary fiscal policy (a rise in G0), an
expansionary monetary policy (a rise in I0 resulting from
lower interest rates), or added exports (a rise in X0) can
increase national income.


dY
dY
dY
1



0
dG0 dI 0 dX 0 1  c  m
While a contractionary fiscal policy, a contractionary
monetary policy or reduced exports will decrease national
income.
8.2 Multiplier Approach

An expansionary fiscal policy or an expansionary
monetary policy can worsen a country’s current account
(and then its balance of payments).


dCA dCA
m


0
dG0
dI 0
1 c  m
While a contractionary fiscal policy or monetary policy
will improve its balance of payments.
8.2 Multiplier Approach

Added exports can improve a country’s current
account (then its balance of payments).
1 c

0
dX 0 1  c  m
 dCA

While reduced exports will worsen its balance of
payments.
8.2 Multiplier Approach

In conclusion, when an economy has
underemployed resources, fiscal policy, monetary
policy and trade policies can be used for adjusting
its balance of payments.
Contractionary
fiscal or monetary policy can improve
the balance of payments but at the cost of a decrease in
national output.
Added exports resulting from export-encouraging
policies will improve the balance of payments and
meanwhile, increase national income.
Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary Approach
8.3 Absorption Approach

The absorption approach assumes that prices remain
constant and emphasizes changes in real domestic
income.
 Hence, the absorption approach is a real-income theory
of the balance of payments.
8.3 Absorption Approach
A  C  I G
Absorption:
Y  C  I  G  (X  M )
 National income:
 Current account:
CA  X  M => CA  Y  A
 Thus
dCA  dY  dA
 It shows whether a currency depreciation can improve
the current account (then the balance of payments)
depends on its effect on national income and on
domestic absorption.

8.3 Absorption Approach

The effect of depreciation on absorption can be divided
into two parts:
 dA  a  dY  dAd
 The
induced effect of income changes resulting from
depreciation on absorption: a  dY
 The direct effect of depreciation on absorption: dAd

Therefore, the effects of depreciation on the current
account:
 dCA  (1  a )  dY  dA
d

the income effect: (1  a )  dY

the absorption effect: dAd
8.3 Absorption Approach

Indirect Effects of Depreciation on National Income
On the supply side, an effective depreciation requires
idle resources in the economy.
On the demand side, an effective depreciation requires
the Marshall-Lerner condition to be met.
From the perspective of government’s macroeconomic
regulation, an effective depreciation requires loosening
protective or restrictive trade polices.
8.3 Absorption Approach

Direct Effects of Depreciation on Absorption
Real cash balance effect
require Ms↓to guarantee
e↑
e↑
P↑
cash balance↓
expenditure↓
C↓
withdraw
financial assets
Price of financial
assets↓
dAd 
r↑
C↓,
I↓
8.3 Absorption Approach
Income
redistribution effect
e↑
P↑
Income redistribution from
wage earners to profit earners
W
C↓
profit earners have lower MPC
dAd 
8.3 Absorption Approach

Taxation effect
Require G↓/ T↑ to
guarantee
e↑
Nominal Y↑
expenditure↓
Enter higher taxation levels
C↓
dAd 
8.3 Absorption Approach

In conclusion, the absorption approach proposes
that depreciation can be effective in improving the
balance of payments when
 the economy has idle resources;
 the economy meets the Marshall-Lerner
condition;
the government fulfills contractionary fiscal or
monetary policy along with depreciation.
Chapter 8 Balance of Payments Adjustments

8.1 Elasticities Approach

8.2 Multiplier Approach

8.3 Absorption Approach

8.4 Monetary Approach
8.4 Monetary Approach

Leaning with or against the Wind
 If
a central bank intervenes to support or speed along the
current trend in the value of its country’s currency in the
foreign exchange market, then economists say that its
interventions are leaning with the wind.
 In contrast, a central bank’s interventions intended to halt or
reverse a recent trend in the value of its country’s currency are
leaning against the wind.
8.4 Monetary Approach

Foreign Exchange Intervention
 Central banks
buy or sell financial assets denominated in foreign
currencies in an effort to influence exchange rates.

Sterilization of Intervention

A central bank sterilizes foreign exchange interventions when it
buys or sells domestic assets in sufficient quantities to prevent
the interventions from influencing the domestic money stock.
 monetary base = domestic credit + foreign exchange reserves
 Sterilization of the sale of foreign exchange reserves requires
an equally-sized expansion of domestic credit.
8.4 Monetary Approach

Monetary Equilibrium Condition
In equilibrium, the actual money stock equals the
quantity of money demanded.
Md=kPy
P
e
P*
Md=keP*y
Ms=Md
Ms=m(D+F)
m(D+F)=keP*y
8.4 Monetary Approach

A Change in Domestic Credit under Fixed Exchange
Rates

If the central bank increases domestic credit through an open
market purchase of securities, the open market purchase causes
the country’s money stock to rise.
 m(D’+F)>keP*y
 Under fixed exchange rates, the country’s monetary authorities
must sell foreign exchange reserves to meet the demand for
foreign currency. As a result, foreign exchange reserves decline,
while the spot exchange rate remains constant.
 Under fixed exchange rates, an increase in domestic credit
generates BP deficit, while a decrease in domestic credit results
in BP surplus.
8.4 Monetary Approach

A Change in Md under Fixed Exchange Rates
 Suppose
that there is an increase in either the foreign price level
or real income, causing an increase in the quantity of money
demanded.
 m(D+F)<ke(P*y)’
 To prevent the domestic currency from appreciating, the
domestic monetary authorities must increase the quantity of
money supplied so that it equals the quantity of money
demanded.
 A rise in either the foreign price level or domestic real income
results in BP surplus. Likewise, a decline in either the foreign
price level or domestic real income results in BP deficit.
8.4 Monetary Approach

A Change in Domestic Credit under Flexible Exchange
Rates

Suppose the domestic central bank increases domestic credit
through a purchase of securities, causing domestic money stock
to rise.
 m(D’+F)>keP*y
 As households increase their expenditures on foreign goods and
services, the domestic currency depreciates and BP keeps in
equilibrium.
 Under flexible exchange rates, an increase in domestic credit
results in a depreciation of the domestic currency, while a
decline in domestic credit results in an appreciation of the
domestic currency.
8.4 Monetary Approach

A Change in Md under Flexible Exchange Rates
 If
the foreign price level or domestic real income increases,
causing an increase in the quantity of money demanded.
 m(D+F)<ke(P*y)’
 The decrease in demand for foreign goods and services causes
the domestic currency to appreciate and BP keeps in
equilibrium.
 Under flexible exchange rates, an increase in the foreign price
level or domestic real income results in an appreciation of the
domestic currency. In contrast, a decline in the foreign price
level or domestic real income results in a depreciation of the
domestic currency.