International Finance

1
International Finance
Academy of Economic Studies Faculty of
International Business and Economics

• Lecture V
• Elasticity and Absorption Approaches to the
  Balance of Payments

Lect. Cristian PAUN Email cpaun_at_ase.ro URL
http//www.finint.ase.ro
2
Introduction

• Current account and trade account balance are
  very important for general equilibrium of an
  economy
• There are two models that investigate the impact
  of exchange-rate changes on the current account
  position of a country these are popularly known
  as the elasticity approach and the absorption
  approach
• The two theories try to answer to a very
  important question will a devaluation (or
  depreciation) of the exchange rate lead to a
  reduction of a current account deficit?
• The answer to this question is of crucial
  importance because if an exchange-rate change
  cannot be relied upon to ensure adjustment of the
  current account, then policy-makers will have to
  rely on other instruments to improve the position.

3
The Elasticity Approach to the Balance of Payments

• This approach provides an analysis of what
  happens to the current account balance when the
  country devalues its currency.
• The analysis was pioneered by Alfred Marshall,
  Abba Lerner and later extended by Joan Robinson
  (1937) and Fritz Machlup (1955).
• Assumptions
• The theory focuses on demand conditions
• The theory assumes that the supply elasticities
  for the domestic export good and foreign import
  good are perfectly elastic, so that changes in
  demand volumes have no effect on prices
• These assumptions mean that domestic and foreign
  prices are fixed so that any changes in relative
  prices are caused only by changes in the nominal
  exchange rate.

4
The model of Elasticity Approach

• The current account balance (CA) when expressed
  in terms of the domestic currency is given by
• where P is the domestic price level, Xv is the
  volume of domestic exports, S is the exchange
  rate (domestic currency units per unit of foreign
  currency), P is the foreign price level and Mv
  is the volume of imports.
• We shall set the domestic and foreign price
  levels at unity, the value of domestic exports
  (PXy) is given by X, while the foreign currency
  value of imports (PMV) is given by M

5
The model of Elasticity Approach

At this point we introduce two definitions the
price elasticity of demand for exports ?x, is
defined as the percentage change in exports over
the percentage change in price as represented by
the percentage change in the exchange rate this
gives
6
The model of Elasticity Approach

• If the price elasticity of demand for imports ?m
  is defined as the percentage change in imports
  over the percentage change in their price as
  represented by the percentage change in the
  exchange rate

Substituting we obtain
7
The model of Elasticity Approach

• Dividing by M

Assuming that we initially have balanced trade
X/SM 1, and rearranging yields
This equation is known as the MarshallLerner
condition and says that starting from a position
of equilibrium in the current account, a
devaluation will improve the current account
that is, dCA/dS gt 0, only if the sum of the
foreign elasticity of demand for exports and the
home country elasticity of demand for imports is
greater than unity, that is, ?x ?m gt 1. If the
sum of these two elasticities is less than unity
then a devaluation will lead to a deterioration
of the current account.
8
Example

• Before devaluation the sterling-dollar exchange
  rate is 0.50/1 (2/1), whereas after
  devaluation the sterling-dollar exchange rate is
  0.666/1 (1.50/1), a 33 per cent devaluation.
• The price of one unit of UK exports is 1, and
  the price of one unit of US exports is 5.
• The volume of UK exports is 100 units and UK
  Imports 40 units

9
Example

• Case 1 Devaluation leads to a CA deficit

• Case 2 Devaluation leads to a CA deficit

10
Example

• Case 3 Devaluation leads to a CA surplus

11
The price and volume effect on BoP

• The price effect exports become cheaper
  measured in foreign currency a UK export earns
  only 1.50 post-devaluation compared to 2 prior
  to devaluation. Imports become more expensive
  measured in the home currency, each unit of
  imports cost 2.50 prior to the devaluation but
  costs 3.33 post-devaluation. The price effect
  clearly contributes to a worsening of the UK
  current account.
• The volume effect the fact that exports become
  cheaper should encourage an increased volume of
  exports, and the fact that imports become more
  expensive should lead to a decreased volume
  of imports. The volume effect clearly contributes
  to improving the current account.
• The net effect depends upon whether the price or
  volume effect dominates (see examples for the net
  effect).

12
Stern Condition

• A more complicated formula can be derived which
  allows for supply elasticities of exports and
  imports of less than infinity (is not perfectly
  elastic).
• Given the assumption of less than infinite supply
  elasticity conditions and assuming initially
  balanced trade, Stern (1973) has shown that a
  more complicated condition needs to be satisfied
  namely, the balance of payments will improve
  following a devaluation if

where ex is the domestic supply elasticity of the
export good and em is the foreign supply
elasticity for its export good (the domestic
country's imports).
13
Interpretation for Stern Condition

• The effect of less than infinite supply
  elasticities is to make the required demand
  elasticities less stringent in the sense that the
  current account may improve even if the sum of
  the demand elasticities is less than unity.
• If the supply elasticities of exports and imports
  are less than infinite, an increase in demand for
  exports will lead to some rise in the domestic
  price of exports which will give an additional
  boost to export revenues.
• The fall in the demand for foreign imports will
  have the effect of reducing the foreign currency
  price of imports so lowering import expenditure.

14
Empirical evidences on elasticity
Source Gylfason (1987), European Economic
Review, vol. 31, p. 377.
15
Empirical evidences on elasticity
Source Gylfason (1987), European Economic
Review, vol. 31, p. 377.
16
Empirical evidences on elasticities

• The possibility that a devaluation may lead to a
  worsening rather than improvement in the balance
  of payments led to much research into empirical
  estimates of the elasticity of demand for exports
  and imports.
• Economists divided up into two camps popularly
  known as 'elasticity optimists' who believed that
  the sum of these two elasticities tended to
  exceed unity, and 'elasticity pessimists' who
  believed that these elasticities tended to less
  than unity.
• It was argued that a devaluation may work better
  for industrialized countries than for developing
  countries
• Many developing countries are heavily dependent
  upon imports so that their price elasticity of
  demand for imports is likely to be very low.
• For industrialized countries that have to face
  competitive export markets, the price elasticity
  of demand for their exports may be quite elastic.

17
Empirical evidences on elasticities

• The implication of the Marshall-Lerner condition
  is that devaluation may be a cure for some
  countries balance-of-payments deficits but not
  for others.
• A summary by Gylfason (1987) of ten econometric
  studies undertaken between 1969 and 1981 has
  shown that the MarshallLerner condition is
  fulfilled for all of the 15 industrial and nine
  developing countries surveyed, and the results
  are shown in the next slide
• Another study made by Artus and Knight (1984) has
  shown that up to a period of six months,
  estimated price elasticities are invariably so
  low that the MarshallLerner conditions are not
  fulfilled.
• Krugman (1991) in an analysis of the effects of a
  sharp depreciation of the US dollar during 19857
  found a J-curve effect for the US current account
  (the deficit initially rose in both absolute
  terms and as a percentage of US gross national
  product, but after a lag of approximately two
  years it improved with long-run elasticities for
  imports and exports summing to 1.9 in excess of
  that required by the Marshall-Lerner condition.)

18
J-Curve

• A general consensus accepted by most economists
  is that elasticities are lower in the short run
  than in the long run, in which case the
  Marshall-Lerner conditions may only hold in the
  medium to long run.
• Goldstein and Kahn (1985), in an excellent survey
  of the empirical literature, conclude that in
  general long-run elasticities (greater than two
  years) are approximately twice as much as
  short-run elasticities (06 months).
• Further, the short-run elasticities generally
  fail to sum to unity while the long-run
  elasticities almost always sum to greater than
  unity.
• The possibility that in the short run the
  MarshallLerner condition may not be fulfilled
  although it generally holds over the longer run
  leads to the phenomenon of what is popularly
  known as the J-curve effect

19
J-Curve Effect
20
Explanations for J-Curve Time Lag for Consumers

• A time lag in consumer responses
• It takes time for consumers in both the devaluing
  country and the rest of the world to respond to
  the changed competitive situation.
• Domestic consumers will be worried about issues
  other than the price change such as the
  reliability and reputation of domestic produced
  goods as compared to the foreign imports
• Foreign consumers may be reluctant to switch away
  from domestically produced goods towards the
  exports of the devaluing country.

21
Explanations for J-Curve A Time Lag for
Producers

• A time lag in producer responses
• Even though a devaluation improves the
  competitive position of exports it will take time
  for domestic producers to expand production of
  exportables.
• Orders for imports are normally made well in
  advance and such contracts are not readily
  cancelled in the short run.
• Producers will be reluctant to cancel orders for
  vital inputs and raw materials. (the waiting list
  for a Boeing aeroplane can be over five years,
  and it is most unlikely that a British airline
  will cancel the order just because the pound has
  been devalued)
• The hedging opportunities for payments

22
Explanations for J-Curve - Imperfect competition

• A time lag due to imperfect competition
• Building up a share of foreign markets can be a
  time-consuming and costly business.
• foreign exporters may be very reluctant to lose
  their market share in the devaluing country and
  might respond to the loss in their
  competitiveness by reducing their export prices
• foreign import competing industries may react to
  the threat of increased exports by the devaluing
  country by reducing prices in their home markets,
  limiting the amount of additional exports by the
  devaluing country.
• Many imports are used as inputs for exporting
  industries, and the increased price of imports
  may lead to higher wage costs as workers seek
  compensation for higher import prices

23
The Absorption Approach to the Balance of Payments

• One of the major defects of the elasticity
  approach is that it is based upon the assumption
  that all other things are equal.
• Any changes in export and import volumes will by
  definition have implications for national income
  and consequently income effects need to be
  incorporated in a more comprehensive analysis of
  the effects of a devaluation (example with a
  economic exposure vs transaction exposure).
• National Income is

24
The Absorption Approach to the Balance of Payments

• Previous equation says that the current account
  (CA) represents the difference between domestic
  output and domestic absorption.
• A current account surplus means that domestic
  output exceeds domestic spending, while a current
  account deficit means that domestic output is
  less than domestic spending.
• Transforming equation into difference form yields

• This equation means that the effects of a
  devaluation on the current account will depend
  upon how it affects national income relative to
  domestic absorption.

If a devaluation raises domestic income relative
to domestic absorption, the current account
improves. If, however, devaluation raises
domestic absorption relative to domestic income
the current account deteriorates.
25
The Absorption Approach to the Balance of Payments

• Absorption can be divided into two parts
• A rise in income will lead to an increase in
  absorption which is determined by the marginal
  propensity to absorb, a.
• There will also be a 'direct effect' on
  absorption which is all the other effects on
  absorption resulting from devaluation denoted by
  Ad.

26
The Absorption Approach to the Balance of Payments

• This equation reveals that there are three
  factors that need to be examined when considering
  the impact of devaluation
• (i) Is the marginal propensity to absorb greater
  or less than unity?
• (ii) Does devaluation raise or lower national
  income?
• (iii) Does devaluation raise or lower direct
  absorption?
• The condition for a devaluation to improve the
  current account in case of this approach is
• (1 a)dY gt dAd

27
Conclusions

• Exchange rate volatility can influence the
  current account balance
• There are two main approaches in this matter
  elasticity approach and absorption approach
• The approach based on elasticities measure the
  effect of FX rate volatility based on demand (and
  supply elasticities)
• Empirical evidences on elasticity approach showed
  a clear difference between short term and long
  term approach (J-Curve)
• Initially, it was believed that the absorption
  approach was an alternative to the elasticities
  approach
• The latter, elasticity approaches concentrated on
  price effects while the absorption approach
  concentrated on income effects.

28

• Authors such as Tsiang (1961) and Alexander
  (1959) showed that the two models are not
  substitutes, but rather are complementary.
• We have seen that the absorption approach, like
  the elasticity approach, does not provide an
  unambiguous answer to the question of whether a
  devaluation leads to an improvement in the
  current account
• Although the two models are comparatively static
  in nature, they both point to the importance of
  dynamic forces and a time dimension to the
  eventual outcome.
• Despite their simplistic assumptions, ambiguous
  conclusions and deficiencies the two approaches
  have remained influential because they contain
  clear and useful messages for policy-makers.
• A devaluation is more likely to succeed when
  elasticities of demand for imports and exports
  are high and when it is accompanied by measures
  such as fiscal and monetary restraint that boost
  income relative to domestic absorption.

29

• Possible additional readings
• Alexander, S. (1952) Effects of a Devaluation on
  a Trade Balance, IMF Staff Papers, pp. 263-78.
• Arms, J. R. and Knight, M. D. (1984), Issues in
  the Assessment of the Exchange Rates of
  Industrial Countries, IMF Occasional Paper, No.
  29
• Johnson, H. G. (1976) Elasticity, Absorption,
  Keynesian Multiplier, Keynesian Policy and
  Monetary Approaches to Devaluation Theory A
  Simple Geometric Exposition, American Economic
  Review
• Machlup, F. (1955) Relative Prices and Aggregate
  Spending in the Analysis of Devaluation,
  American Economic Review, June 1955
• Robinson, J. (1937) The Foreign Exchanges, J.
  Robinson (ed.), Essays in the Theory of
  Employment (Oxford Basil Blackwell).
• Ster, R. M. (1973) The Balance of Payments
  Theory and Economic Policy, London Macmillan
• Tsiang, S. C. (1961) The Role of Money in Trade
  Balance Stability Synthesis of the Elasticity
  and Absorption Approaches, American Economic
  Review, vol. 51, pp. 912-36.