The Elasticity Approach to BalanceofPayments and ExchangeRate Determination

1
The Elasticity Approach to Balance-of-Payments
andExchange-Rate Determination
2
Overview of the Elasticity Approach

• The elasticity approach emphasizes price changes
  as a determinant of a nations balance of
  payments and exchange rate.
• The elasticity approach is helpful in
  understanding the different outcomes that might
  arise from the short to long run.

3
Review of Elasticity

• Price Elasticity of Demand is a measure of the
  responsiveness of quantity demanded to a change
  in price.
• If quantity demanded is highly responsive to a
  change in price, then demand is said to be
  relatively elastic.
• If quantity demanded is not very responsive to a
  change in price, then demand is said to be
  relatively inelastic.

4
The Effect of Exchange Rate Changes

• The exchange rate is an important price to an
  economy.
• When a nations currency depreciates, domestic
  goods become relatively cheaper and foreign goods
  relatively more expensive in the global market.
• Hence, we would expect exports to rise and
  imports to decline.

5
The Responsiveness of Imports and Exports

• The elasticity approach, therefore, considers the
  responsiveness of imports and exports to a change
  in the value of a nations currency.
• For example, if import demand is highly elastic,
  a depreciation of the domestic currency will
  cause a disproportional decline in the nations
  imports.

6
Elasticity of Foreign Exchange Supply and Demand

• A nations supply of foreign exchange is
  dependent upon (among other things) its import
  demand, e.g. when a nation imports, it supplies
  foreign exchange as payment.
• A nations demand for foreign exchange is
  dependent upon its export supply, e.g. when a
  nation exports, it demands foreign exchange as
  payment.

7
Surpluses and Deficits

• An excess supply of foreign exchange is
  equivalent to a current account deficit.
• An excess demand for foreign exchange is
  equivalent to a current account surplus.
• The current account is in balance when the
  quantity of foreign exchange supplied and
  quantity demanded are equal.

8
The superscripts I and E denote the relatively
inelastic and relatively elastic supply and
demand curves.
Spot Exchange Rate
SE
DE
DI
SI
Foreign Exchange in domestic currency units
9
At a spot exchange rate of S0, the nation has an
excess supply of foreign exchange and, therefore,
is running a current account deficit.
Spot Exchange Rate
S0
SE
DE
DI
SI
Foreign Exchange in domestic currency units
10
The elasticity approach considers how the
responsiveness of imports and exports to changes
in the exchange rate determines the extent to
which a depreciation will improve the current
account balance.
Spot Exchange Rate
S0
SE
DE
DI
SI
Foreign Exchange in domestic currency units
11
If foreign exchange supply and demand are
relatively elastic, a small change in the spot
rate can correct the deficit.
Spot Exchange Rate
S0
S1
SE
DE
DI
SI
Foreign Exchange in domestic currency units
12
If foreign exchange supply and demand are
relatively inelastic, a larger change in the spot
rate is required to correct the deficit.
Spot Exchange Rate
S0
SE
S1
DE
DI
SI
Foreign Exchange in domestic currency units
13
The J-Curve

• The J-Curve is an (often, but not always)
  observed phenomenon.
• What is observed is that, follow a depreciation
  or devaluation, the nations balance of payments
  worsens before it improves.

14
Pass-Through Effects

• A pass-through effect is when the domestic price
  of an imported good rises (falls) following the
  depreciation (appreciation) of the domestic
  currency.

15
The Absorption Approachto Balance-of-Payments
andExchange-Rate Determination
16
Overview of The Absorption Approach

• The absorption approach emphasizes changes in
  real domestic income as a determinant of a
  nations balance of payments and exchange rate.
• Because it treats prices as constant, all
  variables are real measures.

17
Expenditures

• A nations expenditures fall into four
  categories, consumption (c), investment (i),
  government (g), and imports (m).
• The total of these four categories is referred to
  as domestic absorption (a)
• a ? c i g m,

18
Real Income

• A nations real income (y) is equivalent to total
  expenditures on its output
• y ? c i g x,
• where x denotes exports.

19
The Current Account

• During the time (early Bretton Woods era) that
  the absorption model was developed, capital flows
  were not very important. Trade flows, therefore,
  determined the current account balance. Hence,
  the current account (ca) is equivalent to
• ca ? x - m.
• Then, for example, if exports exceed imports, x gt
  m, the nation is running a current account
  surplus.

20
Current Account Determination

• The absorption approach hypothesizes that a
  nations current account balance is determined by
  the difference between real income and
  absorption, which can be written as
• y - a (cigx) - (cigm) x - m,
• or
• y - a ca.

21
Contractions and Expansions

• Though a simple theory, the absorption approach
  is helpful in understanding a nations external
  performance during contractions and expansions.
• For example, when a nation experiences an
  economic contraction, does its current account
  necessarily improve and does its currency
  definitely appreciate?
• Does the opposite necessarily hold during an
  economic expansion?

22
Balance of Payments Determination

• Consider the case of an economic expansion. Real
  income rises, thereby increasing real
  expenditures or absorption.
• Whether the current account balance improves or
  worsens depends on the relative changes in these
  two variables.

23
Current Account Adjustment

• If real income rises faster than absorption, then
  the current account improves
• ?y gt ?a ? ?ca gt 0.
• If real income rises slower than absorption, then
  the current account worsens
• ?y lt ?a ? ?ca lt 0.
• Similar conclusions can be reached for a nation
  experiencing an economic contraction.

24
Exchange Rate Determination

• The absorption approach can also be used to
  examine how changes in income affect the value of
  a nations currency.
• Recall that y - a x - m.
• For example, if real income is rising faster than
  absorption, then exports must be increasing
  relative to imports. Hence, the nations
  currency will appreciate.

25
Policy Implications

• A nation may resort to absorption instruments or
  expenditure switching instruments to correct an
  external imbalance.
• The effectiveness of these instruments, however,
  is uncertain, as can be seen in the model.

26
Policy Instruments

• Absorption Instrument Influences absorption by
  altering expenditures.
• Suppose the government reduces its expenditures
  (g). Absorption will decline as g declines.
• However, since expenditures decline, so does
  output. The absorption instrument is effective
  only if absorption declines faster than output.

27
Policy Instruments, Continued

• Expenditure Switching Instrument Alters
  expenditures among imports and exports by
  changing relative prices.
• Suppose the government devalues the domestic
  currency. Imports are relatively more expensive,
  and exports are relatively cheaper.
• If households and businesses switch directly
  between imports and domestic output without
  changing overall absorption or income, there is
  no impact on the current account balance.

28
Conclusion

• The Absorption Approach emphasizes real income
  in balance-of-payments and exchange-rate
  determination.
• The approach hypothesizes that relative changes
  in real income or output and absorption determine
  a nations balance-of-payments and exchange-rate
  performance.
• It is not clear that expenditure switching and
  absorption instruments are effective.