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Chapter 3
Elasticity and
absorption approaches
to the balance of
payments
1
3.1 Introduction
This chapter studies two models that
investigate the impact of exchange-
rate changes on the current account
position of a country: will a
devaluation (or depreciation) of the
exchange rate lead to a reduction of a
current account deficit?
2
The main contents of the chapter:
 Elasticity approach:examines the effects
of exchange-rate changes on the current
account →3.2~3.4;
 Absorption approach:examines the
effects of exchange-rate changes on
domestic income and spending →3.5~3.7;
 Analyzing the similarities and differences
between the two models →3.8.
3
Note:
 Ignore the complications of unilateral
transfers and interest,profit and
dividends on the current account
balance and concentrate on the export
and import of goods and services;
 The exchange rate is defined as
domestic currency units per unit of
foreign currency.
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3.2 The Elasticity Approach to
the Balance of Payments


The approach provides an analysis of
what happens to the current account
balance when the country devalues its
currency.
The approach was pioneered by Alfred
Marshall, Abba Lerner and later
extended by Joan Robinson(1937) and
Fritz Machlup(1955).
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
Some simplifying assumptions:
It focuses on demand conditions
and assumes that the supply elasticities
for the domestic export good and
foreign import good are perfectly elastic
changes in demand volumes have no
effect on prices
domestic and
foreign prices are fixed
changes in
relative prices are caused by changes in
the nominal exchange rate.
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
Current account balance(CA) expressed
in terms of the domestic currency:
CA=PXv-SP*Mv
(3.1)
Where:
P:the domestic price level;
Xv:the volume of domestic exports;
S:the exchange rate;
P*:the foreign price level;
Mv:the volume of imports.
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Simplifications:

Set the domestic and foreign price
levels at unity;

The value of domestic exports(PXv) is
given by X;

The foreign currency value of
imports(P*Mv) is given by M.
CA=X-SM
(3.2)
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

In difference form (3.2) becomes:
d CA=d X-Sd M-Md S
(3.3)
Dividing (3.3) by the change in the
exchange rate d S, we obtain:
dCA dX
dM
dS

S
M
dS
dS
dS
dS
(3.4)
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
Introduce two definitions:
The price elasticity of demand for exports:
dX X
x 
dS S
dS
dX   x X
S
(3.5)
The price elasticity of demand for imports:
dM M
m  
dS S
dS
dM   m M
(3.6)
S
10

Substituting (3.5) and (3.6) into (3.4):
dCA  x X

 ( m M )  M
dS
S
Dividing by M:
dCA 1  x X

 m  1
dS M SM
(3.7)
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
Assuming X/SM=1, and rearranging (3.7)
yields:
dCA
 M ( x   m  1)
dS
(3.8)
12
The Marshall-Lerner condition:
Starting from a position of equilibrium in
the current account, a devaluation will
improve the current account; that
is, dCA / dS  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,     1 .
x
m
13
There are two effects in play once a
currency is devalued:
(1)the price effect----exports become
cheaper measured in foreign currency,
and imports become more expensive
measured in the home currency. The
price effect clearly contributed to a
worsening of the UK current account.

14
(2)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
improve the current account.
The net effect depends upon
whether the price or volume effect
dominates.
15
Given the assumption of less than infinite
supply elasticity conditions and assuming
initially balance trade, a more complicated
condition needs to be satisfied:
 x ( x  1)  m ( m  1)

0
(3.9)
x m
m   m
Where:
 x :the domestic supply elasticity of the
export good;
 m :the foreign supply elasticity for its
export good.

16
The effect of less than infinite supply
elasticities: 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.
Why?
There is two effects to ensure it.
17


An increase in demand for exports
some rise in the domestic price of
exports
give an additional boost to
export revenues .
The fall in the demand for foreign
imports
reducing the foreign
currency price of imports
lowering
import expenditure.
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3.3 Empirical Evidence on Import
and Export Demand Elasticities


The elasticity approach led to much
research into empirical estimates of the
elasticities.
Economists are divided into two camps:
Elasticity optimists: who believed that
the sum of these two elasticities tended
to exceed unity;
Elasticity pessimists: on the contrary.
19


It was argued that a devaluation may
work better for industrial countries than
for developing countries.
There are enormous problems involved
in estimating the elasticities.
While the devaluation can improve
the current account during a period of
time, it does not preclude an initial J-
curve effect.
20
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.
J-curve effect: shows that there is a
time lag before the current account is
improved from the devaluation of the
currency. The time lag may be 6
months or two year.
21
The idea underlying the J-curve effect is
that in the short run export volumes and
import volumes do not change much, so
that the price effect outweighs the
volume effect leading to a deterioration in
the current account. However, after a
time lag export volumes start to increase
and import volumes start to decline;
consequently the current deficit starts to
improve and eventually moves into
surplus.
22
Current account
Surplus
0
time
Deficit
Figure 3.1 the J-curve effect
23
Three of the most important reasons:
1. A time lag in consumer responses:
1) It takes time for domestic consumers
to switch away from foreign imported
goods to domestically produced goods;
2) Foreign consumers may be reluctant
to switch away from domestically
produced goods towards the exports
of the devaluing country.

24
2. A time lag in producer responses:
1) It takes time for domestic producers to
expand production of exportables;
2) Orders for imports are normally made well
in advance and such contracts are not
readily cancelled in the short run;
3) Factories will be reluctant to cancel orders
for vital inputs and raw materials;
4) The payments for many imports will have
been hedged against exchange risk in the
forward market and so will be left
unaffected by the devaluation.
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3. Imperfect competition:
1) Foreign exporters might respond to
the loss in their competitiveness by
reducing their export prices;
2) Foreign import competing industries
might react to the threat of increased
exports by the devaluing country by
reducing prices in their home markets.
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4. It is unlikely the price of exports as
measured in the domestic prices will
remain fixed:
1) Many imports are used as inputs for
exporting industries.
2) The increased price of imports may
lead to higher wage costs.
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Homework:
1.在对进出口商品需求价格弹性值都不取
相反数的情况下，推导直接和间接标价
法下马歇尔-勒纳条件的数学表达式。
2.了解我国进出口商品的需求价格弹性是
否满足马歇尔-勒纳条件，2005年以来人
民币的持续升值是否对我国贸易收支起
到了改善作用。
3.4 The pass-through effect of
a depreciation or appreciation

economists use the term pass through
effect to describe the extent to which a
1% depreciation (appreciation) leads to
a rise (fall) in import prices(elasticity of
exchange rate pass-through).
Complete pass through effect=1
Partial pass through effect<1
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

On average there is partial pass-through
effect in the short run.
Reasons:
Foreign firms may decide to absorb part of the
depreciation by reducing their local currency
price of exports to maintain their market
share.
If a currency appreciates foreign firms may
decide not to change their foreign currency
prices to increase their profits as measured in
their local currency.
30



A recent paper by Yang(1997) found
that the elasticity of pass-through was
0.3185 for one quarter of a year.
However, there was a quite a bit of
dispersion between different industries.
As the time horizon increased, however,
in all industries the elasticity of passthrough increased and often
approached unity.
31

One of the key factors determining the
elasticity of pass-through being the
degree of product differentiation; the
greater the degree of product
differentiation then the more ability of
foreign exporters to raise their prices
presumably.
32

To the extent that there is only a partial
pass-through effect on the price of
imports in the short run, the effect will
be to dampen the size and complicate
the dynamics and timing of the J-curve
effect.
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3.了解我国人民币汇率变动的价格传递效
应的大小，我国学者具体是如何来考查
此效应的。
3.5 The Absorption Approach
One of the major defects of the elasticity
approach is that it assumes that all the
other things are equal.
However
Changes in export and import volumes
changes in national income
income effects need to be incorporated in
a more comprehensive analysis.
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Alexander(1952) focus on the fact that
a current account imbalance can be
viewed as the difference between
domestic output and domestic spending
(absorption).
 National income equation:
Y=C+I+G+X-M
(3.10)
 Define domestic absorption as
A=C+I+G
CA=X-M=Y-A
(3.11)
If CA>0, then Y>A; if CA<0, then Y<A.

36
Transforming equation(3.11) into
difference form yield:
dCA=dY-dA
(3.12)
It implies that the effects of a devaluation
on the CA will depend upon how it
affects Y relative to A.

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absorption determined by


the marginal propensity to
Absorption absorb, aY;
absorption derived by all
the other effects from
devaluation, Ad.
dA=adY+dAd
(3.13)
Substituting (3.13) into (3.12) yields:
dCA=(1-a)dY-dAd
(3.14)
38
Three factors need to be examined:
1) 1-a>0 or <0;
2) Y↑ or Y↓;
3) Ad ↑ or Ad↓.
The condition for a devaluation to
improve the CA is (1-a)dY>dAd;
That is, any change in income not
spent on absorption must exceed any
change in direct absorption.
39

Note:
To distinguish two possible states
of an economy: below full employment
and full employment.
40
3.6 The Effects of a Devaluation
on National Income

Assume the economy is at less than full
employment and a is less than unity,
A rise in income will improve CA,
A fall in income will worsen CA.
to consider the effects of
devaluation on national income.
41
Two important effects on income:
(less than full employment)
1.Employment effect:

M-L condition fulfilled net export↑
devaluation the foreign trade multiplier income
and employment↑
M-L condition not fulfilled net export↓
income↓
The employment effect is not clear.
42
2.Terms of trade effect:
Terms of trade are the price of
exports divided by the price of imports,
expressed as:
Price of exports
P
Price of imports
SP*
Where:
P:domestic price.
S:exchange rate.
P*:foreign price.
43
Devaluation → S↑ → P/SP*↓(P and P*
unchanged) → the terms of trade
deteriorate → imports more expensive
in domestic terms → more units of
exports have to be given to obtain a
unit of imports → a loss of real national
income.
The terms of trade effect lowers
national income.
The overall effects are ambiguous.
44

About the marginal propensity of
absorption:
Even if income rises overall, the
effects of devaluation on CA still
depend upon the value of a.
If a<1, then CA improved;
If a>1, then CA worsened.
45
Although one may think that a will be less
than unity, this need not be the case:
1)unemployed workers who obtain jobs
are likely to have a high propensity to
consume;
2)an increase in income may well
stimulate a great deal of investment.
It is conceivable in the short run that
a could be greater than unity
a rise
in income leads to a deterioration in CA.
46
3.7 The Effects of Devaluation
on Direct Absorption
Assume the net effect of a devaluation
on income is zero to consider the effect
of the devaluation on direct absorption.
47

Possible ways in which devaluation can be
expected to impact upon direct absorption:
1.Real balance effect:
A money demand function:
M/PI=k
(3.15)
Where: k:some constant;
PI:aggregate price index defined as:
PI=ąP+(1-ą)SP*
(3.16)
Assume other factors unchanged, the
devaluation (S↑) will raise the average price
index(PI↑).
48
Given an unchanged money stock
(Ms:unchanged) and assumption that
economic agents aim to maintain a
given amount of real money balances
(k:constant),
Then: S↑ → PI↑ k:constant M↑
Ms:unchanged sell bonds → push down
the price of bonds raising the domestic
interest rate → investment and
consumption↓→ direct absorption↓.
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Note:
For the real balance effect to come into play,
the authorities must not accommodate the
increased money demand by a corresponding
increase in the money supply.
If it is the case(Md↑ and Ms↑) → k can be kept
constant without selling bonds → leave
interest rate unchanged → I and C
unchanged → direct absorption unchanged →
the real balance effect will not come into play.
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2.Income redistribution effect:
S↑ → PI↑ → income redistribution
If income of people with high a↑ →direct
income of people with low a↓
A↑
If the reverse is true→ direct A↓
The overall effect on direct A is not clear.
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A few possibilities:
(a)PI↑→real income of those with fixed
incomes↓ overall income unchanged
those with variable incomes will have
gained
fixed incomes,poor,high a
variable incomes,better off,low a
→ direct A ↓

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(b) S↑ → company profits↑ not clear
S↑ → PI↑ →real wages↓
If firm: low a
→ direct A↓
workers: high a
If expectations are favorable →firms
I↑→direct A↑
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(c)there are considerable income adjustments
within groups of companies and workers:
S↑→ export companies profits↑
import companies profits↓
workers represented by strong trade
S↑→PI↑→ unions can secure compensating rise,
workers with no union representation
may not secure compensating rise.
The overall effect on Ad depend on whether
the companies and workers that gain have a
higher a than those that lose.
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3.Money illusion effect:
Money illusion:Mistaking changes in
nominal values for changes in real
values; failing to allow for inflation.
Money illusion:refers to the tendency of
people to think of currency in nominal,
rather than real terms.
55



S↑→PI↑→consumers real spending
power↓ money illusion buy exactly the
same bundle of goods as before→Ad↑;
S↑→PI↑money illusion works in reverse
cut back direct absorption by more than
the proportion to the price rise→Ad↓.
It is unlikely to be that significant and is
more probably only a temporary rather
than permanent factor.
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4.Expectational effects:
 S↑→PI↑→expect further price rise→
C↑→ direct A↑.
 S↑→PI↑→expect further price rise→
I↓→ direct A↓.
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5.Laursen-Metzler effect:
Devaluation→terms of trade deteriorate
Two effects:
 Income effect:→lower national income→
income related A↓.
 Substitution effect:→domestically produced
goods cheaper than foreign produced
goods→consumption of domestically
produced goods↑→direct A↑.
if substitution effect outweigh income effect,
direct A↑.
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

Overall, the effects of a devaluation on
current account are indeterminate.
None the less, the absorption approach has
some important lessons for policy-makers. Its
central message is that raising domestic
income relative to domestic absorption will
improve the current balance. In this respect,
a devaluation is more likely to succeed if it is
accompanied by economic policy measures
that concentrate on raising income while
constraining absorption.
59
3.8 A Synthesis of the Elasticity
and Absorption Approaches


Initially, the absorption approach was
believed an alternative of the elasticity
approach;
However, authors showed that the two
models are not substitutes, but rather
are complementary.
60
How to understand this complementarity?
1)When analysing with the absorption approach,
taking the price effect illustrated in the
elasticity approach into account will affect the
results:
If Marshall-Lerner condition is fulfilled, X-M>0,
income↑;
If Marshall-Lerner condition is not fulfilled, XM<0, income↓;
The Marshall-Lerner condition is clearly
relevant to the absorption approach.

61
2) When analysing with the elasticity approach,
taking the income effect illustrated in the
absorption approach into account will affect
the results:
If the sum of elasticities is greater than unity
the initial improvement of current account
income increase
imports increase
the sum of elasticities needs to be somewhat
greater than the unity value derived from the
elasticity approach.
The absorption approach is relevant to the
elasticity approach.
62
3.9 Conclusions
1.the final conclusion and correlation of the two
analyses
Does not provide an unambiguous answer;
Are not alternative but complementary
theories.
2.research methods
Although are comparatively static in
nature, both point to the importance of
dynamic forces and a time dimension.
63
3.policy implication
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.
64
4.notice
 At a two years and above horizon the
Marshall-Lerner conditions are fulfilled;
 Should not expect a devaluation to work in
the same manner for all countries;
 It will in part be determined by whether or
not the economy is at or below full
employment and on the structural parameters;
 Do not take the interaction between countries
into account.
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Further reading:
 黄苹，《汇率影响进出口国别结构的机
理分析及弹性测度》，《商业研究》，
2008/06.
 王相宁、李晓峰，《马歇尔－勒那条件
的实证研究》，《运筹与管理》，2005
年12月。
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On the web:
 Learn more about the Canadian economy
at http://www.statcan.ca/.
 Visit the Brookings institution at
http://www.brook.edu for economic,
foreign policy, and governmental studies
and research.
 To access research conducted by
economists at the Federal Reserve Bank
of New York, visit the Bank’s research
page at http://www.ny.frb.org/research/.
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