Download Absorption Approach

INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Third Edition
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.
Balance-ofPayments and
Exchange-Rate
Determination
Elasticities Approach and
Absorption Approach
Overview of the Elasticities Approach
• The elasticities approach emphasizes price
changes as a determinant of a nation’s balance
of payments and exchange rate.
• The elasticities approach is helpful in
understanding the different outcomes that
might arise from the short to long run.
2
Traditional Approaches
• Traditional approaches to balance-of-payments
and exchange-rate determination assume that
capital flows occur only to finance real-sector
transactions.
• Hence, the quantity of foreign exchange
demanded and the quantity of foreign
exchange supplied depend only on
international transactions of goods and
services.
3
The Demand for and Supply of
Foreign Exchange
• The demand for a nation’s currency is dependent
upon foreign residents’ demand for its exports, that is,
it depends on foreign residents’ desire to obtain the
domestic currency to facilitate their purchases of the
domestic country’s exports.
• The supply of a nation’s currency is dependent upon
(among other things) domestic residents’ demand for
imports, that is, when a nation’s residents import,
they supply the domestic currency as payment.
4
U.S Import Demand and the Demand
for the Euro
The left-hand panel illustrates an import demand curve for the United States as
combinations of the quantities of champagne demanded at various prices. The
right-hand panel illustrates the corresponding demand for foreign exchange as
combinations of the quantities of foreign exchange demanded at various exchange
rates.
5
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.
6
Elasticity of Import Demand and the
Elasticity of Foreign Exchange Demand
In the left-hand panel, the import demand curve denoted D′C is more elastic
that the demand curve DC. In the right-hand panel, the foreign exchange
demand curve denoted D′€ is more elastic than the foreign exchange demand
curve D€.
7
The Export Supply Curve and the
Supply of the Euro
The left-hand panel illustrates an export supply curve for the United States as
combinations of the quantities of music CDs supplied at various prices. The
right-hand panel shows the corresponding supply of foreign exchange as
combinations of the quantities of foreign exchange supplied at various
exchange rates.
8
Elasticity of Export Supply and the
Elasticity of Foreign Exchange Supply
In the left-hand panel, the export supply curve S′CD is more elastic than the
supply curve SCD. In the right-hand panel, the foreign exchange supply
curve S′€ is more elastic than the foreign exchange supply curve S€.
9
The Effect of Exchange Rate Changes
• The exchange rate is an important price to an
economy.
• When a nation’s currency depreciates,
domestic goods become relatively cheaper and
foreign goods relatively more expensive in the
global market.
• Hence, we would expect the nation’s exports to
rise and imports to decline.
10
The Responsiveness of Imports and Exports
• The elasticities approach, therefore, considers
the responsiveness of the quantity of imports
and the quantity of exports to a change in the
value of a nation’s currency.
• For example, if import demand is highly
elastic, a depreciation of the domestic currency
will cause a relatively larger decline in the
nation’s imports.
11
Surpluses and Deficits
• It follows that an excess quantity supplied of the
domestic currency is equivalent to a current account
deficit.
• Likewise, an excess quantity demanded of the
domestic currency is equivalent to a current account
surplus.
• The current account is in balance when the quantity
of the domestic currency supplied and the quantity
demanded are equal.
12
The Current Account
The current account deficit is
equivalent to the difference
between the quantity of
foreign exchange demanded
and the quantity of foreign
exchange supplied. At the
spot exchange rate of 1.00,
U.S. residents demand €220
million in foreign exchange
and European residents
supply €180 million. Hence,
the current account deficit is
€40 million.
13
The Role of Elasticity
• The previous chart illustrated a current account
deficit for the United States.
• The amount of depreciation required to
eliminate this deficit depends on elasticity.
• When demand and supply are relatively more
elastic, a smaller deprecation is required to
eliminate the current account deficit.
14
The Marshall-Lerner Condition
• Will a depreciation always improve the current
account balance?
• The Marshall-Lerner condition specifies the
necessary conditions for the current account to
improve.
• According to this condition, the current
account balance will improve if the sum of the
elasticity of import demand and the elasticity
of export supply exceed unity.
15
The J-Curve Effect
• The current account balance may respond
differently to a currency change in the short
run relative to the long run.
• The J-Curve effect refers to a phenomenon in
which a depreciation of the domestic currency
causes a nation’s balance of payment to
worsen before it improves.
16
The J-Curve
Initially there is a current
account deficit of $40
million. At time t, the dollar
depreciates. In the short run,
import demand and export
supply may be inelastic and
the current account widens to
$48 million. Eventually, as
businesses and households
have time to adjust their
planned expenditures on
imports and exports, the
deficit improves.
17
Pass-Through Effects
• Pass-through effects are also important to
understanding the response of the current
account to changes in the exchange rate.
• A pass-through effect is when the domestic
price of an imported good rises following the
depreciation of the domestic currency.
18
The Absorption Approach
• The absorption approach emphasizes changes
in real domestic income as a determinant of a
nation’s balance of payments and exchange
rate.
• Because it treats prices as constant, all
variables are real measures.
19
Expenditures
• A nation’s 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,
20
Real Income
• A nation’s real income (y) is equivalent to total
expenditures on its output
y  c + i + g + x,
where x denotes exports.
21
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 > m,
and the nation is running a current account surplus.
22
Current Account Determination
• The absorption approach hypothesizes that a
nation’s current account balance is determined
by the difference between real income and
absorption, which can be written as:
•
y - a = (c+i+g+x) - (c+i+g+m) = x - m,
or
y - a = ca.
23
Contractions and Expansions
• Though a simple theory, the absorption approach is
helpful in understanding a nation’s 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?
24
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.
25
Current Account Adjustment
• If real income rises faster than absorption, then the
current account improves
•
y > a → ca > 0.
• If real income rises slower than absorption, then the
current account worsens
•
y < a → ca < 0.
• Similar conclusions can be reached for a nation
experiencing an economic contraction.
26
Exchange Rate Determination
• The absorption approach can also be used to
examine how changes in income affect the
value of a nation’s 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
nation’s currency will appreciate.
27
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.
28
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.
29
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.
30
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 nation’s balance-ofpayments and exchange-rate performance.
• It is not clear that expenditure switching and
absorption instruments are effective.
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