Model Answer
0 min readIntroduction
The Balance of Payments (BOP) is a systematic record of all economic transactions between residents of one country and the rest of the world over a given period. A disequilibrium in the BOP, manifesting as a deficit or surplus, can create economic instability. Addressing these disequilibria requires adjustment mechanisms. Two prominent theoretical frameworks for understanding and managing BOP adjustments are the elasticity approach and the absorption approach, both developed in the mid-20th century. These approaches offer different perspectives on how exchange rates and domestic policies can restore BOP equilibrium.
The Elasticity Approach
Developed by James Meade in the 1950s, the elasticity approach focuses on the role of price elasticity of demand for exports and imports in achieving BOP equilibrium. The core idea is that a devaluation (or depreciation) of a country’s currency will improve the BOP only if the Marshall-Lerner condition is satisfied. This condition states that the sum of the price elasticities of demand for exports and imports must be greater than one (i.e., |εx + εm| > 1).
- Mechanism: Devaluation makes exports cheaper for foreigners and imports more expensive for domestic residents. This leads to an increase in exports and a decrease in imports, improving the trade balance.
- Policy Implications: This approach suggests that exchange rate adjustments are the primary tool for BOP correction. However, it emphasizes the importance of having sufficiently elastic demand curves. If demand is inelastic, devaluation may worsen the trade balance (known as the J-curve effect).
- Limitations: The approach assumes that the initial impact of devaluation is on volumes, not prices. It also overlooks the possibility of retaliatory devaluation by trading partners.
The Absorption Approach
Developed by Dudley Seers and John Hicks in the 1950s, the absorption approach emphasizes the relationship between a country’s domestic absorption (aggregate domestic expenditure – consumption, investment, and government spending) and its foreign earnings (exports). The approach posits that a BOP disequilibrium arises when there is a mismatch between a country’s absorption and its foreign earnings.
- Mechanism: The fundamental equation of the absorption approach is: X = A + M, where X = Exports, A = Absorption, and M = Imports. A BOP deficit implies that absorption (A) exceeds foreign earnings (X). To restore equilibrium, either absorption must be reduced or foreign earnings must be increased.
- Policy Implications: The absorption approach suggests that BOP correction requires adjustments in domestic policies to control absorption. This can be achieved through fiscal contraction (reducing government spending or increasing taxes) or monetary tightening (raising interest rates to reduce investment and consumption). Devaluation can play a supporting role by increasing foreign earnings, but it is not sufficient on its own.
- Limitations: The approach can be politically difficult to implement, as measures to reduce absorption are often unpopular. It also assumes a stable exchange rate regime.
Comparison of the Elasticity and Absorption Approaches
The following table summarizes the key differences between the two approaches:
| Feature | Elasticity Approach | Absorption Approach |
|---|---|---|
| Focus | Price Elasticities of Demand | Relationship between Absorption and Foreign Earnings |
| Primary Adjustment Mechanism | Exchange Rate Adjustments (Devaluation) | Domestic Policy Adjustments (Fiscal/Monetary) |
| Key Condition | Marshall-Lerner Condition (|εx + εm| > 1) | Absorption = Foreign Earnings |
| Role of Exchange Rate | Central to BOP correction | Supportive, but not sufficient |
| Political Feasibility | Relatively easier to implement | Often politically difficult |
Real-world examples: The 1997 Asian Financial Crisis saw several countries attempting devaluation (elasticity approach) with limited success due to high import dependence and inelastic demand. Germany in the 1980s, facing a persistent trade surplus, used fiscal austerity (absorption approach) to reduce domestic demand and prevent further imbalances. More recently, countries facing current account deficits often employ a combination of both approaches, utilizing exchange rate flexibility alongside fiscal and monetary policies.
Conclusion
Both the elasticity and absorption approaches provide valuable insights into the mechanisms of BOP adjustment. While the elasticity approach highlights the importance of exchange rate policy and price competitiveness, the absorption approach emphasizes the role of domestic demand management. In practice, a combination of both approaches is often necessary to achieve sustainable BOP equilibrium. The effectiveness of each approach depends on the specific economic circumstances of the country, including the elasticity of demand, the degree of openness, and the prevailing exchange rate regime. Modern macroeconomic models often integrate elements of both approaches to provide a more nuanced understanding of BOP dynamics.
Answer Length
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