Discuss the elasticity approach and absorption approach for adjustments in balance of payments.

The Elasticity Approach

The elasticity approach, largely based on the principles of Marshall-Lerner condition, posits that a country experiencing a BoP deficit can restore equilibrium through price and income adjustments. The core idea is that a devaluation of the currency will improve the trade balance by making exports cheaper and imports more expensive. However, the success of devaluation hinges on the Marshall-Lerner condition, which states that the sum of the price elasticities of demand for exports and imports must be greater than one.

• Mechanism: Devaluation leads to a change in relative prices, altering the volume of exports and imports. If the Marshall-Lerner condition holds, the percentage increase in export volume will outweigh the percentage decrease in import volume, leading to an improvement in the trade balance.
• Policy Implications: This approach advocates for flexible exchange rates and minimal government intervention. The focus is on allowing market forces to correct the imbalance. Fiscal and monetary policies are used to manage domestic demand and inflation.
• Limitations: The Marshall-Lerner condition may not always hold, especially in the short run. J-curve effect (initial worsening of trade balance after devaluation) can occur. It assumes perfect competition and ignores other factors influencing trade, such as non-tariff barriers.

The Absorption Approach

The absorption approach, developed by Jan Tinbergen, focuses on the relationship between a country’s national income (Y) and its total absorption (A). Absorption (A) is the sum of domestic consumption (C) and investment (I) plus government expenditure (G) on domestically produced goods, plus exports (X). The approach suggests that a BoP deficit arises when absorption exceeds domestic output (Y). Therefore, to restore equilibrium, absorption must be reduced or domestic output must be increased.

• Mechanism: A BoP deficit implies A > Y. To restore equilibrium, either A must fall (through contractionary fiscal or monetary policy) or Y must rise (through expansionary policies). The choice depends on the specific circumstances of the economy.
• Policy Implications: This approach emphasizes the use of fiscal and monetary policies to manage aggregate demand. Contractionary policies (higher taxes, reduced government spending, higher interest rates) can reduce absorption, while expansionary policies (lower taxes, increased government spending, lower interest rates) can increase output.
• Limitations: Implementing contractionary policies can lead to unemployment and recession. Increasing output may be difficult if the economy is already operating at full capacity. The approach may not be effective if the deficit is caused by external shocks.

Comparative Analysis

The elasticity and absorption approaches differ significantly in their focus and policy prescriptions. The elasticity approach prioritizes exchange rate adjustments and relies on the responsiveness of trade volumes to price changes. The absorption approach, on the other hand, emphasizes domestic demand management and focuses on aligning absorption with output.

Feature	Elasticity Approach	Absorption Approach
Core Principle	Price and income elasticities of demand	Relationship between absorption and output
Primary Adjustment Mechanism	Exchange rate devaluation	Fiscal and monetary policies
Focus	External sector	Domestic sector
Key Condition	Marshall-Lerner condition	A ≤ Y
Short-run Effects	J-curve effect possible	Potential for recession

In practice, a combination of both approaches is often necessary to achieve sustainable BoP equilibrium. For example, a country might devalue its currency (elasticity approach) while simultaneously implementing fiscal austerity measures (absorption approach) to reduce domestic demand.