Presentation on Elasticity & Absorption

8/3/2019 Presentation on Elasticity & Absorption

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The Elasticity Approach toThe Elasticity Approach to

BalanceBalance--ofof--Payments andPayments and

ExchangeExchange--RateRateDeterminationDetermination


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Daniels and VanHoose Elasticity Approach 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.


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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.


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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.


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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 disproportionaldecline in the nations imports.


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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. whena nation exports, it demands foreign

exchange as payment.


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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.


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DI

DE

SI

SE

Foreign Exchangein domestic currency units

Spot Exchange Rate

The superscripts I and E

denote the relatively

inelastic and relatively

elastic supply and

demand curves.


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DI

DE

SI

SE


Spot Exchange Rate

S0

At a spot exchange rate

of S0, the nation has an

excess supply of foreign

exchange and, therefore,

is running a current

account deficit.


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DI

DE

SI

SE


Spot Exchange Rate

S0

The elasticity approach

considers how the

responsiveness ofimports

and exports to changes

in the exchange rate

determines the extent

to which a depreciation

will improve the current

account balance.


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DI

DE

SI

SE


Spot Exchange Rate

S0

If foreign exchange

supply and demand

are relatively elastic, asmall change in the spot

rate can correct the

deficit.S1


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DI

DE

SI

SE


Spot Exchange Rate

S0

If foreign exchange supply

and demand are relatively

inelastic, a larger change in

the spot rate is required to

correct the deficit.

S1


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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.


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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.


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The Absorption ApproachThe Absorption Approach

to Balanceto Balance--ofof--Payments andPayments and

ExchangeExchange--RateRateDeterminationDetermination


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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.


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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,


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Real Income A nations real income (y) is equivalent to

total expenditures on its output

y | c + i + g + x,

where x denotes exports.


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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, the nation is running a current account surplus.


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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 = (c+i+g+x) - (c+i+g+m) = x - m,or

y - a = ca.


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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?


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Consider the case of an economic

expansion. Real income rises, therebyincreasing real expenditures or absorption.

Whether the current account balance

improves or worsens depends on the

relative changes in these two variables.

Balance of Payments

Determination


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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

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Presentation on Elasticity & Absorption