The Elasticity Approach to

Balance-of-Payments and
Exchange-Rate
Determination
 Overview of the Elasticity
Approach
• The elasticity approach emphasizes price
changes as a determinant of a nation’s
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 nation’s 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 nation’s
currency.
• For example, if import demand is highly
elastic, a depreciation of the domestic
currency will cause a disproportional
decline in the nation’s imports.
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 Elasticity of Foreign Exchange
Supply and Demand
• A nation’s 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 nation’s demand for foreign exchange is
dependent upon its export supply, e.g. when
a 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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Spot Exchange Rate
The superscripts I and E
denote the relatively
inelastic and relatively
elastic supply and
demand curves.

SE
DE

SI DI
Foreign Exchange
in domestic currency units

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 At a spot exchange rate
of S0, the nation has an
Spot Exchange Rate
excess supply of foreign
exchange and, therefore,
S0 is running a current
account deficit.

SE
DE

SI DI
Foreign Exchange
in domestic currency units

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 The elasticity approach
Spot Exchange Rate considers how the
responsiveness of
imports
S0
and exports to changes
in the exchange rate
determines the extent
SE to which a depreciation
will D E
improve the current
account balance.

SI DI
Foreign Exchange
in domestic currency units

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 If foreign exchange
supply and demand
Spot Exchange Rate
are relatively elastic, a
small change in the spot
S0 rate can correct the
S1 deficit.

SE
DE

SI DI
Foreign Exchange
in domestic currency units

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 If foreign exchange supply
and demand are relatively
Spot Exchange Rate inelastic, a larger change
in the spot rate is required
S0 to
correct the deficit.

S1 SE
DE

SI DI
Foreign Exchange
in domestic currency units

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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 nation’s
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 Approach
to Balance-of-Payments and
Exchange-Rate
Determination
 Overview of 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.

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 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,

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 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.

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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
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.

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 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?
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 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.

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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 < a  ca < 0.
• Similar conclusions can be reached for a nation
experiencing an economic contraction.

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 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.
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 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.

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 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.

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 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.
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 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-of-
payments and exchange-rate performance.
• It is not clear that expenditure switching and
absorption instruments are effective.
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