International Finance

Third edition

by Keith Pilbeam

Chapter 3 - Elasticity and Absorption Approaches to the Balance of Payments

Jump to Revision Questions for chapter 3

In the opening two chapters we have introduced the exchange rate and the balance of payments. In this chapter, we investigate the relationship between the exchange rate and the balance of payments. In particular, we shall be studying two models that investigate the impact of exchange rate changes on the current account position of a country. These two approaches are popularly known as the elasticity approach and the absorption approach. Both models were designed to tackle one of the most important questions in international economics – will a devaluation (or depreciation) of the exchange rate lead to a reduction of a current account deficit? The answer to this question is of crucial importance because if an exchange rate change cannot be relied upon to ensure adjustment of the current account, then policy-makers will have to rely on other instruments to improve the position.

We start the chapter by examining the impact of exchange rate changes according to the elasticity approach which looks at the impact of exchange rate changes assuming domestic and foreign prices are fixed. This is followed by an analysis of the absorption model which examines the effects of the exchange rate in terms of its impact on domestic income and spending. The chapter concludes by analysing the similarities and differences between the two models. For simplicity, throughout this chapter we shall ignore the complications of unilateral transfers and interest, profit and dividends on the current account balance and concentrate on the export and import of goods and services. Throughout this chapter, the exchange rate is defined as domestic currency units per unit of foreign currency, so that a devaluation/depreciation of the currency is represented by a rise in the exchange rate.

Revision Questions
  1. A devaluation will lead to a deterioration of the current account." Discuss this statement with reference to the elasticity approach to devaluation.
  2. "A devaluation will lead to a improvement in the current account." Discuss this statement with reference to the absorption approach to devaluation.
  3. "A devaluation will lead to a J-curve effect on the balance of payments." Discuss.
  4. "Devaluation is a sign of economic failure and will do little to help improve the balance of payments or economic performance." Discuss