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Topic 4

ELASTICITIES AND ABSORPTION APPROACHES TO THE CURRENT ACCOUNT - 2020

In this topic

Investigate the relationship between the exchange rate and the balance of payments

What are the effects of an exchange rate change on the current account balance of a country?

Content

Introduction to the Elasticities Approach to the balance of payments

Small and Large Countries

Small country in Export and Import market

Large country in Export and Import market

Introduction to the Absorption Approach

Diagrammatic Analysis

Impact of exchange rate change on trade balance

Below full employment

At full employment

Terms of trade effect

Introduction

Parity conditions do not pay particular attention to the interaction between the exchange rate and the current account.

Does an increase in the exchange rate result in an improvement in the balance of trade?

Review – 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.

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.

ELASTICITIES APPROACH:INTRODUCTION

Concentrates on the Trade Balance (TB) the value of exports minus the value of imports

The Trade Balance can be measured in terms of either the domestic (d) or foreign currency (f).

As FX is earned through Exports the Supply of FX is foreign currency Export receipts.

As the Demand for FX is derived from Imports foreign currency Import expenditure is the D for FX.

Standard Assumptions

Level of economic activity is fixed

Neglect of second round effects

As exports and imports change it will typically cause other things such as income to change which will in turn have implications for exports and income but these feedback effects are neglected

Capital flows are strictly accommodating

The financial implications of imports and exports are neglected ie capital inflows and outflows are treated as being passive

Law of one price holds

It is assumed the prices of all goods, exports and imports, are the same domestically as they are overseas after adjusting for the exchange rate.

Pd=Pfe.

Which Currency ?

Import Market

The D for IM is a function of the domestic currency price of IM

The S of IM is function of the foreign currency price.

To have the D and S curves on the one diagram the currency of the price of IM has to be determined. In order to bring both together the exchange rate need to be used.

DIM

SIM

Which Currency ?

Export Market

The S of X is a function of the domestic currency price of X

The D for X is a function of the foreign currency price.

For the D and S curves to be drawn on the one diagram the currency of the price of X has to be determined. In order to bring both together the exchange rate need to be used.

LARGE AND SMALL COUNTRIES

Small

A country that is a small in the IM (X) market can not effect the foreign currency price of its IM (X) no matter how much or little they purchase (sell) of the IM (X) good.

Large

A country that is a large country in the IM (X) market can effect the foreign currency price of its IM (X) by the amount that it purchases (sells).

If it purchases more IM (sells more X) it causes the foreign currency price of IM (X) to increase (decrease).

While if it purchases less IM (sells less X) it causes the foreign currency price of IM (X) to fall (increase).

CASE 1: SMALL COUNTRY IN IM AND X MARKET

Import Side The D for IM is a function of the domestic currency price of IM If the demand curve for imports is drawn against the foreign currency price of imports there will be a different demand curve for imports at every different exchange rate As the exchange rate goes up it means that purchasers of imports will only purchase the same quantity of imports as before if the foreign currency price of imports goes down.

This is because every foreign currency price after the increase in the exchange rate translates into a higher domestic currency price

Demand and Supply of Imports

Assuming a world/foreign price of imports which the small country can not effect, and an exchange rate increase.

SIM

(e0)

(e1)

A decrease in the value of the A$ leaves the foreign currency price of IM unchanged but decreases IM therefore decreasing the value of import expenditure.

CASE 1: SMALL COUNTRY IN IM AND X MARKET

Export Side

The S for X is a function of the domestic currency price of X If the supply curve for exports is drawn against the foreign currency price of exports there will be a different supply curve for exports at every different exchange rate

As the exchange rate goes up exporters are prepared to supply the same quantity of exports as before at a lower foreign currency price because each unit of foreign currency gives more units of the domestic currency.

Demand and Supply of Exports

Assuming a world price of exports, which the small country can not effect, and an increase in the exchange rate.

(e0)

(e1)

An increase in the exchange rate, ie a decrease in the value of the domestic currency, causes the value of export receipts to increase

Summary

What will happen to the trade balance measured in foreign currency as a result of an increase in e when the country is small in the export and import market?

Unambiguous improvement in the trade balance.

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS

The Market for Imports (IM)

Since the country is a large country in the import market it faces an upward sloping supply curve of imports so as the demand for imports decreases, as a result of an increase in the exchange rate, the price of imports in terms of the foreign currency also decreases.

SIM

DIM

D’IM

PFM

PFA

PFB

IMB IMA

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS.

The Market for Imports (IM)

With the Supply of Imports being less than perfectly elastic, as the exchange rate increases (ie the value of the domestic currency decreases) foreign currency expenditure on imports falls for two reasons

the quantity of IM falls and

the foreign currency price of IM decreases

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS.

The Market for Exports (X)

Since the country is a large country in the export market it faces a downward sloping demand curve for exports so as the supply of exports increases, as a result of an increase in the exchange rate, the price of exports in terms of the foreign currency decreases

SX’

PFX

PFA

PFB

XA XB

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS.

The Market for Exports (X)

The increase in the quantity of exports works to increase foreign currency export receipts (ie supply of foreign exchange)

But the reduction in the foreign currency price of exports works to reduce foreign currency exports receipts (ie supply of foreign exchange).

What happens overall to foreign currency value of export receipts depends on elasticities.

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS.

Difficult to determine what overall happens to the balance of trade as a result of a decrease in the value of the domestic currency for a country that is large in both the IM and X market.

The result is dependent on what happens to foreign currency export receipts as it has been established that foreign currency import expenditure definitely decreases.

If foreign currency export receipts increase, because the increase in export quantity outweighs the effect of the lower foreign currency price, the balance of trade must improve.

CASE 2 LARGE COUNTRY IN EXPORT AND IMPORT MARKETS.

2.If foreign currency export receipts decrease, because the increase in export quantity is outweighed by the the effect of the lower foreign currency price, there are two further possibilities.

2(a) The decrease in foreign currency export receipts is outweighed by the decrease in foreign currency import expenditure causing the balance of trade to improve

2(b) The decrease in foreign currency export receipts outweighs the decrease in foreign currency import expenditure causing the balance of trade to worsen

Small country: – increase in e – depreciation of domestic currency

Large country: – increase in e – depreciation of domestic currency

Gradual Trade Flow Adjustment 1. Small Country and Incomplete Exchange Rate Pass Through

The percentage by which import prices rise when e increases by 1 percent is known as the degree of pass-through from the exchange rate to the domestic currency price of imports.

We have assumed that the law of one price holds, and therefore the degree of pass-through is 1: any exchange rate change is passed through completely to the domestic currency price of imports.

Exchange rate pass-through, however, can be incomplete, particularly where there is market power.

This will result in a slow adjustment of trade volumes to an exchange rate change.

Gradual Trade Flow Adjustment 2. Large Country and the J-Curve

Elasticities are greater in the long run than in the short run, so export and import volumes may not immediately change following a change in the exchange rate.

An increase in the exchange rate can initially result in a worsening of the trade balance, followed by an improvement as quantities start to change

https://www.youtube.com/watch?v=7sQbJmukOb4

The J Curve

Exchange rate pass through

https://www.rba.gov.au/publications/bulletin/2011/sep/2.html

For a sample period between1992:Q1–2011:Q1, RBA show that a 10% appreciation of AUD lowers import prices by 8% after the first year (first-stage pass-through). Manufactured goods prices requires 5 quarters to achieve 75% pass through as compared to consumer prices that take10 quarters

The second stage relates movements in overall consumer price inflation to changes in import prices. The estimates suggest that a 10 per cent exchange rate appreciation can typically be expected to result in a reduction in overall consumer prices (modelled in underlying terms) of around 1 per cent, spread over around three years.

Exchange Rate Pass Through for Consumer Durable Items-Australia

Exchange rate pass through might be less than 100% if there is ‘pricing to market’ or ‘price discrimination’. Pricing-to-market means a foreign supplier adjusts its export prices depending on the national market to which it exports

price levels of a range of consumer durable items in Australia estimated to be higher than those in a number of other developed economies, including the United States, although below those in many European economies

Chung, Kohler and Lewis (2011) The Exchange Rate and Consumer Prices, RBA. https://www.rba.gov.au/publications/bulletin/2011/sep/2.html

Weakness of the Elasticities Approach

Assumes that income does not change, therefore any feedback from a change in income to a change in net exports is ignored.

The Absorption Approach will complement the Elasticities Approach by incorporating income effects.

INTRODUCTION TO ABSORPTION APPROACH

Complements the Elasticities Approach by incorporating income effects.

Central focus on income and the demand side of the economy

Concentrates on the goods market

Ignores Financial Account transactions

Absorption Approach

Absorption, A, can be defined as total spending by domestic residents, be it on domestically produced goods or foreign produced goods.

A nation’s expenditures fall into four categories: consumption (C), investment (I), government expenditures (G), and imports (M). The sum of these four categories is Absorption (A):

A=C+I+G+M

While, a nation’s income (Y) equals its total expenditures on output, where X is real exports; income is expressed as:

Y=C+I+G+X

Alternative way to derive the relationship between national income and absorption with CA

Absorption

A nation’s current account (CA) balance equals the difference between real income (Y) and absorption (Y), which can be written as:

Y-A=(C+I+G+X)- (C+I+G+M)=(X-M)

Thus, the change in CA equals the change Y minus the change in A as follows:

Δ(Y-A)= Δ(X-M)

The trade balance can only improve when output is increased relative to absorption.

Since (X-IM)= (Sn – I)

Y-A= (Sn – I)

Absorption

Savings: positive function of the level of income

Investment: negative function of the rate of interest

Exports: positive function of the foreign level of income and of the price of foreign exchange

Imports: positive function of the domestic level of income and negative function of the price of foreign exchange

Balance of trade: negative function of the domestic level of income

Government: exogenous

X - IM

X – IM

Y1 Y0 Y2 Y

The three key determinants are Y, Y* and e

Changes in e and Y* shift the (X – IM) schedule.

Assume the domestic economy is a small country in the market for imports and exports, so an increase in e will shift the (X-IM) schedule upwards.

A change in Y will result in a movement along the schedule

Slope depends on the Marginal Propensity to Import

DIAGRAMMATIC ANALYSIS

Balance of Trade Schedule

National Savings minus Investment Schedule

The main determinants of (Sn – I) are i G and Y

If i and G are fixed, an increase in Y will increase (Sn – I)

Slope represents the Marginal National Propensity to Save (MNPS) A change in i or G shifts the (Sn – I) schedule while a change in Y is a move along the schedule

Sn – I

Y1 Y0 Y2 Y

Sn - I

Equilibrium

X-IM

Sn-I

X-IM

Sn-I

An increase in the exchange rate (A decrease in value of domestic currency)

If a reduction in the value of the domestic currency raises income and output relative to absorption, the trade balance will improve.

A reduction in the value of the domestic currency will increase income if net exports increase, and we are below full employment.

A reduction in the value of the domestic currency will have indirect (via change in Y) and direct effects on absorption.

An increase in the exchange rate (A decrease in value of domestic currency) Case 1. Below full employment

X – IM

Y0 Y1 Y

(X – IM)2

(Sn – I)1

(X – IM)1

An increase in the exchange rate (A decrease in value of domestic currency)

Trade balance improvement, but smaller than the full exogenous increase in net exports. Higher income has lead to an increase in import spending (indirect absorption).

An increase in the exchange rate (A decrease in value of domestic currency)

Suppose, however, Y0 is the full employment level of income.

An excess demand will lead to an increase the general price level.

If we are at full employment, the trade balance cannot improve via an increase in income and output.

Trade balance can only improve if there is a reduction in direct absorption.

An increase in the exchange rate (A decrease in value of domestic currency)

Case 2. At full employment

X – IM

Y0 Y1 Y

(X – IM)3

(X – IM)2

(Sn – I)1

(X – IM)1

(Sn – I)2

An increase in the exchange rate (A decrease in value of domestic currency)

Following the increase in the general price level

Net export function will shift to the left (X-IM)3

Savings-investment balance schedule will shift leftwards (Sn – I)2

Real balance effect: A reduction in direct absorption, as real wealth has fallen and wealth holders will cut their spending to restore their real money balance holdings.

In the long run the (X-M) and (Sn – I) functions may intersect through Y0. The reduction in the value of the domestic currency has eliminated the trade deficit through a reduction in direct absorption.

However:

An increase in the general price level leads to a redistribution of wealth from creditors to debtors.

If debtors have a higher marginal propensity to spend out of wealth than creditors, then this could swamp the real balance effect, resulting in an increase in direct absorption (shifting the (Sn – I) rightwards), leading to a deterioration in the trade balance.

Implications for policy

Therefore if the government wants to eliminate a trade deficit and avoid inflation

it may need to use a combination of macroeconomic policies

to reduce direct absorption and shift the (Sn – I) leftwards,

and exchange rate changes that shift the (X-M) curve rightwards.

We will consider these issues in the next topic.

The terms of trade effect

We assumed that a reduction in the value of the domestic currency will increase income if we are below full employment and net exports increase.

However, there may be a terms of trade effect that lowers national income!

The terms of trade are the domestic currency price of exports/domestic currency price of imports. Assuming a small country in the import market and a large country in the export market, a reduction in the value of the currency worsens a country’s terms of trade

A deterioration in the terms of trade will reduce real income. Consumers will reduce their saving, and therefore the (Sn – I) curve will shift rightwards. This has a negative effect on the trade balance.

A reduction in the value of the domestic currency is now less effective at improving the trade balance.

The terms of trade effect

X – IM

Y0 Y1 Y

(X – IM)2

(Sn – I)1

(X – IM)1

(Sn – I)2

Weakness of the Elasticities and Absorption Approaches

Ignores financial account. Assumes that the financial account passively adjusts to trade balance

ie a Balance of Trade surplus ( an increase in the supply of FX) results in an equivalent capital outflow ( an increase in the demand for FX) so that there is no overall excess supply of the foreign currency.

Additional notes

Topic 4

The Marshall Lerner Condition

The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments.

The condition states that, provided that the sum of the price elasticity of demand coefficients for exports and imports is greater than one then a fall in the exchange rate will reduce a deficit and a rise will reduce a surplus.

The Marshall-Lerner (M-L)

The Elasticity Approach, The Marshall-Lerner condition and the J-curve are all interconnected. However, empirical evidence is at best mixed.

Marshall-Lerner (M-L) Condition is a further extension of the elasticities approach. The M-L condition, which stipulates that a devaluation or depreciation of its currency will improve a country’s trade balance only if the sum of the absolute values of a country’s import and export price elasticities are greater than one, is a fundamental tenet of international economics

Caporale, Gil-Alana, and Mudida (2012), show that there exists a well-defined cointegrating relationship linking the balance of payments to the real exchange rate and relative income, and that the ML condition is satisfied in the long run although the convergence process is relatively slow

Its Criticisms:

The elasticity approach based on the Marshall-Lerner condition has the following defects:

1. Misleading:

The elasticity approach which applies the Marshallian concept of elasticity to solve BOP deficit is misleading. This is because it has relevance only to incremental change along a demand or supply curve and to problems dealing with shifts in these curves. Moreover, it assumes constant purchasing power of money which is not relevant to devaluation of the country’s currency.

2. Partial Elasticities:

The elasticity approach has been criticised by Alexander because it uses partial elasticities which exclude all factors except relative prices and quantities of exports and imports. This is applicable only to single-commodity trade rather than to a multi-commodity trade. It makes this approach unrealistic.

3. Supplies not Perfectly Elastic:

The Marshall-Lerner condition assumes perfectly elastic supplies of exports and imports. But this assumption is unrealistic because the country may not be in a position to increase the supply of its exports when they become cheap with devaluation of its currency.

4. Partial Equilibrium Analysis:

The elasticity approach assumes domestic price and income levels to be stable within the devaluing country. It, further, assumes that there are no restrictions in using additional resources into production for exports. These assumptions show that this analysis is based on the partial equilibrium analysis.

It, therefore, ignores the feedback effects of a price change in one product on incomes, and consequently on the demand for goods. This is a serious defect of the elasticity approach because the effects of devaluation always spread to the entire economy.

5. Inflationary:

Devaluation can lead to inflation in the economy. Even if it succeeds in improving the balance of payments, it is likely to increase domestic incomes in export and import-competing industries. But these increased incomes will affect the BOP directly by increasing the demand for imports, and indirectly by increasing the overall demand and thus raising the prices within the country.

6. Ignores Income Distribution:

The elasticity approach ignores the effects of devaluation on income distribution. Devaluation leads to the reallocation of resources. It takes away resources from the sector producing non-traded goods to export and import-competing industries sector. This will tend to increase the incomes of the factors of production employed in the latter sector and reduce that of the former sector.

7. Applicable in the Long Run:

As discussed above in the J-curve effect of devaluation, the Marshall-Lerner condition is applicable in the long-run and not in the short. This is because it takes time for consumers and producers to adjust themselves when there is devaluation of the domestic currency.

8. Ignores Capital Flows:

This approach is applicable to BOP on current account or balance of trade. But BOP deficit of a country is mainly the result of the outflow of capital. It thus ignores BOP on capital account. Devaluation as a remedy is meant to cut imports and the outflow of capital and increase exports and the inflow of capital.

Marshall-Lerner Condition

Abbas Ali, D., Johari, F., & Haji Alias, M. (2014). The effect of exchange rate movements on trade balance: A chronological theoretical review. Economics Research International, 2014.

Evidence Against The Marshall-Lerner

Bahmani, Harvey and Hegerty (2013) re-estimation using previous studies’ coefficients and standard errors shows that, although the point estimates in many studies suggest that the M-L condition is met, it really is not met in half of the cases. This lack of evidence is confirmed with the Bahmani, Harvey and Hegerty (2013) own empirical tests.

They suggest that Policymakers who hope to improve their countries’ competitive position could benefit from learning that this policy is indeed less effective than might be supposed. This could lead to the implementation of more effective economic policies

Sek and Har (2014) test the M-L and their results fail to show the validity of Marshall-Lerner condition in all five pairs of bilateral trades for Malaysia with its major trading partners. However, their results show that higher income level of trading partners may lead to improvement in the trade balance of domestic country.

Sek, S. K., & Har, W. M. (2014). Testing for Marshall-Lerner condition: Bilateral trades between Malaysia and trading partners. Journal of Advanced Management Science Vol, 2(1)

Bahmani, M., Harvey, H., & Hegerty, S. W. (2013). Empirical tests of the Marshall-Lerner condition: a literature review. Journal of Economic Studies, 40(3), 411-443.