BOP Elasticities Approach

Chapter 5
5. The Balance of Payment
17-Jan-20 fentahun.baylie@uog.com 1

5.1. NIA and BOP
5.1.1. National Income Account (NIA)
❑Y = C + I + G + X-M
• Y = GDP
• C = consumption
• G = government spending
• X-M=CA = current account balance
❑This is called National Income Identity
❑Consumption = spending by households, including consumer
spending on durable goods
❑Investment = Business sector’s adding to the physical stock of
capital, including inventories. (individual household’s purchases of
stocks, bonds or real estates are not included)

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❑Government purchases= spending by federal, state, or
local governments
❑Current Account
➢CA = X – M = net export of goods and services
➢Strictly speaking CA = X – M +UT but, for a while, we
ignore UT = unilateral transfer
➢In a closed economy, there is no CA. (because X = M = 0)
❑(Domestic spending on goods and services produced
domestically) = C + I + G – M
❑(Foreign spending on goods and services produced
domestically) = X
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5.1.1. National Income Account (NIA)

Current account balance (cont’d)
❑CA = X – M
➢When X > M or CA > 0, we say current account surplus.
➢When X < M or CA < 0, we say current account deficit.
❑CA = Y – (C + I + G) = Y – A
➢where A = domestic absorption
❑A country with current account deficit is buying more
from foreigners than it sells to them
➢It has to increase net foreign debts.
➢CA = net foreign wealth
❑Let S = national saving = Y – C – G.
❑Then S = I + CA (In a closed economy S = I)
❑An open economy can increase investment by
borrowing abroad.

Saving
❑S = SP + SG
where SP = Yd – C = Y – T – C
SG = T – G
SP = private saving; SG = government saving;
Yd = disposable income; T = net tax.
❑Then SP = (C + I + G + CA) – T – C
= I + CA + (G - T)
where G – T = government budget deficit.
❑So CA = SP – I – (G – T)
❑A large gov’t budget deficit leads to a large current account
deficit.

5.1.2. Balance of Payments
❑Balance of payments
• Record of the economic transactions
• Between the residents of one country and the rest of the world
• Double-entry accounting system
❑International transaction
• Exchange of goods, services, or assets
• Between residents of one country and those of another
❑Residents
• Businesses, individuals, and government agencies
❑Credit transaction (+)
• Receipt of a payment from foreigners
❑Debit transaction (-)
• Payment to foreigners
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❑Ethiopia credit transaction (+)
• Merchandise exports
• Transportation and travel receipts
• Income received from investments abroad
• Gifts received from foreign residents
• Aid received from foreign governments
• Investments in Ethiopia by overseas residents
❑Ethiopia debit transaction (-)
• Merchandise imports
• Transportation and travel expenditures
• Income paid on the investments of foreigners
• Gifts to foreign residents
• Aid given by Ethiopia government
• Overseas investment by Ethiopia residents
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❑Current account balance
• Balance on goods and services
• Investment income
• Unilateral transfers
❑Capital and financial account
• All international purchases or sales of assets
• Private-sector and official transactions
❑Official settlements transactions
• Movement of financial assets among official holders
• Official reserve assets
• Liabilities to foreign official agencies
❑Statistical discrepancy
• Errors and omissions
• Information – some is collected, some is estimated
17-Jan-20

34-10
17-Jan-20 fentahun.baylie@uog.com

A) Current Account (CA)
❑Exports (credit)
❑Imports (debit)
• Merchandise: commodity transaction
• Services: travel, tourism, royalties, transportation costs,
insurance premiums.
• Income
• Income receipts on Ethiopia assets abroad (credit)
• Income payments on foreign assets in Ethiopia (debit)
• Direct investment receipts and payments
• Interest, dividends.
❑Unilateral Transfers (debit)
• Ethiopia foreign aid, gifts, retirement pensions, interest
payments to foreigners on their Ethiopia gov’t debt, workers’
remittances.

B) Capital Account (KA)
❑Ethiopia assets abroad
• Ethiopia official reserve assets (Gold, reserve in IMF, foreign
currencies)
• Ethiopia gov’t assets
• Ethiopia private assets (direct investment, foreign securities)
❑Foreign assets in Ethiopia
• Foreign official assets (gov’t securities)
• Other foreign assets (direct investment, treasury securities)
C) Statistical Discrepancy
• Theoretically, current account and capital account should add
up to zero. But in reality, there is a discrepancy due to errors,
time lags, and so on.
D) Official Reserve Assets
• purchase or sale of foreign assets held by the central bank
• Official international reserves: gold, foreign currencies, etc.

Examples
1. An Ethiopian buys a share of German stock, paying
by writing a $10,000 check on his account with a
Swiss Bank.
• Debit: Ethiopia asset held abroad $10,000
• Credit: Ethiopia asset held abroad $10,000.
For Germany
• Credit: Foreign asset held in Germany
• Debit: German asset held abroad
2. An Ethiopian buys a share of German stock, paying
the seller with a $10,000 check on an American bank.
• Debit: Ethiopia asset held abroad $10,000
• Credit: Foreign asset held in Ethiopia $10,000

3. The French government carries out an official foreign
exchange intervention in which it uses dollars held in an
Ethiopian bank to buy French currency from its citizens.
• Debit: Foreign asset held in Ethiopia $1 million
• Credit: Foreign asset held in Ethiopia $1 million
4. A tourist from Ethiopia buys a meal at an expensive
restaurant in Lyons, France, paying with a VISA credit
card. VISA uses a checking account in France to make
payments.
• Debit: Import, Services $300
• Credit: Ethiopia assets held abroad $300
Examples

5.2. Approaches to The BOP
❑The Elasticities Approach to the Balance of Trade
❑The Absorption Approach to the Balance of Trade
❑The Monetary Approach to the Balance of Payment

5.2.1. The Elasticities Approach to BOT
❑The elasticities approach emphasizes price changes as a
determinant of a nation’s balance of payments and
exchange rate.
❑The elasticities approach is helpful in understanding the
different outcomes that might arise from the short to long
run.
❑Traditional approaches to balance-of-payments and
exchange-rate determination assume that capital flows
occur only to finance real-sector transactions.
❑Hence, the quantity of foreign exchange demanded and
the quantity of foreign exchange supplied depend only on
international transactions of goods and services.
16

5.2.1. The Elasticities Approach to BOT
❑d = elasticity of demand: the responsiveness of
quantity demanded to changes in price
d = (%Qd)/(%P) which is usually negative
❑| d | > 1  the demand is elastic
❑| d | < 1  the demand is inelastic
❑If the demand is elastic, the 1% rise in price leads
to more than 1% decline in quantity demanded.
❑If the demand is inelastic, the 1% rise in price leads
to less than 1% decline in quantity demanded.

1. The Demand for and Supply of Foreign Exchange
❑The demand for a nation’s currency is dependent
upon foreign residents’ demand for its exports, that is,
it depends on foreign residents’ desire to obtain the
domestic currency to facilitate their purchases of the
domestic country’s exports.
❑The supply of a nation’s currency is dependent upon
(among other things) domestic residents’ demand for
imports, that is, when a nation’s residents import, they
supply the domestic currency as payment.
• The left-hand panel illustrates an import demand curve for
as combinations of the quantities of champagne demanded
at various prices.
• The right-hand panel illustrates the corresponding demand
for foreign exchange as combinations of the quantities of
foreign exchange demanded at various exchange rates.
18

Import Demand and the Demand for the FX
19

The Export Supply Curve and the
Supply of the FX
20

2. 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 the nation’s exports to rise and
imports to decline.
❑The elasticities approach, therefore, considers the
responsiveness of the quantity of imports and the
quantity of 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
relatively larger decline in the nation’s imports.
21

3. Devaluation and BOT
(1): stable FX market equilibrium
(2): unstable FX market equilibrium
❑The case (2) could occur when Ethiopian birr demand for
US imports and US demand for Ethiopian exports are both
very inelastic.
❑The greater the elasticities of both country’s demand for
the other country’s goods, the greater the improvement in
Ethiopian trade balance after a birr devaluation.
❑The condition that guarantees the case (1) is called
Marshall-Lerner Condition.
❑After the devaluation, it is often observed that the trade
balance initially deteriorates for a while before getting
improved.

=>Elasticities and J-Curves
❑Why do we have a J-Curve?
❑The initial demands tend to be inelastic.
❑Suppose Ethiopia imports good X from the US and
exports good Y to the US.
❑Devaluation  EB/$ 
 PY
B  & PX
B 
 QY
d  & QX
d 
❑But if Ethiopian demand for Y is inelastic, the %
decrease in QY
d would be smaller than the % increase
in PY
B so that Imports = PX
B QX
d would increase.
❑Further, if US demand for X is inelastic, the %
increase in QX
d would be smaller than the % decline in
PX
B so that Exports = PY
B QY
d would fall.

=>Surpluses and Deficits
❑It follows that an excess quantity supplied of the domestic
currency is equivalent to a current account deficit.
❑Likewise, an excess quantity demanded of the domestic
currency is equivalent to a current account surplus.
❑The current account is in balance when the quantity of the
domestic currency supplied and the quantity demanded are
equal.
❑The current account deficit is equivalent to the difference
between the quantity of foreign exchange demanded and
the quantity of foreign exchange supplied.
24

=>The Marshall-Lerner Condition
❑Will a depreciation always improve the current account
balance?
❑The Marshall-Lerner condition specifies the necessary
conditions for the current account to improve.
❑According to this condition, the current account balance
will improve if the sum of the elasticity of import demand
and the elasticity of export supply exceed unity.
❑The current account balance may respond differently to a
currency change in the short run relative to the long run.
❑The J-Curve effect refers to a phenomenon in which a
depreciation of the domestic currency causes a nation’s
balance of payment to worsen before it improves.
25

The J-Curve
26

J-Curve Effect
❑Initially there is a current account deficit of $40 million.
❑At time t, the dollar depreciates.
❑In the short run, import demand and export supply may be
inelastic and the current account widens to $48 million.
❑Eventually, as businesses and households have time to
adjust their planned expenditures on imports and exports,
the deficit improves.
❑There is a pass-through effect when the domestic price of
an imported good rises following the depreciation of the
domestic currency.
❑These effects are important to understanding the response
of the current account to changes in the exchange rate.
27

28
5.2.2.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.
❑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
❑Real Income: a nation’s real income (y) is equivalent to
total expenditures on its output
y  c + i + g + x,

29
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, and
the nation is running a current account surplus.
❑The absorption approach hypothesizes that a nation’s
current account balance is determined by the difference
between real income and absorption, that is,
y - a = (c+i+g+x) - (c+i+g+m) = x – m=ca

30
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?
❑Consider the case of an economic expansion.
❑Real income rises, thereby increasing real expenditures
or absorption.
❑Whether the current account balance improves/worsens
depends on the relative changes in these two variables.

31
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.

32
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.
❑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.

33
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.

Devaluation and BOP
❑Does devaluation always improve BOT?
❑Recall: If Y = Y*  Full employment level of output,
then all resources are already employed and hence, X –
M  needs A .
❑If Y < Y*, then X – M  obtains through increasing Y
with A unchanged, i.e. by producing more to sell to
foreigners.
❑So, when Y < Y*, devaluation would improve BOT.
❑But when Y > Y*, devaluation would increase X – M
but create inflation.

5.2.3. Monetary Approach to the BOP
❑The Monetary Approach focuses on the supply and demand
of money and the money supply process.
❑The monetary approach hypothesizes that BOP and
exchange-rate movements result from changes in money
supply and demand.
❑A small country is modeled as:
(1) Md = kPy
(2) M = m(DC + R)
(3) P = SP*
and, in equilibrium,
(4) Md = M.

Small Country Model
❑The balance of payments is defined as:
(5) CA + KA = R.
❑For example, if R< 0, then CA + KA < 0, and the
nation is running a balance of payments deficit.
❑Substituting (4) and (3) into (1) yields,
M = kP*Sy.
❑Sub in (2),
(6) m(DC + R) = kP*Sy.

Small Country Model
❑Under fixed exchange rates, the spot rate, S, is not
allowed to vary.
➢R must vary to maintain the parity value of the spot rate.
➢Hence, the BOP must adjust to any monetary disequilibrium.
➢Consider what happens if the central bank raises DC.
➢Money supply exceeds money demand.
m(DC + R) > kP*Sy
➢There is pressure for the domestic currency to depreciate.
➢The central bank must sell R until M = Md.
m(DC + R) = KP*Sy
➢There has been no net impact on the monetary base and money
supply as the change in R offset the change in DC.
➢There results, however, a balance of payments deficit as R< 0.

Small Country Example
❑Under a flexible exchange rate regime, the R
component of the monetary base does not change.
➢The spot exchange rate, S, will adjust to eliminate any
monetary disequilibrium.
➢Consider the impact of an increase in DC.
➢Again money supply will exceed money demand
m(DC + R) > kP*Sy.
➢Now the domestic currency must depreciate to balance
money supply and money demand
m(DC + R) = kP*Sy.
➢The monetary approach postulates that changes in a nation’s
balance of payments as a monetary phenomenon.
➢The small country illustrates the impact of changes in
domestic credit, foreign price shocks, and changes in
domestic real income.

Views based on MABOP
❑BOP disequilibria are essentially monetary
phenomena.
❑Devaluation is a substitute for reducing the growth
of domestic credit.
❑Appreciation is a substitute for increasing domestic
credit growth.

BOP Elasticities Approach

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