The document discusses two approaches to balance-of-payments and exchange rate determination: the elasticity approach and the absorption approach. The elasticity approach emphasizes how price changes affect a nation's balance through the responsiveness of imports and exports. The absorption approach focuses on changes in real domestic income and how it compares to absorption, which is the total of consumption, investment, government spending, and imports. Both models examine how economic contractions and expansions can impact a nation's current account and currency value.

1. The Elasticity Approach to
Balance-of-Payments and
Exchange-Rate
Determination

2. Daniels and VanHoose Elasticity Approach 2
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.

3. Daniels and VanHoose Elasticity Approach 3
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.

4. Daniels and VanHoose Elasticity Approach 4
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.

5. Daniels and VanHoose Elasticity Approach 5
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.

6. Daniels and VanHoose Elasticity Approach 6
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.

7. Daniels and VanHoose Elasticity Approach 7
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.

8. Daniels and VanHoose Elasticity Approach 8
DI
DE
SI
SE
Foreign Exchange
in domestic currency units
Spot Exchange Rate
The superscripts I and E
denote the relatively
inelastic and relatively
elastic supply and
demand curves.

9. Daniels and VanHoose Elasticity Approach 9
DI
DE
SI
SE
Foreign Exchange
in domestic currency units
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.

10. Daniels and VanHoose Elasticity Approach 10
DI
DE
SI
SE
Foreign Exchange
in domestic currency units
Spot Exchange Rate
S0
The elasticity approach
considers how the
responsiveness of
imports
and exports to changes
in the exchange rate
determines the extent
to which a depreciation
will improve the current
account balance.

11. Daniels and VanHoose Elasticity Approach 11
DI
DE
SI
SE
Foreign Exchange
in domestic currency units
Spot Exchange Rate
S0
If foreign exchange
supply and demand
are relatively elastic, a
small change in the spot
rate can correct the
deficit.
S1

12. Daniels and VanHoose Elasticity Approach 12
DI
DE
SI
SE
Foreign Exchange
in domestic currency units
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

13. Daniels and VanHoose Elasticity Approach 13
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.

14. Daniels and VanHoose Elasticity Approach 14
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.

15. The Absorption Approach
to Balance-of-Payments and
Exchange-Rate
Determination

16. Daniels and VanHoose Elasticity Approach 16
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.

17. Daniels and VanHoose Elasticity Approach 17
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,

18. Daniels and VanHoose Elasticity Approach 18
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.

19. Daniels and VanHoose Elasticity Approach 19
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.

20. Daniels and VanHoose Elasticity Approach 20
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.

21. Daniels and VanHoose Elasticity Approach 21
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?

22. Daniels and VanHoose Elasticity Approach 22
• 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.
Balance of Payments
Determination

23. Daniels and VanHoose Elasticity Approach 23
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.

24. Daniels and VanHoose Elasticity Approach 24
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.

25. Daniels and VanHoose Elasticity Approach 25
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.

26. Daniels and VanHoose Elasticity Approach 26
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.

27. Daniels and VanHoose Elasticity Approach 27
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.

28. Daniels and VanHoose Elasticity Approach 28
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.