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As a traditional approach to the balance of payments, elasticities approach assumes that capital flows occur only as a means of financing current account transactions. Derivation of the Demand for Foreign Exchange: The quantity of a currency demanded in the foreign exchange market is derived from the countrys demand for imports.
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S S B
Price of iPod
800 700
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DI O 8 10 QI
D$ O 800 1000 Q$
Price of iPod
800 700
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D I
DI O
6
D$ O
600
D$
10
QI
800
1000
Q$
Derivation of the Supply of Foreign Exchange The supply of foreign exchange to a country results from its exports of goods and services.
PT ST B
e
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S$
Price of Toy
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S$ S$
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Price of Toy
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The elasticities approach centers on changes in the prices of goods and services as the determinant of a countrys balance of payments and the exchange value of its currency.
a change in the exchange rate the domestic currency price of goods and services the quantity of foreign exchange
The Role of Elasticity The elasticities of the supply of and demand for foreign exchange are fundamental determinants of adjustment to a balance-of-payments deficit.
The Marshall-Lerner Condition The Marshall-Lerner condition specifies the necessary condition for a positive effect of depreciation of domestic currency on the balance of payments.
Capital flows occur only as a means of financing current account transactions. Trade balance exclusively represents the current account.
in domestic currency:
CA PX eP * M
Derivate it with e:
Initial CA in equilibrium:
dCA dX dM P P * M eP * de de de
eP * M 1 PX dCA eP * M dX dM P P * M eP * de PX de de
Then:
Rearrange it:
Finally:
dCA dX e dM e P*M ( 1) de de X de M
x
dX e de X
dCA P * M (x m 1) de
, m dM
e de M
dCA 0 de
So:
Marshall-Lerner condition states that a depreciation of domestic currency can improve a countrys balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds 1.
J-Curve Effect
A
depreciation of the domestic currency is unlikely to immediately improve a countrys balance-of-payments deficit. It is even possible that the depreciation could cause a countrys balance of payments to worsen before it improves.
BP Surplus C t2 Time
t0 A e
t1
B BP Deficit
for J-Curve Effect: Recognition lags of changing competitive conditions; Decision lags in forming new business connections and placing new orders; Delivery lags between the time new orders are placed and their impact on trade and payment flows is felt; Replacement lags in using up inventories and wearing out existing machinery before placing new orders; Production lags involved in increasing the output of commodities for which demand has increased.
The multiplier approach is a modified and extended version of the elasticity analysis. The exchange rate is assumed fixed. The theory is suitable to analyze the adjustment process under a pegged regime. The only possibility for BP adjustment in this model is by changes in national income.
Assumptions Underemployed resources; Rigidity of all prices; Absence of capital mobility; All exports are made out of current output.
National income:
Y C I G (X M )
C C0 cY
I I0
G G0
X X0
M M 0 mY
Thus:
1 (C0 I 0 G0 X 0 M 0 ) 1 c m
An expansionary fiscal policy (a rise in G0), an expansionary monetary policy (a rise in I0 resulting from lower interest rates), or added exports (a rise in X0) can increase national income.
dY dY dY 1 0 dG0 dI 0 dX 0 1 c m
While a contractionary fiscal policy, a contractionary monetary policy or reduced exports will decrease national income.
An expansionary fiscal policy or an expansionary monetary policy can worsen a countrys current account (and then its balance of payments).
While a contractionary fiscal policy or monetary policy will improve its balance of payments.
Added exports can improve a countrys current account (then its balance of payments).
dCA
1 c 0 dX 0 1 c m
In conclusion, when an economy has underemployed resources, fiscal policy, monetary policy and trade policies can be used for adjusting its balance of payments.
Contractionary
fiscal or monetary policy can improve the balance of payments but at the cost of a decrease in national output. Added exports resulting from export-encouraging policies will improve the balance of payments and meanwhile, increase national income.
The absorption approach assumes that prices remain constant and emphasizes changes in real domestic income. Hence, the absorption approach is a real-income theory of the balance of payments.
induced effect of income changes resulting from depreciation on absorption: a dY The direct effect of depreciation on absorption: dAd
Indirect Effects of Depreciation on National Income On the supply side, an effective depreciation requires idle resources in the economy. On the demand side, an effective depreciation requires the Marshall-Lerner condition to be met. From the perspective of governments macroeconomic regulation, an effective depreciation requires loosening protective or restrictive trade polices.
expenditure
withdraw financial assets
C
Price of financial assets r C, I
dAd
redistribution effect
P
W
dAd
Taxation effect
Require G/ T to guarantee
Nominal Y
expenditure
dAd
In conclusion, the absorption approach proposes that depreciation can be effective in improving the balance of payments when the economy has idle resources; the economy meets the Marshall-Lerner condition; the government fulfills contractionary fiscal or monetary policy along with depreciation.
a central bank intervenes to support or speed along the current trend in the value of its countrys currency in the foreign exchange market, then economists say that its interventions are leaning with the wind. In contrast, a central banks interventions intended to halt or reverse a recent trend in the value of its countrys currency are leaning against the wind.
buy or sell financial assets denominated in foreign currencies in an effort to influence exchange rates. A central bank sterilizes foreign exchange interventions when it buys or sells domestic assets in sufficient quantities to prevent the interventions from influencing the domestic money stock. monetary base = domestic credit + foreign exchange reserves Sterilization of the sale of foreign exchange reserves requires an equally-sized expansion of domestic credit.
Sterilization of Intervention
Monetary Equilibrium Condition In equilibrium, the actual money stock equals the quantity of money demanded.
P e P*
Md=kPy
Ms=m(D+F)
If the central bank increases domestic credit through an open market purchase of securities, the open market purchase causes the countrys money stock to rise. m(D+F)>keP*y Under fixed exchange rates, the countrys monetary authorities must sell foreign exchange reserves to meet the demand for foreign currency. As a result, foreign exchange reserves decline, while the spot exchange rate remains constant. Under fixed exchange rates, an increase in domestic credit generates BP deficit, while a decrease in domestic credit results in BP surplus.
that there is an increase in either the foreign price level or real income, causing an increase in the quantity of money demanded. m(D+F)<ke(P*y) To prevent the domestic currency from appreciating, the domestic monetary authorities must increase the quantity of money supplied so that it equals the quantity of money demanded. A rise in either the foreign price level or domestic real income results in BP surplus. Likewise, a decline in either the foreign price level or domestic real income results in BP deficit.
Suppose the domestic central bank increases domestic credit through a purchase of securities, causing domestic money stock to rise. m(D+F)>keP*y As households increase their expenditures on foreign goods and services, the domestic currency depreciates and BP keeps in equilibrium. Under flexible exchange rates, an increase in domestic credit results in a depreciation of the domestic currency, while a decline in domestic credit results in an appreciation of the domestic currency.
the foreign price level or domestic real income increases, causing an increase in the quantity of money demanded. m(D+F)<ke(P*y) The decrease in demand for foreign goods and services causes the domestic currency to appreciate and BP keeps in equilibrium. Under flexible exchange rates, an increase in the foreign price level or domestic real income results in an appreciation of the domestic currency. In contrast, a decline in the foreign price level or domestic real income results in a depreciation of the domestic currency.