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balance of payments deficit correction

How do (a) the elasticities approach,
(b) the absorption approach, and
(c) the monetary approach,
explain the process by which a balance of payments deficit is corrected under
a flexible exchange rate system?

Solution This solution is FREE courtesy of BrainMass!

Dear Student,

There are three approaches to correct BOP deficits. They are 1) Elasticity approach 2) Absorption approach 3) Monetary approach.
The elasticity approach emphasis price changes as a determinant of a nation's BOP (Balance Of Payments) and exchange rate. The elasticities approach applies the Marshallian analysis of elasticities of supply and demand for individual commodities to the analysis of exports and imports as a whole. The concern here is the conditions under which devaluation of a currency would lead to an improvement in the balance of trade. Suppose the BOP equation is written as:

E = value of exports
I = value of imports

In this context, it is generally assumed that exports depend on the price of exports, and imports depend on the price of imports. These relations are then translated into elasticities, by differentiating the above equation with respect to the exchange rate. A criterion for a change of the balance of trade in the desired direction can be established, assuming that export and import prices adjust to equate the demand for and supply of exports and imports.

The effect of a devaluation on the trade balance depends on four elasticities: the foreign elasticity of demand for exports, and the home elasticity of supply, the foreign elasticity of supply of imports, and the home elasticity of demand for imports. The elasticity approach considers the responsiveness of imports and exports to a value of the nation's currency. For example, if import demand is highly elastic, then depreciation of the domestic currency, will result in disproportionate decline in nation's imports. So to put it simply, by understanding the elasticity of demand for its export products and import demand products, the balance of payment can be corrected. This is precisely the elasticity approach.

2)The absorption approach looks at the at the balance of payment from the point of view of national income accounting. The absorption approach emphasis changes in real domestic income as a determinant of a nation's balance of payments and exchange rate.

P = domestic production of goods and services or total income.
A = domestic absorption of goods and services, or domestic total expenditure
By increasing the Income namely 'P' above the Balance of Payment can be corrected. So BOP variance is explanied as a relationship between P and A above in Absorption Approach.

The above identity is useful in pointing out that an improvement in the balance of payment calls for an increase in production relative to absorption. When unemployed resources exist, the following mechanism is visualized: the effect of a devaluation is to increase exports and decrease imports. This in turn causes an increase in production (income) through the multiplier mechanism. If total expenditure rises by a smaller amount, there will be an improvement in the balance of payment. Thus, the balance is set to be identical with the real hoarding of the economy, which is the difference between total production and total absorption of goods and services, and therefore equal to the accumulation of securities and/or money balances. In the presence of unemployment, therefore, devaluation not only aids the balance of payments, but also helps the economy move towards full employment and is, therefore, doubly attractive.

c)The monetary approach focusses on the supply and demand of money and the money supply process. This approach hypothesis that BOP and exchange rate movements result from changes in money supply and demand.The monetary approach, like the absorption approach, stresses the need for reducing domestic expenditure relative to income, in order to eliminate a deficit in the balance of payments. However, whereas the absorption approach looks at the relationship between real output and expenditure on goods, the monetary approach concentrates on deficient or excess nominal demand for goods and securities, and the resulting accumulation or decumulation of money.

The monetary approach looks at the balance of payments as the change in the monetary base less the change in the domestic component:

CM = change in the quantity of money demanded
CC = domestic credit creation

Putting just monetary assets rather than all assets "below the line" contributes to the simplicity of the monetary approach. Other things being equal, growth in demand for money, and of factors that affect it positively should lead to a surplus in the balance of payments. Growth in domestic money, other things being equal, should worsen it. Thus, the growth of real output in a country with constant interest rates causes its residents to demand a growing stock of real and nominal cash balances. This means that the country will run a surplus in the balance of payments. In order to avoid a payments surplus, the increase in money must be satisfied through domestic open market operations. To produce a deficit, domestic money stock must grow faster than the growth of real income.

So put it simply,under monetary approach, by suitably changing the monetary policy of the country, the BOP can be corrected. The change in monetary policy will have a direct impact of CM and also CC.