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balance of payments deficit correction

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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?

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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 ...

Solution Summary

Describe fully the three approaches to correct BOP deficits.

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U.S. current account deficit

Details: Your hometown newspaper needs someone to write an informative article on large scale economic issues. The reporter who spoke with you before thinks of you, welcomes you home, and requests another article. Click here to view a summary of disaggregated data drawn from information provided on the 2000 U.S. balance of payments which is in the 2002 federal document, Economic Report of the President, available on the web.

In addition to the balance of payments data presented above, the Bureau of Economic Analysis document entitled International Investment Position of the United States (http://www.bea.gov/bea/newsrel/intinvnewsrelease.htm) offers the following information.

"At year-end 2002, the value of foreign investments in the United States exceeded the value of U.S. investments abroad by $2,387.2 billion (preliminary) with direct investment valued at current cost. At year-end 2001, foreign investments in the United States exceeded U.S. investments abroad by $1,979.9 billion (revised)."

Write a 2-3 page article on the United States' current account deficit. The reporter will edit your material down to a usable length but asked for plenty of material with which to start. She requests that you answer the following questions:

What has caused the U.S. run a merchandise trade deficit year after year since the early 1980s?
Is the current account a deficit problem? Explain.
Is the trend of the international investment position of the U.S. problematic? Why or why not?
How is the current account related to a country's business cycle?
What is the relationship between a country's net financial inflow and its current account?
How does the U.S make adjustments for the balance of payment issues?

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