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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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Solution Summary

Describe fully the three approaches to correct BOP deficits.

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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
BOP =E-I

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 ...

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