Balance of Payments Adjustments

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International Economics
Chapter 8

• Balance of Payments Adjustments

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Chapter 8 Balance of Payments Adjustments

• 8.1 Elasticities Approach
• 8.2 Multiplier Approach
• 8.3 Absorption Approach
• 8.4 Monetary Approach

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8.1 Elasticities Approach

• 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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8.1 Elasticities Approach

• Chinas Import Demand Curve and the Demand for
  dollar

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8.1 Elasticities Approach

• Elasticity of Import Demand and the Elasticity of
  Foreign Exchange Demand.

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8.1 Elasticities Approach

• Derivation of the Supply of Foreign Exchange
• The supply of foreign exchange to a country
  results from its exports of goods and services.

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8.1 Elasticities Approach

• Elasticity of Export Supply and the Elasticity of
  Foreign Exchange Supply

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8.1 Elasticities Approach

• 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.

the quantity of foreign exchange
a change in the exchange rate
the domestic currency price of goods and services
a change in the exchange rate
a change in the exchange rate
countrys balance of payments and exchange value
the quantity of goods and services
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8.1 Elasticities Approach

• The Current Account Deficit

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8.1 Elasticities Approach

• 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.

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8.1 Elasticities Approach

• 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.

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8.1 Elasticities Approach

• Assumption
• Capital flows occur only as a means of financing
  current account transactions.
• Trade balance exclusively represents the current
  account.

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8.1 Elasticities Approach

• CA in domestic currency
• Derivate it with e
• Initial CA in equilibrium
• Then
• Rearrange it
• Finally
• (
  , )

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8.1 Elasticities Approach

• A depreciation to improve CA
• 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 unity.

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8.1 Elasticities Approach

• 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.

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8.1 Elasticities Approach

• Reasons 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.

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Chapter 8 Balance of Payments Adjustments

• 8.1 Elasticities Approach
• 8.2 Multiplier Approach
• 8.3 Absorption Approach
• 8.4 Monetary Approach

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8.2 Multiplier Approach

• 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.

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8.2 Multiplier Approach

• Assumptions
• Underemployed resources
• Rigidity of all prices
• Absence of capital mobility
• All exports are made out of current output.

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8.2 Multiplier Approach

• National income
• Thus

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8.2 Multiplier Approach

• An expansionary fiscal policy (a rise in G0), an
  expansionary monetary policy (a rise in I0
  resulting from lower interest rate), or added
  exports (a rise in X0) can increase national
  income.
• While a contractionary fiscal policy, a
  contractionary monetary policy or reduced exports
  will decrease national income.

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8.2 Multiplier Approach

• 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.

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8.2 Multiplier Approach

• Added exports can improve a countrys current
  account (then its balance of payments).
• While reduced exports will worsen its balance of
  payments.

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8.2 Multiplier Approach

• 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.

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Chapter 8 Balance of Payments Adjustments

• 8.1 Elasticities Approach
• 8.2 Multiplier Approach
• 8.3 Absorption Approach
• 8.4 Monetary Approach

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8.3 Absorption Approach

• 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.

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8.3 Absorption Approach

• Absorption
• National income
• Current account gt
• Thus
• It shows whether a currency depreciation can
  improve the current account (then the balance of
  payments) depends on its effect on national
  income and on domestic absorption.

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8.3 Absorption Approach

• The effect of depreciation on absorption can be
  divided into two parts
• The induced effect of income changes resulting
  from depreciation on absorption
• The direct effect of depreciation on absorption
  
• Therefore, the effects of depreciation on the
  current account
• the income effect
• the absorption effect

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8.3 Absorption Approach

• 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.

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8.3 Absorption Approach

• Direct Effects of Depreciation on Absorption
• Real cash balance effect

require Ms?to guarantee
e?
e?
cash balance?
P?
expenditure?
C?
withdraw financial assets
Price of financial assets?
C?, I?
r?
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8.3 Absorption Approach

• Income redistribution effect

e?
e?
Income redistribution from wage earners to profit
earners
P?
profit earners have lower MPC
C?
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8.3 Absorption Approach

• Taxation effect

Require G?/ T? to guarantee
e?
e?
Enter higher taxation levels
Nominal Y?
expenditure?
C?
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8.3 Absorption Approach

• 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.

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Chapter 8 Balance of Payments Adjustments

• 8.1 Elasticities Approach
• 8.2 Multiplier Approach
• 8.3 Absorption Approach
• 8.4 Monetary Approach

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8.4 Monetary Approach

• Leaning with or against the Wind
• If 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.

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8.4 Monetary Approach

• Foreign Exchange Intervention
• Central banks buy or sell financial assets
  denominated in foreign currencies in an effort to
  influence exchange rates.
• Sterilization of Intervention
• 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.

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8.4 Monetary Approach

• Monetary Equilibrium Condition
• In equilibrium, the actual money stock equals the
  quantity of money demanded.

MdkPy
MdkePy
MsMd
m(DF)kePy
Msm(DF)
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8.4 Monetary Approach

• Fixed Exchange Rate and A Change in Domestic
  Credit
• 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(DF)gtkePy
• Under a fixed exchange rate arrangement, 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 a fixed exchange rate arrangement, an
  increase in domestic credit generates BP deficit,
  while a decrease in domestic credit results in BP
  surplus.

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8.4 Monetary Approach

• Fixed Exchange Rate and A Change in Md
• Suppose that there is an increase in either the
  foreign price level or real income, causing an
  increase in the quantity of money demanded.
• m(DF)ltke(Py)
• 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.

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8.4 Monetary Approach

• Flexible Exchange Rate and A Change in Domestic
  Credit
• Suppose the domestic central bank increases
  domestic credit through a purchase of securities,
  causing domestic money stock to rise.
• m(DF)gtkePy
• As households increase their expenditures on
  foreign goods and services, the domestic currency
  depreciates and BP keeps in equilibrium.
• Under a flexible exchange rate arrangement, 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.

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8.4 Monetary Approach

• Flexible-Exchange-Rate and A Change in Md
• If the foreign price level or domestic real
  income increases, causing an increase in the
  quantity of money demanded.
• m(DF)ltke(Py)
• The decrease in demand for foreign goods and
  services causes the domestic currency to
  appreciate and BP keeps in equilibrium.
• Under a flexible exchange rate arrangement, 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.