The following points highlight the top three approaches of balance of payments. The approaches are: 1. The Elasticity Approach 2. The Absorption Approach 3. The Monetary Approach.
1. The Elasticity Approach:
The elasticity approach to BOP is associated with the Marshall-Lerner condition which was worked out independently by these two economists. It studies the conditions under which exchange rate changes restore equilibrium in BOP by devaluing a country’s currency. This approach is related to the price effect of devaluation.
This analysis is based on the following assumptions:
1. Supplies of exports are perfectly elastic.
2. Product prices are fixed in domestic currency.
3. Income levels are fixed in the devaluing country.
4. The supply of imparts are large.
5. The price elasticities of demand for exports and imports are arc elasticities.
6. Price elasticities refer to absolute values.
7. The country’s current account balance equals its trade balance.
Given these assumptions, when a country devalues its currency, the domestic prices of its imports are raised and the foreign prices of its exports are reduced. Thus devaluation helps to improve BOP deficit of a country by increasing its exports and reducing its imports.
But the extent to which it will succeed depends on the country’s price elasticities of domestic demand for imports and foreign demand for exports. This is what the Marshall-Lerner condition states: when the sum of price elasticities of demand for exports and imports in absolute terms is greater than unity, devaluation will improve the country’s balance of payments, i.e.
Ex + em > 1
where ex is the demand elasticity of exports and Em is the demand elasticity for imports. On the contrary, if the sum of price elasticities of demand for exports and imports, in absolute terms, is less unity, ex + em< 1, devaluation will worsen (increase the deficit) the BOP. If the sum of these elasticities in absolute terms is equal to unity, ex + em = 1, devaluation has no effect on the BOP situation which will remain unchanged.
The following is the process through which the Marshall-Lerner condition operates in removing BOP deficit of a devaluing country. Devaluation reduces the domestic prices of exports in terms of the foreign currency. With low prices, exports increase.
The extent to which they increase depends on the demand elasticity for exports. It also depends on the nature of goods exported and the market conditions. If the country is the sole supplier and exports raw materials or perishable goods, the demand elasticity for its exports will be low.
If it exports machinery, tools and industrial products in competition with other countries, the elasticity of demand for its products will be high, and devaluation will be successful in correcting a deficit.
Devaluation has also the effect of increasing the domestic price of imports which will reduce the import of goods. By how much the volume of imports will decline depends on the demand elasticity of imports. The demand elasticity of imports, in turn, depends on the nature of goods imported by the devaluing country.
If it imports consumer goods, raw materials and inputs for industries, its elasticity of demand for imports will be low. It is only when the import elasticity of demand for products is high that devaluation will help in correcting a deficit in the balance of payments. Thus it is only when the sum of the elasticity of demand for exports and the elasticity of demand for imports is greater than one that devaluation will improve the balance of payments of a country devaluing its currency.
The J-Curve Effect:
Empirical evidence shows that the Marshall- Lerner condition is satisfied in the majority of advanced countries. But there is a general consensus among economists that both demand-supply elasticities will be greater in the long run than in the short run. The effects of devaluation on domestic prices and demand for exports and imports will take time for consumers and producers to adjust themselves to the new situation.
The short-run price elasticities of demand for exports and imports are lower and they do not satisfy the Marshall-Lerner condition. Therefore, to begin with, devaluation makes the BOP worse in the short- run and then improves it in the long-run. This traces a J-shaped curve through time. This is known as the J-curve effect of devaluation. This is Â£ illustrated in Fig. 3 where time is taken on the horizontal axis and deficit- O surplus on the vertical axis. Suppose devaluation takes place at time T.
In the beginning, the curve / has a big loop which shows increase in BOP deficit beyond D. It is only after time T1 that it starts sloping upwards and the deficit begins to reduce. At time T2 there is equilibrium in BOP and then the surplus arises from T2 to J. If the Marshall-Lerner condition is not satisfied, in the long run the J-curve will flatten out to F from T2.
However, in case the country is on a flexible exchange rate, BOP will get worse when there is devaluation of its currency. Due to devaluation, there is excess supply of currency in the foreign exchange market which may go on depreciating the currency. Thus the foreign exchange market becomes unstable and the exchange rate may overshoot its long-run value.
The elasticity approach based on the Marshall-Lerner condition has the following defects:
The elasticity approach which applies the Marshallian concept of elasticity to solve BOP deficit is misleading. This is because it has relevance only to incremental change along a demand or supply curve and to problems dealing with shifts in these curves. Moreover, it assumes constant purchasing power of money which is not relevant to devaluation of the country’s currency.
2. Partial Elasticities:
The elasticity approach has been criticised by Alexander because it uses partial elasticities which exclude all factors except relative prices and quantities of exports and imports. This is applicable only to single-commodity trade rather than to a multi-commodity trade. It makes this approach unrealistic.
3. Supplies not Perfectly Elastic:
The Marshall-Lerner condition assumes perfectly elastic supplies of exports and imports. But this assumption is unrealistic because the country may not be in a position to increase the supply of its exports when they become cheap with devaluation of its currency.
4. Partial Equilibrium Analysis:
The elasticity approach assumes domestic price and income levels to be stable within the devaluing country. It, further, assumes that there are no restrictions in using additional resources into production for exports. These assumptions show that this analysis is based on the partial equilibrium analysis.
It, therefore, ignores the feedback effects of a price change in one product on incomes, and consequently on the demand for goods. This is a serious defect of the elasticity approach because the effects of devaluation always spread to the entire economy.
Devaluation can lead to inflation in the economy. Even if it succeeds in improving the balance of payments, it is likely to increase domestic incomes in export and import-competing industries. But these increased incomes will affect the BOP directly by increasing the demand for imports, and indirectly by increasing the overall demand and thus raising the prices within the country.
6. Ignores Income Distribution:
The elasticity approach ignores the effects of devaluation on income distribution. Devaluation leads to the reallocation of resources. It takes away resources from the sector producing non-traded goods to export and import-competing industries sector. This will tend to increase the incomes of the factors of production employed in the latter sector and reduce that of the former sector.
7. Applicable in the Long Run:
As discussed above in the J-curve effect of devaluation, the Marshall-Lerner condition is applicable in the long-run and not in the short. This is because it takes time for consumers and producers to adjust themselves when there is devaluation of the domestic currency.
8. Ignores Capital Flows:
This approach is applicable to BOP on current account or balance of trade. But BOP deficit of a country is mainly the result of the outflow of capital. It thus ignores BOP on capital account. Devaluation as a remedy is meant to cut imports and the outflow of capital and increase exports and the inflow of capital.
There has been much controversy over the Marshall-Lerner condition for improvements in the balance of payments. Economists tried to measure demand elasticities in international trade. Some economists found low demand elasticities and others high demand elasticities.
Accordingly, the former suggested that devaluation was not an effective method while the latter suggested that it was a potent mechanism of balance of payments adjustment. But it is difficult to generalize due to these diverse findings on account of differences in the volume and structure of foreign trade.
2. The Absorption Approach:
The absorption approach to balance of payments is general equilibrium in nature and is based on the Keynesian national income relationships. It is, therefore, also known as the Keynesian approach. It runs through the income effect of devaluation as against the price effect to the elasticity approach.
The theory states that if a country has a deficit in its balance of payments, it means that people are ‘absorbing’ more than they produce. Domestic expenditure on consumption and investment is greater than national income. If they have a surplus in the balance of payments, they are absorbing less. Expenditure on consumption and investment is less than national income. Here the BOP is defined as the difference between national income and domestic expenditure.
This approach was developed by Sydney Alexander. The analysis can be explained in the following form Y = C + Id + G + X-M … (1) where Y is national income, C is consumption expenditure, total domestic investment, G is autonomous government expenditure, X represents exports and M imports.
The sum of (C + Id + G) is the total absorption designated as A, and the balance of payments (X – M) is designated as B. Thus Equation (1) becomes
Y = A + B
or B = Y-A …(2)
which means that BOP on current account is the difference between national income (Y) and total absorption (A). BOP can be improved by either increasing domestic income or reducing the absorption. For this purpose, Alexander advocates devaluation because it acts both ways. First, devaluation increases exports and reduces imports, thereby increasing the national income.
The additional income so generated will further increase income via the multiplier effect. This will lead to an increase in domestic consumption. Thus the net effect of the increase in national income on the balance of payments is the difference between the total increase in income and the induced increase in absorption, i.e.,
DB = DY-DA … (3)
Total absorption (DA) depends on the marginal propensity to absorb when there is devaluation. This is expressed as a. Devaluation also directly affects absorption through the change in income which we write as D. Thus
DA = a DY + DD … (4)
Substituting equation (4) in (3), we get
DB = DY-aDY-DD
or DB = (1 – a) DY-DD …(5)
The equation points toward three factors which explain the effects of devaluation on BOP. They are: (i) the marginal propensity to absorb (a), (ii) change in income (DY), and (iii) change in direct absorption (DD). It may be noted that since a is the marginal propensity (MP) to absorb, (1 – a) is the propensity to hoard or save. These factors, in turn, are influenced by the existence of unemployed or idle resources and fully employed resources in the devaluing country.
Effects of Devaluation on BOP:
1. MP to Absorb:
To take the MP to absorb, it is less than unity (a< 1), with idle resources in the country, devaluation will increase exports and reduce imports. Output and income will rise and BOP on current account will improve. If, on the other hand, a > 1, there will be an adverse effect of devaluation on BOP.
It means that people are absorbing more or spending more on consumption and investing more. In other words, they are spending more than the country is producing. In such a situation, devaluation will not increase exports and reduce imports, and BOP situation will worsen.
Under conditions of full employment if a > 1, the government will have to follow expenditure reducing policy measures along with devaluation whereby the resources of the economy are so reallocated as to increase exports and reduce imports. Ultimately, BOP situation will improve.
2. Income Effects:
Let us take the income effects of devaluation. If there are idle resources, devaluation increases exports and reduces imports of the devaluing country. With the expansion of export and import- competing industries, income increases. The additional income so generated in the economy will further increase income via the multiplier effect.
This will lead to improvement in BOP situation. If resources are fully employed in the economy, devaluation cannot correct an adverse BOP because national income cannot rise. Rather, prices may increase thereby reducing exports and increasing imports, thereby worsening the BOP situation.
3. Terms of Trade Effect:
The effect of devaluation on national income is also through its effects on the terms of trade. The conditions under which devaluation worsens the terms of trade, national income will be adversely affected, and vice versa. Generally, devaluation worsens the terms of trade because the devaluing country has to export more goods in order to import the same quantity as before. Consequently, the trade balance deteriorates and national income declines.
If prices are fixed in buyer’s (other country’s) currency after devaluation, the terms of trade improve because exports increase and imports decline. The importing country pays more for increased exports of the devaluing country than it receives from its imports. Thus the trade balance of the devaluing country improves and its national income rises.
4. Direct Absorption:
Devaluation affects direct absorption in a number of ways. It the devaluing country has idle resources, an expansionary process will start with exports increasing and imports declining. Consequently, income will rise and so will absorption. If the increase in absorption in less than the rise in income, BOP will improve. Generally, the effect of devaluation on direct absorption is not significant in a country with idle resources.
If the economy is fully employed and has also a BOP deficit, national income cannot be increased by devaluing the currency. So an improvement in BOP can be brought about by reduction in direct absorption. Domestic absorption can fall automatically as a result of devaluation due to real cash balance effect, money illusion and income redistribution.
5. Real Cash Balance Effect:
When a country devalues its currency, its domestic prices rise. If the money supply remains constant, the real value of cash balances held by the people falls. To replenish their cash balances, people start saving more. This can be possible only by reducing their expenditure or absorption. This is the real cash balance effect of devaluation.
If people hold assets and when devaluation reduces their real cash balances, they sell them. This reduces the prices of assets and increases the interest rate. This, in turn, will reduce investment and consumption, given the constant money supply. As a result, absorption will be reduced. This is the asset effect of real cash balance effect of devaluation.
6. Money Illusion Effect:
The presence of money illusion also tends to reduce direct absorption. When prices rise due to devaluation, consumers think their real incomes have fallen, even though their money incomes have risen. They have the money illusion under whose influence they reduce their consumption expenditure or direct absorption.
7. Income Re-distribution Effect:
Direct absorption falls automatically if devaluation redistributes income in favour of people with high marginal propensity to save and against those with high marginal propensity to consume. If the marginal propensity to consume of workers is higher than those of profit-earners, absorption will be reduced.
Further, when money incomes of lower income groups increase with devaluation, they enter the income tax bracket. When they start paying income tax, they reduce their consumption as compared with higher income groups which are already paying the ‘tax. This leads to reduction in absorption in case of the former.
Income redistribution also takes place between production sectors after devaluation. Those sectors whose prices rise more than their costs of production earn more profits than the other sectors whose costs rise more than their prices. Thus the effect of devaluation will be to redistribute income in favour of the former sectors.
Devaluation will also redistribute income in favour of sectors producing and selling traded goods and against non-traded goods sectors. Prices of traded goods rise more than that of non-traded goods. As a result, profits of producers and traders and wages of workers producing traded goods rise more as compared to those engaged in non-traded goods.
8. Expenditure-Reducing Policies:
Direct absorption is also reduced if the government adopts expenditure- reducing monetary-fiscal policies which are deflationary. They will make devaluation successful in reducing
BOP deficit. But they will create unemployment in the country.
The absorption approach to BOP deficit has been criticised on the following grounds:
1. Neglects Price Effects:
This approach neglects the price effects of devaluation which are very important.
2. Calculation Difficult:
Analytically, it appears to be superior to the elasticity approach but propensities to consume, save and invest cannot be accurately calculated.
3. Ignores Effects on Other Countries:
The absorption approach is weak in that it relies too much on policies designed to influence domestic absorption. It does not study the effects of a devaluation on the absorption of other countries.
4. Not Operative in a Fixed Exchange Rate System:
The absorption approach fails as a corrective measure of BOP deficit under a fixed exchange rate system. When prices rise with devaluation, people reduce their consumption expenditure. With money supply remaining constant, interest rate rises which brings a fall in output along with absorption. Thus devaluation will have little effect on BOP deficit.
5. More Emphasis on Consumption:
This approach places more emphasis on the level of domestic consumption than on relative prices. A mere reduction in the level of domestic consumption for reducing absorption does not mean that resources so released will be redirected for improving BOP deficit.
3. The Monetary Approach:
The monetary approach to the balance of payments is an explanation of the overall balance of payments. It explains changes in balance of payments in terms of the demand for and supply of money. According to this approach, “a balance of payments deficit is always and everywhere a monetary phenomenon.” Therefore, it can only be corrected by monetary measures.
This approach is based on the following assumptions:
1. The Taw of one price’ holds for identical goods sold in different countries, after allowing for transport costs.
2. There is perfect substitution in consumption in both the product and capital markets which ensures one price for each commodity and a single interest rate across countries.
3. The level of output of a country is assumed exogenously.
4. All countries are assumed to be fully employed where wage price flexibility fixes output at full employment.
5. It is assumed that under fixed exchange rates the sterilisation of currency flows is not possible on account of the law of one price globally.
6. The demand for money is a stock demand and is a stable function of income, prices, wealth and interest rate.
7. The supply of money is a multiple of monetary base which includes domestic credit and the country’s foreign exchange reserves.
8. The demand for nominal money balances is a positive function of nominal income. The Theory
Given these assumptions, the monetary approach can be expressed in the form of the following relationship between the demand for and supply of money:
The demand for money (MD) is a stable function of income (Y), prices (P) and rate of interest (i)
MD=f(Y, P ,i) â€¦â€¦(1)
The money supply (Ms) is a multiple of monetary base (m) which consists of domestic money (credit) (D) and country’s foreign exchange reserves (R). Ignoring m for simplicity which is a constant,
Ms = D + R â€¦..(2)
Since in equilibrium the demand for money equals the money supply,
Md = Ms â€¦(3)
or Md = D + R [MS = D + R] …(4)
A balance of payments deficit or surplus is represented by changes in the country’s foreign exchange reserves. Thus
Î” R = DMD -DD … (5)
or Î” R = B …(6)
where B represents balance of payments which is equal to the difference between change in the demand for money (DMd) and change in domestic credit (DD).
A balance of payments deficit means a negative B which reduces R and the money supply. On the other hand, a surplus means a positive B which increases R and the money supply. When B = O, it means BOP equilibrium or no disequilibrium of BOP.
The automatic adjustment mechanism in the monetary approaches is explained under both the fixed and flexible exchange rate systems.
Under the fixed exchange rate system, assume that MD = Ms so that BOP (or B) is zero. Now suppose the monetary authority increases domestic money supply, with no change in the demand for money. As a result, Ms > M0 and there is a BOP deficit. People who have larger cash balances increase their purchases to buy more foreign goods and securities.
This tends to raise their prices and increase imports of goods and foreign assets. This leads to increase in expenditure on both current and capital accounts in BOP, thereby creating a BOP deficit. To maintain a fixed exchange rate, the monetary authority will have to sell foreign exchange reserves and buy domestic currency. Thus the outflow of foreign exchange reserves means a fall in R and in domestic money supply. This process will continue until Ms = MD and there will again be BOP equilibrium.
On the other hand, if Ms < MD at the given exchange rate, there will be a BOP surplus. Consequently, people acquire the domestic currency by selling goods and securities to foreigners. They will also seek to acquire additional money balances by restricting their expenditure relatively to their income. The monetary authority on its part, will buy excess foreign currency in exchange for domestic currency. There will be inflow of foreign exchange reserves and increase in domestic money supply. This process will continue until Ms = MD and BOP equilibrium will again be restored. Thus a BOP deficit or surplus is a temporary phenomenon and is self-correcting (or automatic) in the long-run.
This is explained in Fig. 4 In Panel (A) of the figure, MD is the stable money demand curve and Ms is the money supply curve. The horizontal line m (D) represents the monetary base which is a multiple of domestic credit, D which is also constant. This is the domestic component of money supply that is why the Ms curve starts from point C.
Ms and MD curves intersect at point Â£ where the country’s balance of payments is in equilibrium and its foreign exchange reserves are OR. In Panel (B) of the figure, PDC is the payments disequilibrium curve which is drawn as the vertical difference between Ms and MD curves of Panel (A). As such, point B0 in Panel (B) corresponds to point E in Panel (A) where there is no disequilibrium of balance of payments.
If Ms < M0 there is BOP surplus of SP in Panel (A). It leads to the inflow of foreign exchange reserves which rise from OR, to OR and increase the money supply so as to bring BOP equilibrium at point Â£. On the other hand, if Ms > M^ there is deficit in BOP equal to DF.
There is outflow of foreign exchange reserves which decline from OR, to OR and reduce the money supply so as to reestablish BOP equilibrium at point Â£. The same process is illustrated in Panel (B) of the figure where BOP disequilibrium is self-correcting or automatic when B,S, surplus and B2D, deficit are equal.
Under a system of flexible (or floating) exchange rates, when B = O, there is no change in foreign exchange reserves (R). But when there is a BOP deficit or surplus, changes in the demand for money and exchange rate play a major role in the adjustment process without any inflow or outflow of foreign exchange reserves. Suppose the monetary authority increases the money supply (Ms > MD) and there is a BOP deficit. People having additional cash balances buy more goods thereby raising prices of domestic and imported goods.
There is depreciation of the domestic currency and a rise in the exchange rate. The rise in prices, in turn, increases the demand for money thereby bringing the equality of MD and Ms without any outflow of foreign exchange reserves. The opposite will happen when MD > Ms, there is fall in prices and appreciation of the domestic currency which automatically eliminates the excess demand for money. The exchange rate falls until M0 = Ms and BOP is in equilibrium without any inflow of foreign exchange reserves.
The monetary approach to the balance of payments has been criticised on a number of counts:
1. Demand for Money not Stable:
Critics do not agree with the assumption of stable demand for money. The demand for money is stable in the long run but not in the short run when it shows less stability.
2. Full Employment not Possible:
Similarly, the assumption of full employment is not acceptable because there exists involuntary unemployment in countries.
3. One Price Law Invalid:
Frankel and Johnson are of the view that the law of one price holds for identical goods sold is invalid. This is because when factors of production are drawn into sectors producing non-trading goods, the excess demand for non-traded goods will spill over into reduced supplies of traded goods. This will lead to higher imports, and disturb the law of one price for all traded goods.
4. Market Imperfections:
There are also market imperfections which prevent the law of one price from working properly in many markets for traded goods. There may be price differentials due to the lack of information about overseas prices and trade regulations faced by traders.
5. Sterilisation not Possible:
The assumption that the sterilisation of currency flows is not possible under fixed exchanged rates, has not been accepted by critics. They argue that “the sterilisation of currency flows is entirely possible if the private sector is willing to adjust the composition of its wealth portfolio with regard to the relative importance of bonds and money balances, or if the public sector is prepared to run a higher budget deficit whenever it has a balance of payments deficit with which to contend.”
6. Link between BOP and Money Supply not Valid:
The monetary approach is based upon direct link between BOP of a country and its total money supply. This has been questioned by economists. The link between the two depends upon the ability of the monetary authority to neutralize the inflows and outflows of foreign exchange reserves when there is BOP deficit and surplus. This requires some degree of sterilisation of external flows. But this is not possible due to globalisation of financial markets.
7. Neglects Short Run:
The monetary approach is related to the self correcting long-run equilibrium in BOP. This is unrealistic because it fails to describe the short time through which the economy passes to reach the new equilibrium. As pointed out by Prof. Krause, the monetary approach’s “concentration on the long-run assumes away all of the problems that make the balance of payments a problem.”
8. Neglects Other Factors:
This approach neglects all real and structural factors which lead to disequilibrium in BOP and concentrates only on domestic credit.
9. Neglects Economic Policy:
This approach emphasises the role of domestic credit in bringing M equilibrium and neglects economic policy measures. According to Prof. Currie, the balance of payments equilibrium can also be “achieved by expenditure-switching policies working through real flows and government budget.”
Despite these criticisms, the monetary approach is realistic in that it takes into consideration both domestic money and foreign money. Emphasis is not on relative price changes, but on the extent to which the demand for real money balances will be satisfied from internal sources, through credit creation or from external sources through surplus or deficit in the balance of payments.
A balance of payments deficit or surplus can be corrected through changes in money supply and their consequent effects on income and expenditure, or more generally on production and consumption of goods.