a.- Classical (Traditional) Approach.

• This approach is mainly based on the ‘relative price movements’.

• It is thought that changes in export and import prices will determine the amounts of EX and
IM, which will have a direct impact on the balance of payments.

• Export and import prices (international prices)

• are expected to be determined by the key market players in the world market.

• It is assumed that the prices of domestic goods

• will be determined by domestic supply and demand conditions.

• According to this approach, ‘relative prices’

• (international prices/domestic prices) crucially depend on the level of exchange rate.

Example on relative prices.

• Price of GOOD A ;

TURKEY = TL 100

USA = $ 300

• Given the domestic prices of GOOD A in two countries, if the exchange rate is TL 1 = $ 1,5;
Turkey will not import GOOD A, because the domestic price of GOOD A (TL 100) is cheaper
than the import price of GOOD A (TL 200) at this exchange rate.

• At this exchange rate level, the import price of GOOD A ($ 150) is much lower than the
domestic price ($ 300) for the USA. [TL 100 = $ 150]

• Therefore, it would be much more profitable for the USA to import GOOD A from Turkey
at this exchange rate level.

• In sum, at this exchange rate level, Turkey should export GOOD A and the USA should
import GOOD A.

• Given the domestic prices of GOOD A in two countries, if the exchange rate is 1 TL = 3 $;
the ratio between the domestic prices of GOOD A in two countries [$ 300 / TL 100 = 3]
would be equal to the international prices and exchange rate ($ 3 / TL 1 = 3).

• Therefore, there would be no possibility of a profitable trade for both countries at this
exchange rate.

• Given the domestic prices of GOOD A in two countries, if the exchange rate is 1 TL = 6 $ ;

• At this exchange rate level, the import price of GOOD A (TL 50) is much lower than the
domestic price (TL 100) for Turkey.

• Therefore, it would be much more profitable for Turkey to import GOOD A from the USA at
this exchange rate level.

• In sum, at this exchange rate level, Turkey should import GOOD A and the USA should
export GOOD A.
Any precondition on effect of exchange rates?

• There is a precondition for a positive effect of exchange rate increase on

exports/competitiveness.

• For an effective rise in competitiveness, exports of a country should increase not only in
terms of 'volume‘, but in terms of 'total value'.

EXAMPLE

CASE 1: Turkey exports 3 Million GOOD A, price of the GOOD A is TL 100.

Total volume of exports = 3 Million

Total value of exports = TL 300 Million

3 Million X TL 100 = TL 300 Million

CASE 2: Turkey devaluates its national currency (TL) from ‘TL 1 = $ 6’ to ‘TL 1 = $ 3’ in order
to increase its exports and reduce trade deficit .

• Suppose that in this case Turkey exports 5 Million GOOD A and the price of the GOOD A is
TL 50.

Total volume of exports = 5 Million

Total value of exports = TL 250 Million

5 Million X TL 50 = TL 250 Million

Evaluation on the precondition.

• It can be concluded that the devaluation of the national currency (TL) may NOT be
‘sufficient’ to increase the total value of exports and therefore to reduce trade deficit.

• Because the total value of exports may actually decrease after devaluation (from TL 300
Million to TL 250 Million), although there is an increase in the total volume of exports.
(from 3 Million to 5 Million)

• Policy Proposal of the Classical Approach.

• The policy proposal of the Classical approach for balance of payments problems is based on
the ‘relative prices’ which are determined by the changes in ‘exchange rates’.

Trade deficit → ‘devaluation’

Trade surplus → ‘revaluation’ of the national currency.

Effect of Devaluation on the Balance of Payments

Effectiveness of Devaluation / Marshall-Lerner Condition

• There is a precondition for positive effect of a devaluation on the total value of exports.

• This condition, known as the Marshall-Lerner (M-L) Condition, is formulated as follows:

ex= Price elasticity of demand for exports.

em= Price elasticity of demand for imports.

• The ‘precondition’ for an effective devaluation policy is the satisfaction of the ‘M-L
condition’.

EX IM Trade Deficit

• The higher the price elasticity of the US’s demand for Turkey’s export goods (ex) and the
higher the price elasticity of Turkey’s demand for US import goods (em), the more effective is
the devaluation.

b.- KEYNESIAN APPROACH TO BALANCE OF PAYMENTS

• The most well-known Keynesian approach is ‘absorption theory’ of balance of payments.

• The absorption approach to the balance of trade focuses on how domestic spending on
domestic goods changes relative to domestic output.

• Keynesian approach is also known as ‘ absorption ’ or ‘ income effect ’ approach.

• Changes in national income and total expenditure constitute the basis of this approach.
• The main policy tool of this approach is to reduce (increase) total expenditure in the case of a
balance of payments deficit (surplus).

• The Keynesian approach is based on the following argument; ‘by reducing (increasing) total
expenditures and hence the demand for import goods, the trade deficit (surplus) problem
can be eliminated’.

• Economic reasoning behind the Keynesian approach can be explained as follows;

• AD (Aggregate /Total Demand) ↓ C ↓  Demand for import goods ↓ IM ↓  Trade

Deficit (EX-IM)↓.

• The foreign trade multiplier (Kf), also known as the export multiplier, operates like the
investment multiplier of Keynes.

• It may be defined as the amount by which the national income of a country will be raised
by a unit increase in domestic investment on exports.
• It is clear from equation (1) that change in either investment or exports will cause national
income to increase by the multiplier .

• Therefore, if exports increase by ΔX, the national income will rise by ΔX .

Kf = Foreign Trade Multiplier

• The foreign trade multiplier works in the same way as Keynes’ investment multiplier.
When there is increase in exports, it will cause the increase in income of the exporters and
those employed in the export industries.

• They will save some of the increase in their incomes and will spend a good part of the
increases in their incomes on consumer goods, both domestic and imported ones.

• While savings do not generate further income and represent leakage from the income
stream, expenditure on imports leads to the increase in the incomes of the foreign
countries from which goods are imported. Thus expenditure on imports also represents a
‘leakage’ from the income stream as far as domestic economy is concerned.

• But the increased expenditure on domestic goods as a result of increase in exports will go
on increasing incomes in various successive rounds of spending till the multiplier fully
works itself out.
 • The effect of a change in EX and hence Y/trade balance (EX-IM) through the multiplier
process crucially depends on the levels of Kf and m. If the increase in exports is greater
(less) than that of imports, the net effect on trade balance is positive (negative).

EX ↑  Y ↑ ; Y ↑  IM ↑

• Whereas increase in exports has an expansionary effect on national income, the increase in
imports will have a negative effect on national income.

• Imports will bring about contraction (narrowing) in national income. Further, the effect of
increase in imports on national income will not be equal to the increase in imports but will
have a multiplier effect in reducing national income.

if m = 0.3, ΔY= $200 Million ΔM = 0.3 . 200 = $60 Million As ΔX = $100 Million and ΔM= $60 Million;
the net effect on trade balance is positive because ($ 100 Million) + ( - $ 60 Million) = $40 Million
c.- MONETARIST APPROACH TO BALANCE OF PAYMENTS

• The monetary approach to the balance of payments is associated with the names of
Mundell and Dornbusch.

• The basic premise of the approach is the recognition that the BOP disequilibrium is
fundamentally ‘a monetary phenomenon’.

• It attempts to explain the BOP deficits or surpluses through demand for and supply of
money.

• The monetary approach holds that the excess of money supply (Ms) over money demand
(Md) reflects the balance of payments deficit (EX < IM).

If Ms = Md  Equilibrium in money market = BOP Balance

If Ms < Md  Excess Md in money market = BOP Surplus

If Ms > Md  Excess Ms in money market = BOP Deficit

• According to monetary approach, the excessive money holdings are utilised by the people
in the purchase of foreign goods and securities.

• The excess supply of money may be offset by the Central Bank under a system of fixed
exchange rates through the sale of foreign exchange reserves and the purchase of domestic
currency. As the excess supply conditions in the money market are removed, the balance of
payments equilibrium gets restored.

• On the opposite, if the supply of money falls short of the demand for money, the country
will have a balance of payments surplus. In such a situation, people try to acquire the
domestic- currency through the sale of goods and securities to the foreigners.

• For meeting the shortage of domestic currency, the Central Bank will buy excess foreign
currency in addition to the purchase of domestic securities. Such measures will remove the
BOP surplus and restore the BOP equilibrium.
Simultaneous Internal and External Balance Analysis.

1.- Targets of Simultaneous Internal and External Balance.

2.- Sources of External Imbalance.

3.- Use of Monetary and Fiscal Policies for Simultaneous Balance.

• The achievement of ‘ simultaneous internal and external balance’ is the prime task of
macroeconomic policy in most countries.

• In some countries there may not be a ‘conflict’ between the achievement of internal
balance and balance of payments equilibrium.

• Circumstances may be such that the goals of ‘ full employment ’ and a ‘satisfactory growth’
rate can be achieved without a ‘balance of payments deficit’ emerging.

Targets of Internal Balance

• Minimizing ‘inflation’ and ‘unemployment’. Targets of External Balance Minimizing ‘BOP

surplus’ and ‘BOP deficit’.

Sources of External Imbalance

• Anything that disrupts the balance between foreign currency inflow and outflow may
create an 'imbalance' in the balance of payments.

• Various factors may have a direct or indirect impact on external imbalance.

- Fluctuations in global income,

- Rapid changes in exchange rates and interest rates,

- Increases in external debts,

- Low level production technology,

- Import‐dependent production and export structure, Low level domestic savings.

Main Sources of External Imbalance

• Main sources of external imbalance can be summarised as;

1.- Changes in Global Income.

2.- Structural Changes.
3.- Short-term Changes.

Main Sources of External Imbalance 1.- Changes in global income.

• Global business cycles are good example of changes in global income.

EXAMPLE: 1998 Russian Crisis;

- Russia was second best export market after Germany for Turkey.

- Russia's national income declined by 50 per cent from 1990 to 1998.

- This crisis created an external imbalance for Turkey by reducing Turkey’s export and
tourism revenues from Russia.
 Measuring a country’s vulnerability to global shocks.

• The vulnerability of a country to global shocks can be measured by the ‘openness rate’ or
‘IMPEX rate’.

• It is generally argued that the greater the openness rate, the more likely it is for the country
to be affected by the global income fluctuations.

• The openness rate and therefore the vulnerability of a country can be estimated as follows:

Openness Rate =

Main Sources of External Imbalance 2.- Structural Changes.

• Structural changes such as the changes in main foreign trade policies (The 24 January 1980
Decisions in Turkey etc.) and the fundamental shifts in consumers' tastes and preferences
(shifts from domestic goods to imported goods etc.) may also result in external imbalances.

Main Sources of External Imbalance 3.- Short term Changes.

• Temporary oil price shocks, bad

harvest years and natural disasters are the main examples of the short term changes
causing external imbalances.

Oil price $10  Turkey’s Current

Deficit $4 Billion Growth rate 0,5 %

3.- Use of Monetary and Fiscal Policies for Simultaneous Balance.

• To what extent are the countries able to reach simultaneous internal and external balance ?

• Is there a ‘policy mismatch’ problem for simultaneous internal and external balance?

• Targets of Internal and External Balance.

• Targets of Internal Balance : Eliminate ‘inflation’ and ‘unemployment’.

• Targets of External Balance : Eliminate ‘trade deficit’ and ‘trade surplus’.

• Point E shows the main policy target for hypothetical simultaneous internal and external
balance.

• What are the required policies for solving the internal and external balance problems in 4
areas using AD as a fiscal policy tool?

• Area 1: There are ‘BOP surplus’ and ‘unemployment’ problems in this area.

- Domestic demand, production and investment can be enhanced by increasing AD. Thereby,
it is possible to dissolve the BOP surplus by increasing domestic demand for imported
goods.

- With new investments, it is also possible to reduce unemployment by this kind of demand
expansionary fiscal policy.

• So there is no ‘policy mismatch problem’ in Area 1.

• Area 2: There are ‘BOP surplus’ and ‘inflation’ problems in this area.

- By increasing AD it is possible to dissolve the BOP surplus. However, it would be

unavoidable to deepen the demand pull inflation problem.

- By decreasing AD it is possible to solve the demand pull inflation problem. However, it

would increase BOP surplus due to the fall in domestic demand and imports.

• Therefore, there is ‘policy mismatch problem’ in Area 2.

• Area 3: There are BOP deficit and inflation problems in this area.

• The BOP deficit problem can be solved by decreasing AD and thereby reducing domestic
demand for imports. This kind of tight fiscal policy would also help us to reduce demand pull
inflation.

• As both internal and external balance problems can be solved together by the same policy,
there is no ‘policy mismatch problem’ in Area 3.

• Area 4: There are ‘BOP deficit’ and ‘unemployment’ problems in this area.

- By decreasing AD it is possible to reduce imports and BOP deficit. However, it would deepen
unemployment problem due to the fall in investment, production and employment level.

• Therefore, there is ‘policy mismatch problem’ in Area 4.

 Overall Evaluation on Model 1

• As seen in the summary table, it is not possible solve the internal and external balance
problems simultaneously in 4 areas by using a single policy tool of AD management.

• While there is no ‘policy mismatch problem’ in Area 1 and 3, it not possible to tackle with the
internal and external balance problems in Area 2 and 4.

• In order to solve the policy mismatch problems in Model 1, we need to add a new policy tool
to reach the simultaneous balance target.

• Rather than depending a single policy tool (AD), we now add a monetary policy tool, ‘r
(interest rate)’, to our analysis and use 2 different policy tools in Model 2.

Model 2: Fiscal (G) and Monetary (r) Policies for Simultaneous Balance.

• Is it possible to reach simultaneous internal and external balance by using public expenditure
(G) as a fiscal policy tool and interest rate (r) as monetary policy tool in fixed exchange rate
system?

• We can try to answer this question by using a graphical presentation of ‘Internal Balance
Curve’ and ‘External Balance Curve’.

• In this model, we will use the Internal Balance (IB) Curve and the External Balance (EB)
Curve.

• There is no ‘unemployment’ and ‘inflation’ on the Internal Balance (IB) curve. Hence, the
internal balance condition is satisfied.

• The area above the IB curve shows the area where we have ‘unemployment’ and the lower
part of the curve shows ‘inflation’.
• There is no ‘BOP surplus’ or ‘BOP deficit’ on the External Balance (EB) curve. Hence, the
external balance condition is satisfied.

• The area above the EB curve shows the area where we have ‘BOP surplus’ and the lower part
of the curve shows ‘BOP deficit’.

• As can be seen from the graphs, the slopes of the IB and the EB are different. This difference
results from the simple fact that the interest rate elasticity of domestic and foreign
investments are different.

• As foreign investments are more sensitive to the changes in interest rate, EB curve is flatter
than IB curve.

• If the interest rate elasticity of foreign investment is zero (0), EB curve is fully vertical to the
‘r’ axis.

• If the interest rate elasticity of foreign investment is infinite (∞), EB curve is horizontal to the
‘G’ axis.

• The higher the interest elasticity of the foreign investments, the flatter EB curve.
• Point A is in Area 1.

- At point A, the current interest rate (rA) is much higher than the equilibrium interest rate
(r*).

- But the current government spending (GB) is much less than the equilibrium government
spending (G*).

• Therefore, we should follow an expansionary fiscal policy to reach G*. We also need an
expansionary monetary policy (Ms ) to reduce the current interest rate from rA to r*.

• Point B is in Area 3.

- At point B, the current interest rate (rB) is much less than the equilibrium interest rate (r*).

- But the current government spending (GB) exceeds the equilibrium government spending
(G*).

• Therefore, we should follow a contractionary (tight) fiscal policy to reach G*. We also need a
tight monetary policy (Ms ) to increase the current interest rate from rB to r*.
 Overall Evaluation on the Simultaneous Balance Analysis.

• Although there is ‘policy mismatch’ problem in Model 1 where we used only fiscal policy
(AD), as seen in Model 2, it is possible to have a simultaneous internal and external balance
by using fiscal (G) and monetary policy (r) together without any ‘policy mismatch’ problem
under fixed exchange rate system.

• This analysis suggests that it is much more effective to use the Keynesian and the Monetary
approaches together.

• Effect of Covid-19 on Turkey’s Tourism Revenues.

Importance of Exchange Rates.

• Exchange Rate (ER) has been acknowledged as one of the most important economic and
financial variables in any economy.

• A possible reason behind ER getting such concern is the fact that it, directly and indirectly,
influences several crucial macroeconomic variables which in turn can generate vital
impacts on an economy as a whole.

• Thus, researchers and policymakers worldwide have endeavored themselves in

understanding the ER movements in different countries across the World.

Exchange Rate (ER) Volatility.

• It is believed that the ER stability within an economy invariably complements its

globalization drives affecting its bilateral and multilateral trade relationships with other
nations.

• As a result, adopting a particular ER regime requires global policymakers to have rich

knowledge regarding the factors that may attribute to ER volatility within an economy.

• Thus, ER volatility and its detrimental impacts on developing and least developed economies
provide immense motivation for further research.
 ER Volatility and Overshooting.

• Keeping the possible adversities attached to ER volatility into consideration, the Exchange
Rate Overshooting (ERO) hypothesis was first introduced by Rudi Dornbusch in 1976.

• ERO hypothesis is basically concerned about high levels of ER volatility.

• It shows that the impact of such high fluctuations of nominal ER trigger changes in money
supply (Ms) within the economy.

• There are several reasons that are presumed to stimulate this overshooting of the ER. For
instance, it has been argued that because of the existence of speculations and inefficiencies
in the foreign exchange markets, ER volatility arises.

• Similarly, the trade balance of a country is also considered to be responsible for attributing
to ERO, which takes place as soon as the country is in a trade deficit with its trading partners.

• The concept of ERO explains the mechanism through which the short-run response of the
ER, to an exogenous shock, exceeds its long-run response.

• It is crucial to identify the factors that can stimulate ERO in order to adopt appropriate
policies to safeguard the economy against ER misalignments.

• ERO is considered to be detrimental to economies that pursue export-led growth strategies.

Thus, understanding the dynamics adhering ER movements is extremely important for a
developing country like Turkey.

Overshooting Mechanism.

• The mechanism called ‘Overshooting’ examines the relationship between money supply
(Ms), interest rate (r), General Price Level (GPL) and exchange rate (ER) under flexible
exchange rate regime.

• The main objective of this mechanism is to analyse the response of r, GPL and ER to
changes in Ms, rather than examining the interrelationship between the 4 variables (Ms, r,
GPL, ER).

• The difference in size of the response of the other 3 variables to changes in Ms is very
useful in estimating the effects of the monetary policy to be implemented during the
financial crisis.

• In short, the overshooting mechanism indicates that the exchange rate (ER) will give the
strongest response to the changes in Ms and that the 4 variables will be equalized in the
long term.

Example; Index value of all variables in T0 period: 100

• Suppose that if the money supply (Ms) is increased by % 50, the values of the other 3
variableas are as follows;

ER: 170 GPL: 100 r: 80

 Ms ↑  r ↓  ER ↑  Demand for the goods produced in export and import

substitution industries ↑  Dom. Production↑ LD ↑  W ↑  GPL ↑  Reel Ms ↓

 r ↑  Foreign capital inflow ↑  Foreign currency supply ↑  ER ↓.

Overshooting Mechanism: Long term Equilibrium

• In long term, at point E, all of the 4 variables are equalised at 150.

• Only the value of exchange rate (170) exceeds the long-term equilibrium level (150).

• Such deviation of exchange rate from the long-term equilibrium level is called ‘
overshooting ’.

• An increase in the money supply can cause the exchange rate to overshoot its long run level
in the short run. If output is given, a permanent money supply increase, for example, causes
a more-than-proportional short-run depreciation of the currency, followed by an
appreciation of the currency to its long-run exchange rate.

• Exchange rate overshooting, which increases the volatility of exchange rates, is a direct
result of slow short-run price and interest level adjustments.

• Policy Recommendation of Overshooting Mechanism.

• In times of financial crisis when the money supply is out of control, policymakers (CB) should
immediately intervene in exchange rates by using official reserves to prevent rapid upward
movement of exchange rates.

J Curve Analysis

• J curve reflects the process by which currency depreciation (devaluation) affects a country's
foreign trade balance (EX - IM).
• The J curve shows the long and short term responses of domestic consumers and importers
to devaluation and the time period after which the expected positive effects will be revealed.

Understanding the J Curve Analysis

• The J Curve analysis shows that says the trade deficit will initially worsen after currency
depreciation.

• The nominal trade deficit initially grows after a devaluation, as prices of exports rise before
quantities can adjust.

• Then, as quantities adjust, there is an increase in imports as exports remain static, and the
trade deficit shrinks or reverses into a surplus forming a ‘ J ’ shape. 

Rationale Behind J Curve

• The J Curve operates under the theory that the trading volumes of imports and exports
first only experience microeconomic changes as prices adjust before quantities.

• The lag between the devaluation and the response on the curve is mainly due to the effect
that even after a nation’s currency experiences a depreciation, the total value of imports
will likely increase. However, the country's exports remain static until the pre-existing
trade contracts occur.

• The J-curve is useful to demonstrate the effects of an event or action over a set period of
time.

• It shows that things are going to ‘get worse’ before they ‘get better’.

ML Condition and J Curve

• The Marshall-Lerner (ML) condition is at the heart of the J curve analysis.

• The condition tries to answer the following question: when does a real devaluation (in
fixed exchange rates) or a real depreciation (in floating exchange rates) of the currency
improve the current account balance of a country?

• The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of the
currency will improve the trade balance if the sum of the elasticities (in absolute values) of
the demand for imports and exports with respect to the real exchange rate is greater than
1. ( )

• If the ML condition is not met, the effect of devaluation on trade balance is negative.

Graphical Presentation of the J Curve

 Overall Evaluation on the J Curve Effect

• Empirical studies show that the elasticities of the demand for EX and IM is 2 times more in
the long term compared to the short term. In addition, the t1 – t2 time interval is
estimated to be about 2 years.

• Therefore, the positive effects of devaluation on trade balance are expected to occur only
after a 2-year delay.

• Overall Evaluation on the J Curve Effect

• The reason for the delay of the positive effect of the devaluation is that, importers increase
their orders, expecting the ER and prices to rise further while exporters postpone their
orders due to the same expectations.

• Because of the above mentioned increase in imports and decrease in exports, the short
term impact of the devaluation on trade balance is ‘negative’.