Basic Theories of the Balance

of Payments
Three Approaches

Three Approaches

The Elasticities Approach to the Balance

of Trade
The Absorption Approach to the Balance
of Trade
The Monetary Approach to the Balance of
Payment (MABOP)

The Elasticities Approach to BOT

d = elasticity of demand
= the responsiveness of quantity
demanded to changes in price
d = (%Qd)/(%P)
which is usually negative

Elasticities

| d | > 1 the demand is elastic

| d | < 1 the demand is inelastic
If the demand is elastic, the 1% rise in
price leads to more than 1% decline in
quantity demanded.
If the demand is inelastic, the 1% rise in
price leads to less than 1% decline in
quantity demanded.

Devaluation and BOT

Does the devaluation of a currency

improve the countrys balance of trade?

Consider EPs/$ = the Mexican peso price of

the dollar

Devaluation and BOT (contd)

(1) If the demand curve for the dollar

slopes downward and the supply curve of
the dollar slopes upward, then the
devaluation of the peso leads to an
excess supply of the dollar, which causes
the Mexican trade deficit to decrease.

Devaluation and BOT

(2) If the demand curve for the dollar is

steep and the supply curve of the dollar is
negatively sloped, then the devaluation of
the peso leads to an excess demand for
the dollar, which causes the Mexican
trade deficit to increase.

Devaluation and BOT (contd)

(1): stable FX market equilibrium

(2): unstable FX market equilibrium
The case (2) could occur when Mexican demand
for US imports and US demand for Mexican
exports are both very inelastic.
The greater the elasticities of both countrys
demand for the other countrys goods, the
greater the improvement in Mexico trade
balance after a peso devaluation.

Devaluation and BOT

The condition that guarantees the case (1)

is called Marshall-Lerner Condition.

J Curve Effect

After the devaluation, it is often observed

that the trade balance initially deteriorates
for a while before getting improved.

Elasticities and J-Curves

Why do we have a J-Curve?

The initial demands tend to be inelastic.
Suppose Mexico imports good X from the
US and exports good Y to the US.
Devaluation Eps/$
PXPs & PY$
QX d & Q Y d

Elasticities and J-Curves

But if Mexican demand for X is inelastic, the

% decrease in QXd would be smaller than
the % increase in PXPs so that Imports =
PXPs QXd would increase.

Further, if US demand for Y is inelastic, the

% increase in QYd would be smaller than the
% decline in PY$ so that Exports = PY$ QYd
would fall.

Pass Through

Devaluation Import prices in the

home country and export prices in
foreign countries.
But prices do not adjust instantaneously.
Persistent BOP deficit devaluation
Home demand for imports and
foreign demand for exports
an improvement in BOP in the L-R

Pass-through Analysis

How do prices adjust to exchange rate changes

in the S-R?
Differences in the pass-through effect across
countries Producers adjust profit margins
Example: When the yen appreciated against the
dollar substantially during late 1980s, Japanese
auto-makers limited the pass-through of higher
prices by reducing the profit margins on their
products.

Pass-though analysis (contd)

In general,
Depreciation of the dollar Foreign
sellers cut their profit margins
Appreciation of the dollar Foreign
sellers increase their profit margins

Absorption Approach to BOT

Recall the national income identity:

Y = C + I + G + (X M)
So
Y A= X M
where A = C + I + G is the total domestic
spending or absorption.

Absorption approach to BOP

(contd)

If Y > A, then X M > 0 or BOT > 0.

If Y < A, then X M < 0 or BOT < 0.
Does devaluation always improve BOT?
Recall: If Y = Y* Full employment level of
output, then all resources are already employed
and hence, X M needs A .
If Y < Y*, then X M obtains through
increasing Y with A unchanged, i.e. by producing
more to sell to foreigners.

Absorption approach

So, when Y < Y*, devaluation would

improve BOT.
But when Y > Y*, devaluation would
increase X M but create inflation.

Monetary Approach to BOP

Recall
Current account
Non-reserve capital account
-------------------------------------Official reserve account money
supply

Feds Balance Sheet

Assets
Domestic Credit
(Treasury securities,
Discount loans, etc )

International
reserves
(Gold, SDR, other foreign
currencies denominated
deposits and bonds)

Liabilities
Currency
(Fed reserve notes
outstanding)

Bank reserves

Monetary base

DC + IR = CU + R MB
(1)
where DC = domestic credit
IR = international reserves
CU = currency
R = bank reserves
MB = monetary base

FX intervention again

Suppose the Fed sells $1 billion of its

foreign assets in exchange for $1 billion of
US currency.
Feds balance sheet
Assets
Liabilities
Foreign assets -$1 billion

So, MB by $1 billion.

Currency -$1 billion

Money Supply

Recall: MS = mMB (2)

where m = money multiplier

M = CU + D
where D = deposits
MB = CU + R
So, M/MB = (CU + D)/(CU + R)
= (1 + c)/(c + r) m
where c = currency-deposit ratio
r = reserve ratio

Money supply and Money

demand

Substituting (2) in (1), we obtain

MS = m (DC + IR)
(3)
Consider Money demand function:
Md = kPL
(4)
where P = price level at home and L is the
liquidity preference function, which
depends on income and the interest rate.
k is a constant.

PPP again

Now assume PPP

P = EP*

(5)

where E = home currency price of the

foreign currency
P* = price level in the foreign country

Substituting (5) into (4), we have

Md = kEP*L
(6)

Monetary equilibrium

In equilibrium, Md = MS.
So, from (3) and (6), we have
kEP*L = m (DC + IR)
In terms of % changes (or growth rates),
E^ + P*^ + L^ = wDC^ + (1-w)IR^
where k^ = m^ =0 because they are
constants. w = DC/(DC + IR).

Finally,

Rearranging, we obtain
(1-w) IR^ - E^ = P*^ + L^ - wDC^

(7)

Monetary approach to Balance of

payments (MABOP)

With a fixed exchange rate (E^ = 0),

BOP^ = IR^ = [1/(1-w)](P*^ + L^)
- [w/(1-w)]DC^
(8)
Fed increases MS (Excess money supply)
DC IR BOP
Fed decreases MS
DC IR BOP

Monetary approach to exchange

rate (MAER)

With a flexible exchange rate (BOP=0),

-E^ = P*^ + L^ - wDC^
(9)
Fed increases MS
DC E (depreciation)
Fed decreases MS
DC E (appreciation)

Managed float

Although exchange rates are market

determined in principle, central banks
intervene at times to peg the rates at
some desired level.
When MS or Md changes, the central bank
can choose either E^ or IR^ to adjust.

Implication of PPP

Recall PPP again: P = EP*.

With a fixed ex rate, E^ = 0, so
P^ = P*^
In other words, when the foreign price
level is increasing rapidly, then the home
price must follow if we are to maintain the
fixed E. Imported Inflation

Implication of PPP (contd)

With flexible rates, E is free to vary so that

even when P*^ > 0, P^ can be zero by
letting E^ = - P*^, or letting the home
currency to appreciate by the same
amount as the foreign inflation rate.

Views based on MABOP

BOP disequilibria are essentially monetary

phenomena.
Devaluation is a substitute for reducing
the growth of domestic credit.
Appreciation is a substitute for increasing
domestic credit growth.