Chapter 2

Balance of Payment’s Approaches

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 Introduction
This chapter studies:
- The relationship between national income and balance
of payment.
- Three approaches for BOP:
+ The Elasticity and Absorption approach investigate the
impact of exchange rate changes on the current account
position of a country: will a devaluation (or depreciation)
of the exchange rate lead to a reduction of a current
account deficit?
+ The Monetary approach explain for BOP movements
base on changes in money supply and demand.
 National Income Accounting for an Open
Economy
• The national income identity for an open
economy is
Y = C + I + G + EX – IM
= C + I + G + CA

Expenditure by domestic Net expenditure by foreign

individuals and institutions individuals and institutions
 National Income Accounting for an Open Economy (cont.)

CA = EX – IM = Y – (C + I + G )
• When production > domestic expenditure, exports > imports: current
account > 0 and trade balance > 0
– when a country exports more than it imports, it earns more income from
exports than it spends on imports
– net foreign wealth is increasing

• When production < domestic expenditure, exports < imports: current

account < 0 and trade balance < 0
– when a country exports less than it imports, it earns less income from exports
than it spends on imports
– net foreign wealth is decreasing
 Balance of Payments Accounts
• A country’s balance of payments accounts accounts for its
payments to and its receipts from foreigners.
• An international transaction involves two parties, and each
transaction enters the accounts twice: once as a credit (+) and
once as a debit (–).
 Balance of Payments Accounts (cont.)

• The balance of payments accounts are separated

into 3 broad accounts:
– current account: accounts for flows of goods and
services (imports and exports).
– financial account: accounts for flows of financial
assets (financial capital).
– capital account: flows of special categories of assets
(capital): typically nonmarket, non-produced, or
intangible assets like debt forgiveness, copyrights and
trademarks.
Elasticities Approach
Elasticities Approach
 Review of Elasticity
• Price Elasticity of Demand is a measure of the
responsiveness of quantity demanded to a change in
price.
• If quantity demanded is highly responsive to a
change in price, then demand is said to be relatively
elastic.
• If quantity demanded is not very responsive to a
change in price, then demand is said to be relatively
inelastic.
 The Marshall-Lerner Condition
• Will a depreciation always improve the current
account balance?
• The Marshall-Lerner condition specifies the
necessary conditions for the current account to
improve.
• According to this condition, the current account
balance will improve if the sum of the elasticity of
import demand and the elasticity of export supply
exceed unity.
 Elasticities Approach

– Assumption
• Capital flows occur only as a means of
financing current account transactions.
• Trade balance exclusively represents the current
account.
 Elasticities Approach
– CA in domestic currency: CA  PX  eP * M
dCA dX dM
– Derivate it with e: P  P * M  eP *
de de de

– Initial CA in equilibrium: eP * M
1
PX
– Then: dCA eP * M dX dM
P  P * M  eP *
de PX de de
– Rearrange it: dCA dX e dM e
 P*M (   1)
de de X de M
– Finally:
dCA ( dX, e dM) e
 P * M ( x  m  1) x  m  
de de X de M
 Elasticities Approach
dCA
– A depreciation to improve CA: 0
de

– So:  x  m  1

– Marshall-Lerner condition states that a depreciation

of domestic currency can improve a country’s balance
of payments only when the sum of the demand
elasticity of exports and the demand elasticity of
imports exceeds unity.
Elasticities Approach
Elasticities Approach
Elasticities Approach
 Elasticities Approach
• J-Curve Effect
– A depreciation of the domestic currency is unlikely to
immediately improve a country’s balance-of-payments
deficit. It is even possible that the depreciation could cause
a country’s balance of payments to worsen before it
improves.
BP Surplus

C
0 t0 t1 t2 Time

A
e↑

B
BP Deficit
 Elasticities Approach
– Reasons for J-Curve Effect:
• Reaction of producers
• Reaction of consumers
 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.
 Absorption Approach
• Absorption: A  C  I G
• National income: Y  C  I  G  (X  M )
• Current account: CA  X  M => CA  Y  A
• Thus dCA  dY  dA
– 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.
 Absorption Approach
• The effect of depreciation on absorption can be divided
into two parts:
– dA  a  dY  dAd
• The induced effect of income changes resulting from
depreciation on absorption: a  dY
(a: MPC: Marginal Propensity to Consume: the proportion of
a raise that is spent on the consumption of goods and
services, as opposed to being saved)
• The direct effect of depreciation on absorption: dA
d
dCA  (1  a )  dY  dAd
• Therefore, the effects of depreciation on the current
account: the income effect: (1  a )  dY
the absorption effect: dAd
 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 government’s
macroeconomic regulation, an effective
depreciation requires loosening protective or
restrictive trade polices.
 Absorption Approach
• Direct Effects of Depreciation on Absorption
– Real cash balance effect
require Ms↓to guarantee

e↑ P↑ cash balance↓

expenditure↓ C↓

withdraw Price of financial r↑ C↓,

financial assets assets↓ I↓

dAd 
 Absorption Approach
– Income redistribution effect

e↑ P↑ Income redistribution from

wage earners to profit earners
W
profit earners have lower MPC

C↓ dAd 
 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.
 Monetary Approach
• Introduction
The Monetary Approach focuses on the supply
and demand of money and the money supply
process.
• The monetary approach hypothesizes that BOP
and exchange-rate movements result from
changes in money supply and demand.
The Monetary Base
Simplified Balance Sheet of the
Central Bank
Assets Liabilities

Domestic Credit Currency

(DC) (C)

Foreign Exchange Total Reserves

Reserves (FER) (TR)

Monetary Base Monetary Base

(MB) (MB)
Money Stock
Money Multiplier
Money Multiplier
 Relating the Monetary Base and the Money Stock

• Under the assumptions above, we can write the

money stock as the monetary base times the
money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
• Focusing only on the asset measure of the
monetary base, the change in the money stock
is expressed as
M = m(DC + FER).
Example - BOJ Intervention
BOJ Balance Sheet
Assets Liabilities

DC C

FER TR
-¥1 million -¥1 million

MB MB
-¥1 million -¥1 million
 BOJ Intervention
• Because the monetary base declined, so will
the money stock.
• Suppose the reserve requirement is 10 percent.
The change in the money stock is
M = m(DC + FER),
M = (1/.10)(-¥1 million) = -¥10 million.
 Monetary Approach
Small Country Example
 Monetary Approach
Small Country Model
The balance of payments is defined as:
(5) CA + KA = FER.

For example, if FER< 0, then CA + KA < 0, and

the nation is running a balance of payments
deficit.
 Monetary Approach
Small Country
(4) and (3) into (1) yields,
Model

M = kP*Sy.

Sub in (2),
(6) m(DC + FER) = kP*Sy.
 Monetary Approach
Small Country Model
• Fixed Exchange Rate Regime
• Under fixed exchange rates, the spot rate, S, is
not allowed to vary.
• FER must vary to maintain the parity value of
the spot rate.
• Hence, the BOP must adjust to any monetary
disequilibrium.
 Monetary Approach
• ConsiderSmall Country
what happens if theModel
central bank
raises DC. Money supply exceeds money
demand.
m(DC + FER) > kP*Sy
• There is pressure for the domestic currency to
depreciate. The central bank must sell FER
until M = Md.
m(DC + FER) = KP*Sy
 Monetary Approach
• Small Country Model
There has been no net impact on the monetary
base and money supply as the change in FER
offset the change in DC.
• There results, however, a balance of payments
deficit as FER < 0.

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 Monetary Approach
•
Small Country Example
Flexible exchange rate regime:
• Under a flexible exchange rate regime, the
FER component of the monetary base does not
change.
• The spot exchange rate, S, will adjust to
eliminate any monetary disequilibrium.

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 Monetary Approach
•ConsiderSmall Country
the impact Modelin DC.
of an increase
• Again money supply will exceed money
demand
m(DC + FER) > kP*Sy.
• Now the domestic currency must depreciate to
balance money supply and money demand
m(DC + FER) = kP*Sy.

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 Monetary Approach
• Smallapproach
The monetary Country Modelthat
postulates
changes in a nation’s balance of payments or
exchange rate are a monetary phenomenon.
• The small country illustrates the impact of
changes in domestic credit, foreign price
shocks, and changes in domestic real income.

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