The BOP Dis-equilibrium and Economic Policy Adjustment

Mechanism

• Expenditure Reducing Policy (Anti-inflationary Fiscal and

Monetary Measures)

• Expenditure Switching Policy (Devaluation)

• Direct Controls (Tariffs, Quota Restrictions, etc.)

 • Expenditure Reducing Policy

Monetary Policy Instruments: Interest Rates and Open Market

Operations
Fiscal Policy Instruments: Taxes, Cut in Govt. expenditure

• Expenditure Switching Policy

It works through changing the relative prices
Devaluation: Effect depends on Marshall-Lerner (ML) condition

ML condition: If (E1m+E2m)>1, then devaluation will lead to

improvement in BOP. E1m= First (devaluing) country’s demand
elasticity for imports and E2m= Second (rest of the world) demand
elasticity for exports from the devaluing country
Devaluation: The Absorption Approach
To measure the impact of devaluation on BOP we
must consider income effect along with price effect
This is important as due to devaluation export increases and
this results into higher national income(via multiplier) which
in turn raises the import demand. So, to find out the impact of
devaluation on trade balance, we need to look into both price
as well as income effect.
Absorption Approach through a simple Keynsian Model
Y= C+I+G+X-M= A+B,
A=Sum of all domestic expenditure or domestic absorption
B= Trade balance

So, B=Y-A
Devaluation: The Absorption Approach (cont’d)
B=Y-A,
dB=dY-dA,
Devaluation affects trade balance through change in income and
change in absorption.
Change in absorption (dA) can be decomposed into two parts.
1) Income induced change in absorption this depends on marginal
propensity to absorb or  and 2) direct or non-income induced
change in absorption or D

So, dA=.dY+dD
More precisely we can write
dB=(1-).dY-dD
The last equation says that the effects of devaluation on trade
balance depend on i) how devaluation affects income
ii) propensity to absorb and iii) the effect on direct absorption
Devaluation: The Absorption Approach (cont’d)

To understand the effect of devaluation we distinguish between

two situations
• where there are idle (unemployed) resources
• where there is full employment
Case I, (with unemployed resources)
After devaluation we can expect production will expand
with an increase in exports, giving rise in national income.
If national income rises because of devaluation its net
effect on BOT will be given by the difference between this
increase and induced increase in total absorption.

Putting aside the effect on direct absorption we can say

that <1 will have a positive effect on BOT
Devaluation: The Absorption Approach (cont’d)

Case II, (with full employment of resources)

In a situation where economy has already reached a full
employment position or the marginal propensity to absorb is
larger than unity, the principal effect of devaluation on trade
balance is through the direct effect on absorption (dD).

The direct effect is not through any change in income. It depends on

the fact that absorption out of a given real income may change as the
price level changes due to devaluation. As economy is initially at full
employment, devaluation will open up an inflationary gap for the
economy leading to an increase in general price level. This will
create pressure to reduce the domestic absorption and thereby to
improve trade balance.
Devaluation: The Absorption Approach (cont’d)
Case II, (with full employment of resources)
There have been several possible ways in which the rise in
domestic price level might reduce domestic absorption. Some of
them are:
Real Balance Effect (with constant nominal money supply)

Money Illusion Effect (Temporary effect as people do not

observe that their income is also rising )

Income Redistribution Effect (In short run profits

increase at the expense of wages and MPC of profit
earners is smaller than that of wage earners. So fall in
absorption. But it gets neutralised if profits are used for
re-investment