Question

According to the absorption approach, under what condition, the depreciation of a nation’s currency leads to an improvement of trade balances of the nation?

Answer 1

The absorbtion approach to balance of payment is based on the keynesian national income relationships.

Y = C+I+G + NX

The sum of (C + Id + G) is the total absorption designated as A, and the balance of payments (X – M) is designated as B.

Y = A + B

B = Y-A

Absorbtion rate: It shows the total amount of consumption by people in an economy regardless of the origin of the goods and services. Absorption includes spending on all goods and services. Countries with a high marginal propensity to consume tend to have a high absorption rate.

a = marginal propensity to consume + marginal propensity to invest

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

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.