Question

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A critical difference between the Absorption Approach and the Elasticities Approach to the effect of a devaluation on the Current Account is the addition of income effects. How will income effects alter the effect of a devaluation, and does this tend to make it more or less difficult for a devaluation to strengthen the current account under the absorption approach?

Answer 1

The absorption approach to BOP is based on the Keynesian national income theory. It mainly depicts the income effect of devaluation as compared to the price effect of the elasticity approach. It simply states that is the economy is spending on consumption and investment more than its national income then it faces a deficit in the current account of balance of payments and vice versa. Hence it has a name as absorption approach because the economy spending is termed as absorbing. The BOP is defined as the difference between the national income and the domestic expenditures. It states that the BOP can be improved by two ways, either by increasing domestic income or by reducing the spending/absorption of the economy. Devaluation can help achieve both. When there are idle resources in the economy, devaluation tends to increase exports and decrease imports. Output and income will increase thereby improving the current account in BOP. With the increase in exports the national income will increase and due to the multiplier effect the increased income will further increase. However, if the resources in the economy are fully employed then the national income will not increase and devaluation could not help improve an adverse BOP situation. The adverse BOP would further worsen with an increase in prices which reduces exports and increase imports.