INTERNATIONAL

FINANCE CH05
Current Account
and Exchange-Rate
Equilibrium
Elasticity Approach and
Absorption Approach
 Traditional Approaches
• Traditional approaches to balance-of-payments
and exchange-rate determination assume that
capital flows occur only to finance real-sector
transactions.
• Hence, the quantity of foreign exchange
demanded and the quantity of foreign
exchange supplied depend only on
international transactions of goods and
services.

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 Fundamental Issues
• 5.1. How does the supply of exports and
demand for imports determine the supply of
and demand for foreign exchange?
• 5.2. What is the elasticity approach to balance-
of-payments and exchange-rate determination?
• 5.3. What is the absorption approach to
balance-of-payments and exchange-rate
determination?
3
Overview of the Elasticities Approach
• The elasticities approach emphasizes price
changes as a determinant of a nation’s balance
of payments and exchange rate.
• The elasticities approach is helpful in
understanding the different outcomes that
might arise from the short to long run.

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 5.1.1 The Demand for
Foreign Exchange and Elasticity
• The demand for a nation’s currency is dependent
upon foreign residents’ demand for its exports, that is,
it depends on foreign residents’ desire to obtain the
domestic currency to facilitate their purchases of the
domestic country’s exports.
• The supply of a nation’s currency is dependent upon
(among other things) domestic residents’ demand for
imports, that is, when a nation’s residents import,
they supply the domestic currency as payment.

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U.S Import Demand and the Demand
for the Euro

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 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.
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 Elasticity of Import Demand and the
Elasticity of Foreign Exchange Demand

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 5.1.2 The Supply of
Foreign Exchange and Elasticity
• The supply of a nation’s currency is dependent
upon (among other things) domestic residents’
demand for imports, that is, when a nation’s
residents import, they supply the domestic
currency as payment.

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The Export Supply Curve and the
Supply of the Euro

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 Elasticity of Export Supply and the
Elasticity of Foreign Exchange Supply

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 5.1.3 Exchange-Rate and
Balance-of-Payments
• The Effect of Exchange Rate Changes
• The exchange rate is an important price to an
economy.
• When a nation’s currency depreciates, domestic
goods become relatively cheaper and foreign goods
relatively more expensive in the global market.
• Hence, we would expect the nation’s exports to rise
and imports to decline.

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 The Responsiveness of Imports and Exports

• The elasticities approach, therefore, considers

the responsiveness of the quantity of imports
and the quantity of exports to a change in the
value of a nation’s currency.
• For example, if import demand is highly
elastic, a depreciation of the domestic currency
will cause a relatively larger decline in the
nation’s imports.

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 Surpluses and Deficits

• It follows that an excess quantity supplied of the

domestic currency is equivalent to a current account
deficit.
• Likewise, an excess quantity demanded of the
domestic currency is equivalent to a current account
surplus.
• The current account is in balance when the quantity
of the domestic currency supplied and the quantity
demanded are equal.

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 The Current Account

The current account deficit is

equivalent to the difference
between the quantity of
foreign exchange demanded
and the quantity of foreign
exchange supplied. At the
spot exchange rate of 1.00,
U.S. residents demand €220
million in foreign exchange
and European residents
supply €180 million. Hence,
the current account deficit is
€40 million.

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 The Role of Elasticity
• The previous chart illustrated a current account
deficit for the United States.
• The amount of depreciation required to
eliminate this deficit depends on elasticity.
• When demand and supply are relatively more
elastic, a smaller deprecation is required to
eliminate the current account deficit.

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Table5-1 Trade Surpluses of Sino-U.S.
(million $)

1200
1000
800
600
400
200
0
94

95

96

97

98

99

01

02

03

04
00

05
19

19

19

19

19

19

20

20

20

20
20

20
Data source:
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 5.2 The Elasticity approach to balance-of-
payments and exchange-rate determination

• Basic Model
• The Marshall-Lerner Condition
• The J-Curve Effect
• Pass-Through Effects
• Conclusions and Critical Analysis

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• The Elasticity approach was put forward by
John Robinson（ 1903 ～ 1983 ） , which is based
on microeconomics and partial equilibrium (
Alfred Marshall（ 1842 ～ 1924 ）
• The theory emphasizes price changes as a
determinant of a nation’s balance of payments
and exchange rate.

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 5.2.1 Basic Model
Assumption
• Incomes, other goods prices and consumption
preference are stable ；
• There is no capital flows, capital flows occur only to
finance real-sector transactions.
• There are two Markets ： Domestic traded goods
market and Foreign traded goods market, excluding
non-traded goods market
• Elasticities of Supply of Imports and Exports are
unlimited.
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 Framework of Analysis
A currency depreciation or appreciation

the domestic currency price for

imports and exports
the elasticity
of exports
and imports
the quantity of imports and exports

The Balance of Payments

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• Conclusion
• A currency depreciation or appreciation
may have effect on a nation’s balance -of-
payments by the changes of relative prices
,which brings out the fluctuations of the
quantity of imports demanded and the
quantity of exports supplied.

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 5.2.2 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
be improved.
• According to this condition, the current
account balance will be improved if the sum of
the absolute elasticity of import demand and
the elasticity of export demand exceed unity.
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 ηm + η x >1

Where η m denotes the elasticity of import demand ,

η x denotes the elasticity of export demand.

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 Further Reading

About calculation of the Marshall-Lerner Condition ，

See ：
• [U.S.A] Dominick Salvatore .
International Economics .Eighth Edition.
Tsinghua University Press.2004.7. pp488.

• [Italy] Giancarlo Gandolfo.

International Monetary Theory and Open-Economy
Macroeconomics. Second, Revised Edition.
China Economics Publishing House.2001.1. pp81-84.

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 An Appl ied Model :
The Marshall-Lerner Condition
Depreciation’s effect on Incomes （＄）
under various elasticities
station domestic exchange foreign the Incomes change change
price of rate price of amount of of exports ratio of ratio of
exports exports exports （＄） price exports’
（% amount
） （ %）
0 RMB7 1/7 ＄1 10000 ＄ 10000 - -
1 RMB7 1/8 ＄ 0.875 11000 ＄ 9625 14.29 10

2 RMB7 1/8 ＄ 0.875 12000 ＄ 10500 14.29 20

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• Question1.What is the difference between the
station1 and station2?
• Question2.What conclusion can you get?

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 Column

• Bickerdike-Robinson-Metzler Condition.

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 5.2.3 The J-Curve Effect

• Could a depreciation improve the

current account balance at once?

• A study from IMF

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• The time horizon is a particularly important
factor that determines the elasticity of export
supply and import demand.

• The current account balance may respond

differently to a currency change in the short
run relative to the long run.
The J-Curve Effect

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• The J-Curve effect refers to a phenomenon
in which a depreciation of the domestic
currency causes a nation’s balance-of-
payments to worsen before it improves.

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Figure 5-1 The J-Curve

BOP
+

T1 T2 T3
O T

-
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 5.2.4 Pass-Through Effects
• The third problem?

• Pass-through effects are also important to

understand the response of the current account
to changes in the exchange rate.

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• A pass-through effect occurs when a change
in the exchange value of the domestic currency
results in a change in the domestic prices of
imported goods and services.

• The degree of pass-through varies across

nations, across time, and across industries
within nations.
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 Management Notebook

　　　　　Do exporters pass through

exchange rate fluctuations?

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 Conclusions and Critical Analysis
• The elasticity of foreign exchange demand and
supply are determined by the elasticity of
export supply and import demand.

• Elasticities determine the impact of exchange

rate changes on the current account.

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• The Marshall-Lerner condition is provided as a
necessary condition for improvement in
current account caused by the depreciation.

• The J-curve effect is explained as a

consequence of the fact that import demand
and export supply tend to be less elastic in the
short run than in the long run.
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• Finally, the pass-through effect is defined as
the effect that changes in the exchange rate can
have on the domestic prices of imported goods
and services.

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 5.3 The Absorption Approach
• The absorption approach emphasizes changes
in real domestic income as a determinant of a
nation’s balance of payments and exchange
rate.
• Because it treats prices as constant, all
variables are real measures.

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 Expenditures
• A nation’s expenditures fall into four
categories, consumption (c), investment (i),
government (g), and imports (m).
• The total of these four categories is referred to
as domestic absorption (a)
a ≡ c + i + g + m,

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 Real Income
• A nation’s real income (y) is equivalent to
total expenditures on its output
y ≡ c + i + g + x,
where x denotes exports.

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 The Current Account
• During the time (early Bretton Woods era) that the
absorption model was developed, capital flows were
not very important. Trade flows, therefore,
determined the current account balance. Hence, the
current account (ca) is equivalent to
ca ≡ x - m.
• Then, for example, if exports exceed imports, x > m,
and the nation is running a current account surplus.

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 Current Account Determination
• The absorption approach hypothesizes that a
nation’s current account balance is determined
by the difference between real income and
absorption, which can be written as:
• y - a = (c+i+g+x) - (c+i+g+m) = x - m,
or
y - a = ca.

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 Contractions and Expansions
• Though a simple theory, the absorption approach is
helpful in understanding a nation’s external
performance during contractions and expansions.
• For example, when a nation experiences an economic
contraction, does its current account necessarily
improve and does its currency definitely appreciate?
• Does the opposite necessarily hold during an
economic expansion?

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Balance of Payments Determination

• Consider the case of an economic expansion.

Real income rises, thereby increasing real
expenditures or absorption.
• Whether the current account balance
improves or worsens depends on the relative
changes in these two variables.

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 Current Account Adjustment
• If real income rises faster than absorption, then the
current account improves
• ∆y > ∆a → ∆ca > 0.
• If real income rises slower than absorption, then the
current account worsens
• ∆y < ∆a → ∆ca < 0.
• Similar conclusions can be reached for a nation
experiencing an economic contraction.

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 Exchange Rate Determination
• The absorption approach can also be used to
examine how changes in income affect the
value of a nation’s currency.
• Recall that y - a = x - m.
• For example, if real income is rising faster
than absorption, then exports must be
increasing relative to imports. Hence, the
nation’s currency will appreciate.

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 Policy Implications
• A nation may resort to absorption instruments
or expenditure switching instruments to correct
an external imbalance.
• The effectiveness of these instruments,
however, is uncertain, as can be seen in the
model.

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 Policy Instruments
• Absorption Instrument: Influences absorption by
altering expenditures.
• Suppose the government reduces its expenditures
(g). Absorption will decline as g declines.
• However, since expenditures decline, so does
output. The absorption instrument is effective only
if absorption declines faster than output.

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 Policy Instruments, Continued
• Expenditure Switching Instrument: Alters
expenditures among imports and exports by
changing relative prices.
• Suppose the government devalues the domestic
currency. Imports are relatively more expensive,
and exports are relatively cheaper.
• If households and businesses switch directly
between imports and domestic output without
changing overall absorption or income, there is no
impact on the current account balance.
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 Conclusion
• The Absorption Approach emphasizes
real income in balance-of-payments and
exchange-rate determination.
• The approach hypothesizes that relative
changes in real income or output and
absorption determine a nation’s balance-of-
payments and exchange-rate performance.
• It is not clear that expenditure switching
and absorption instruments are effective.
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