The absorption approach to BOP and exchange rate determination

1. The absorption approach to BOP and exchange rate determination Concepts and exemplification

2. What is absorption? A nation’s total expenditures on final goods and services

3. The absorption approach: Concept BOP is determined by real national income and its absorption In other words, BOP is determined by how much is produced and how much is consumed

4. Definitions Absorption (a): a = c + inv + g + imp Real income (y): y = c + inv + g + exp

5. Corollary y-a = exp - imp = current account The current account is determined by the difference between income (how much is produced) and absorption (how much is consumed internally)

6. Important When internal consumption surpasses national income a current account deficit will result When internal consumption is lower than national income a current account surplus will result

7. The impact of economic expansions and contractions During economic expansions both income and absorption will increase. The change in the current account depends on which one will rise faster. During economic contractions both income and absorption will decrease. The change in the current account depends on which one will fall faster.

8. Policy implications Governments have incentives to fiddle with absorption by: • changing the volume of the government expenditures • limiting the absorption of the economy through taxes Attention: • Fiddling with government expenditures will affect private consumption and vice-versa. • Taxing people to death will also impact national income.

9. Policy implications (2) Governments have incentives to fiddle with imports through: • trade restrictions • currency depreciation Attention: • Fiddling with imports is futile if total income and absorption remain the same. • Trade barriers trigger retaliations • Foreign exchange intervention often do not work.

10. Summary BOP and exchange rates are determined by how much is produced relative to how much is consumed A reduction in absorption does not always guarantee the elimination of deficits An increase in income does not always guarantee the elimination of deficits either