Absorption approach to BoP

Introduction• The absorption approach was developed in a famous

paper in 1952 by Sydney Alexander.• It looks at effects of devaluation on trade balance by

analysing the macroeconomic effects of devaluation. • More supply based approach as opposed to demand

side approach in Elasticity approach.• It is a much improved and complementary

approached compared Elasticity approach, particularly when economy is at full employment.

• Elasticity approach fails to explain effect of devaluation when economy is at full employment

ModelY= C+I+G+(X-M)

• Domestic Absorption A= C+I+G

CAB= X-M= Y-A

• Trade balance is positive if income or output is more than expenditure

dCAB= d(X-M)= dY-dA

• Trade balance or current account balance improves if any change in BoP policy instruments like devaluation increases income more than absorption.

• Explaining how devaluation affects both income and absorption is the main point in absorption approach.

• Absorption can be divided into two parts: income induced absorption and direct absorption resulting from devaluation.

• dA= adY+dAd

• ‘a’= Marginal propensity to absorb• dCAB= (1-a)dy-dAd

• For Devaluation to improve trade balance,

(1-a)dy>dAd.

Effect of Devaluation on national Income

• Foreign Trade multiplier and net exports effect• Term of Trade Effect

Effect of Devaluation on national Income

• Income redistribution effect• Real Balance Effect