Basic Theories of the Balance
of Payments
Three Approaches
Three Approaches

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The Elasticities Approach to the Balance
of Trade
The Absorption Approach to the Balance
of Trade
The Monetary Approach to the Balance of
Payment (MABOP)
The Elasticities Approach to BOT

d = elasticity of demand
= the responsiveness of quantity
demanded to changes in price
d = (%Qd)/(%P)
which is usually negative
Elasticities
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| d | > 1  the demand is elastic
| d | < 1  the demand is inelastic
If the demand is elastic, the 1% rise in
price leads to more than 1% decline in
quantity demanded.
If the demand is inelastic, the 1% rise in
price leads to less than 1% decline in
quantity demanded.
Devaluation and BOT

Does the devaluation of a currency
improve the country’s balance of trade?

Consider EPs/$ = the Mexican peso price of
the dollar
Devaluation and BOT (cont’d)

(1) If the demand curve for the dollar
slopes downward and the supply curve of
the dollar slopes upward, then the
devaluation of the peso leads to an excess
supply of the dollar, which causes the
Mexican trade deficit to decrease.
Devaluation and BOT

(2) If the demand curve for the dollar is
steep and the supply curve of the dollar is
negatively sloped, then the devaluation of
the peso leads to an excess demand for
the dollar, which causes the Mexican trade
deficit to increase.
Devaluation and BOT (cont’d)
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(1): stable FX market equilibrium
(2): unstable FX market equilibrium
The case (2) could occur when Mexican
demand for US imports and US demand for
Mexican exports are both very inelastic.
The greater the elasticities of both country’s
demand for the other country’s goods, the
greater the improvement in Mexico trade
balance after a peso devaluation.
Devaluation and BOT

The condition that guarantees the case (1)
is called Marshall-Lerner Condition.
J Curve Effect

After the devaluation, it is often observed
that the trade balance initially deteriorates
for a while before getting improved.
Elasticities and J-Curves
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Why do we have a J-Curve?
The initial demands tend to be inelastic.
Suppose Mexico imports good X from the
US and exports good Y to the US.
Devaluation  Eps/$ 
 PXPs  & PY$ 
 Q X d  & QY d 
Elasticities and J-Curves
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But if Mexican demand for X is inelastic,
the % decrease in QXd would be smaller
than the % increase in PXPs so that
Imports = PXPs QXd would increase.
Further, if US demand for Y is inelastic,
the % increase in QYd would be smaller
than the % decline in PY$ so that Exports =
PY$ QYd would fall.
Pass Through
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
Devaluation  Import prices  in the
home country and export prices  in
foreign countries.
But prices do not adjust instantaneously.
Persistent BOP deficit  devaluation
 Home demand for imports  and
foreign demand for exports 
 an improvement in BOP in the L-R
Pass-through Analysis
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How do prices adjust to exchange rate changes
in the S-R?
Differences in the pass-through effect across
countries  Producers adjust profit margins
Example: When the yen appreciated against the
dollar substantially during late 1980s, Japanese
auto-makers limited the pass-through of higher
prices by reducing the profit margins on their
products.
Pass-though analysis (cont’d)
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In general,
Depreciation of the dollar  Foreign
sellers cut their profit margins
Appreciation of the dollar  Foreign
sellers increase their profit margins
Absorption Approach to BOT

Recall the national income identity:
Y = C + I + G + (X – M)
So
Y–A=X–M
where A = C + I + G is the total domestic
spending or absorption.
Absorption approach to BOP
(cont’d)
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If Y > A, then X – M > 0 or BOT > 0.
If Y < A, then X – M < 0 or BOT < 0.
Does devaluation always improve BOT?
Recall: If Y = Y*  Full employment level of
output, then all resources are already employed
and hence, X – M  needs A .
If Y < Y*, then X – M  obtains through
increasing Y with A unchanged, i.e. by
producing more to sell to foreigners.
Absorption approach
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So, when Y < Y*, devaluation would
improve BOT.
But when Y > Y*, devaluation would
increase X – M but create inflation.
Monetary Approach to BOP

Recall
Current account
Non-reserve capital account
-------------------------------------Official reserve account  money
supply
Fed’s Balance Sheet

Assets
 Domestic Credit
(Treasury securities,
Discount loans, etc )
 International
reserves
(Gold, SDR, other foreign
currencies denominated
deposits and bonds)
Liabilities
 Currency
(Fed reserve notes
outstanding)
 Bank reserves
Monetary base

DC + IR = CU + R  MB
(1)
where DC = domestic credit
IR = international reserves
CU = currency
R = bank reserves
MB = monetary base
FX intervention again

Suppose the Fed sells $1 billion of its
foreign assets in exchange for $1 billion of
US currency.
Fed’s balance sheet
Assets
Liabilities
Foreign assets -$1 billion
So, MB  by $1 billion.
Currency -$1 billion
Money Supply

Recall: MS = m•MB (2)
where m = money multiplier
M = CU + D
where D = deposits
MB = CU + R
So, M/MB = (CU + D)/(CU + R)
= (1 + c)/(c + r)  m
where c = currency-deposit ratio
r = reserve ratio

Money supply and Money
demand
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Substituting (2) in (1), we obtain
MS = m (DC + IR)
(3)
Consider Money demand function:
Md = k•P•L
(4)
where P = price level at home and L is the
liquidity preference function, which
depends on income and the interest rate.
k is a constant.
PPP again

Now assume PPP
P = E•P*
(5)
where E = home currency price of the
foreign currency
P* = price level in the foreign country

Substituting (5) into (4), we have
Md = k•E•P*•L
(6)
Monetary equilibrium
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In equilibrium, Md = MS.
So, from (3) and (6), we have
k•E•P*•L = m (DC + IR)
In terms of “% changes” (or growth rates),
E^ + P*^ + L^ = w•DC^ + (1-w)•IR^
where k^ = m^ =0 because they are
constants. w = DC/(DC + IR).
Finally,

Rearranging, we obtain
(1-w)• IR^ - E^ = P*^ + L^ - w•DC^
(7)
Monetary approach to Balance of
payments (MABOP)
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With a fixed exchange rate (E^ = 0),
BOP^ = IR^ = [1/(1-w)]•(P*^ + L^)
- [w/(1-w)]•DC^
(8)
Fed increases MS (Excess money supply)
 DC   IR   BOP 
Fed decreases MS
 DC  IR  BOP
Monetary approach to exchange
rate (MAER)
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With a flexible exchange rate (BOP=0),
-E^ = P*^ + L^ - w•DC^
(9)
Fed increases MS
 DC  E (depreciation)
Fed decreases MS
 DC  E (appreciation)
Managed float
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Although exchange rates are market
determined in principle, central banks
intervene at times to peg the rates at
some desired level.
When MS or Md changes, the central bank
can choose either E^ or IR^ to adjust.
Implication of PPP
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Recall PPP again: P = EP*.
With a fixed ex rate, E^ = 0, so
P^ = P*^
In other words, when the foreign price
level is increasing rapidly, then the home
price must follow if we are to maintain the
fixed E.  Imported Inflation
Implication of PPP (cont’d)

With flexible rates, E is free to vary so that
even when P*^ > 0, P^ can be zero by
letting E^ = - P*^, or letting the home
currency to appreciate by the same
amount as the foreign inflation rate.
Views based on MABOP
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BOP disequilibria are essentially monetary
phenomena.
Devaluation is a substitute for reducing the
growth of domestic credit.
Appreciation is a substitute for increasing
domestic credit growth.