Absorption Approach to BoP Deficit (Income Effect, Macro Effect)

The Absorption Approach to the Balance of Payments, developed by Sidney Alexander in the 1950s, defines a country’s trade balance as the difference between total national income (Y) and total domestic expenditure (A, or absorption). A trade deficit (B) occurs when absorption exceeds income (A>Y), and to improve it, income must rise more than expenditure, or expenditure must fall.

Devaluation = (X-M)↑

Y↑ = C + G +I + (X-M)↑  यहाँ C + G +I लाई Absorption गरेर Balance of Payment adjust गरिन्छ !

This approach to BoP explains the income or macro effect of devaluation, which argues that devaluation can be used as a policy instrument to correct the BoP deficit problem. However, the success of devaluation in solving the BoP deficit depends on the absorption or expenditure rate of the economy.

When we devalue the domestic currency, it makes exports relatively cheaper and imports relatively expensive.

This increases net export. Such an increase in net export increases aggregate income or output, which encourages consumption and investment expenditure.

If the increase in expenditure due to increased income is lower than the increase in income, then only devaluation helps to correct the BoP deficit. If the increased expenditure after devaluation is higher than the increased income, then devaluation further increases the BoP deficit.

It means the absorption rate of the economy determines whether the devaluation can correct the BoP deficit or not.

This approach uses the Keynesian identity for an open economy to explain the effect of devaluation on the BoP position. Which is given as Y= C + I + G + (X -M ) ———– (i)

Here, if  (X -M ) increases due to devaluation, it increases income (Y).

  • Now, Y = C + I + G  + (X -M)
  • or, (X -M) = Y –  (C + I + G)

or, (X – M)  = Y – A (Where A = C + I + G, and it is the aggregate absorption (expenditure) of the economy)  ——- (ii)

Let the country devalue its own currency, which increases net export by Δ(X-M). Then income changes by ΔY, which changes the absorption by ΔA. Then equation (ii) can be written as

Δ(X-M) = ΔY – ΔA

This approach considers that the changes in net export are equivalent to the changes in the BoP position. i.e.

i.e., ΔBoP = ΔY – ΔA ———– (iii)

  • If ΔY > ΔA, then ΔBoP > 0. (Devaluation helps to correct the BoP deficit)
  • If ΔY < ΔA, then ΔBoP > 0. (Devaluation further increases the BoP deficit)
  • If ΔY = ΔA, then ΔBoP > 0. (Devaluation does not affect the BoP deficit)

Now, we have

A = C + I  + G ———– (iv)

Here, C is assumed to be a positive non-proportional function of income, which means if income increases, consumption also increases, but not in proportion to income. So, the consumption function is given as

C = Ca + bY ——- (v)

  • Where, Ca = Autonomous consumption Ca > 0 (दैनिक अत्यावश्यक वस्तु खपत गरिन्छ)
  • b = Marginal propensity to consume (MPC) 0 < b 1

I is assumed to be the positive function of income, and the investment function is given as

I = Ia + iY ———— (vi)

  • Where, Ia = autonomous investment, Ia >0  (आम्दानी नभए पनि लगानी गर्ने पर्ने जस्तै शिक्षा, स्वास्थ्य)
  • i is marginal propensity to investment (MPI) (एक एकाई आम्दानी बढ्दा कति बढी लगानी गर्न तत्पर हुन्छ भन्ने मान )

G is assumed to be given or fixed.

G = Ga ————– (vii)

Now, from equations (iv), (v), (vi), and (vii), we have

A = C + I + G

or, A = Ca + bY + Ia + iY + Ga ———— (viii)

Let income change by ΔY, which changes absorption by ΔA, then equation (viii) can be written as

A + ΔA = Ca + b(Y+ΔY) + Ia + i(Y + ΔY) + Ga

or, A + ΔA = Ca + bY+ΔbY + Ia + iY + iΔY + Ga —– (ix)

Substituting equation (ix) in equation (viii), we get

ΔA = ΔbY + iΔY 

or, ΔA = ΔY (b + i)

Now, substituting the value of ΔA in equation (iii)

ΔBoP = ΔY – ΔY (b + i) 

or, ΔBoP = ΔY {1 – (b +i)}

or, ΔBoP = ΔY (1 – a) ———– (x) Where a = (b + i), which is the marginal propensity to absorption (MPA)

According to equation (x), it shows that the changes in BoP position depend on the value of MPA.

  • If a = 1, then ΔBoP = No change
  • If a > 1, then ΔBoP Devaluation further increases the BoP deficit
  • If a < 1, then ΔBoP = Devaluation helps to correct the BoP deficit

Therefore, the absorption rate of the economy (a) determines whether the devaluation is successful or not in correcting the BoP deficit. It is successful only if MPA is less than 1. 

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