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International Trade and Finance

Notes Similarly, when money supply exceeds money demand, BOP shows a deficit. For example, at foreign
exchange reserves of Rs. 60 billion, money supply exceeds money demand by LM = Rs. 400 billion –
Rs. 300 billion = Rs. 100 billion. This means a BOP deficits of Rs. 100 billion. The deficit in the BOP
decreases the money supply over time. The decrease in money supply makes the system move back
to point E. This process continues until the money supply falls to Rs. 400 billion to equal the money
demand. At point E, the demand for money equals the supply of money. It means B = 0 [in Eq. ( l)]
and their is neither deficit nor surplus in the balance of payment. This is how the BOP equilibrium is
automatically restored.
13.2 Elasticity Approach

The elasticity approach, which has been associated with Robinson (1937), places its emphasis on the
effects of exchange rate changes on the exports and imports of a country and, hence, on the trade
account balance, whilst ignoring all other variables such as income. The elasticity approach applies
the Marshall-Lerner condition, which states that the sum of the elasticities of demand for imports
and exports must be greater than unity in absolute terms for a devaluation to improve the balance of
payments (Du Plessis et al., 1998).
The logic behind this condition is as follows. Suppose the elasticity of demand for exports is zero. In
this case exports in domestic currency are the same as before devaluation. If the sum of the elasticities
is greater than one, the elasticity of demand for imports must be greater than one, so that the value of
imports falls. With no fall in the value of exports and a fall in the value of imports, the balance of
payments improves. Now, suppose the demand for imports has zero elasticity. The value of imports
will rise by the full percentage of devaluation. If the elasticity of demand for exports is greater than
unity, the value of exports will expand by more than the percentage of devaluation. Therefore, the
balance of payments will improve. If each element of the elasticity of demand is less than unity, but
the sum is greater than unity, the balance of payments will improve because expansion of exports in
domestic currency will exceed the value of imports.
Absorption Approach

The absorption approach was first presented by Alexander (1952). He sought to look at the balance of
trade from the point of view of national income accounting. It is useful in pointing out that an
improvement in the balance of trade calls for an increase in production relative to absorption. The
absorption approach intends to show how devaluation might change the relationship between
expenditures or between absorption and income - in both nominal and real terms. It is worth noting
that great emphasis is laid on the current account balance. This approach contends that the devaluation
of a currency would lead to an increase in inflationary prices, which would in turn revoke the initial
effect of an increase in prices.
The starting point of the absorption approach is the national income identity: Y=C +I + G + X-M (5)
Where Y = national income; C = private consumption of goods and services purchased at home and
from abroad; I = total investment, by firms as well as by government; G = government expenditure
on goods and services; X = exports of goods and services; and M = imports of goods and services.
Combining C + I + G expenditure terms into a single term, A, representing domestic absorption (i.e.,
total domestic expenditure) and X - M terms into B, net exports/trade balance, we get: Y=A+B (6)
equation 6 states that national income equals absorption plus the trade balance, or alternatively B=Y-
A (7) Equation 7 states that the trade balance is equal to the difference between domestic income and
total absorption. Equation (7) is the fundamental equation of the absorption approach. It implies that,
if total absorption (expenditure) exceeds income (production), then imports will exceed exports,
resulting in a balance of payments deficit. If the opposite occurs, i.e. where income exceeds absorption,
then the balance of payments will be in surplus. A balance of payments deficit can, therefore, only be
corrected if the level of absorption changes relative to the level of income (Du Plessis et al., 1998:251).
The empirical literature is replete with studies on the monetary approach to balance of payment.
Mixed results were obtained from the different studies on the MABP. Obioma (1998) used data for
1960-1993 to test the validity of monetary approach to the balanceof-payments adjustment for Nigeria

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