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Elasticity Approach
Review of Elasticity
Price Elasticity of Demand is a measure of the responsiveness of quantity demanded to a change in price. If quantity demanded is highly responsive to a change in price, then demand is said to be relatively elastic. If quantity demanded is not very responsive to a change in price, then demand is said to be relatively inelastic.
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The elasticity approach, therefore, considers the responsiveness of imports and exports to a change in the value of a nations currency. For example, if import demand is highly elastic, a depreciation of the domestic currency will cause a disproportional decline in the nations imports.
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The superscripts I and E denote the relatively inelastic and relatively elastic supply and demand curves.
SE DE
SI
DI Foreign Exchange
in domestic currency units
Elasticity Approach
At a spot exchange rate of S0, the nation has an excess supply of foreign exchange and, therefore, is running a current account deficit.
SE DE
SI
DI Foreign Exchange
in domestic currency units
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SE
The elasticity approach considers how the responsiveness of imports and exports to changes in the exchange rate determines the extent to which a depreciation E will D improve the current account balance. DI Foreign Exchange
in domestic currency units
SI
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If foreign exchange supply and demand are relatively elastic, a small change in the spot rate can correct the deficit.
DE
SI
DI Foreign Exchange
in domestic currency units
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If foreign exchange supply and demand are relatively inelastic, a larger change in the spot rate is required to correct the deficit.
S1
SE DE
SI
DI Foreign Exchange
in domestic currency units
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The J-Curve
The J-Curve is an (often, but not always) observed phenomenon. What is observed is that, follow a depreciation or devaluation, the nations balance of payments worsens before it improves.
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Pass-Through Effects
A pass-through effect is when the domestic price of an imported good rises (falls) following the depreciation (appreciation) of the domestic currency.
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Expenditures
A nations expenditures fall into four categories, consumption (c), investment (i), government (g), and imports (m). The total of these four categories is referred to as domestic absorption (a) a c + i + g + m,
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Real Income
A nations real income (y) is equivalent to total expenditures on its output y c + i + g + x, where x denotes exports.
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Policy Implications
A nation may resort to absorption instruments or expenditure switching instruments to correct an external imbalance. The effectiveness of these instruments, however, is uncertain, as can be seen in the model.
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Policy Instruments
Absorption Instrument: Influences absorption by altering expenditures. Suppose the government reduces its expenditures (g). Absorption will decline as g declines. However, since expenditures decline, so does output. The absorption instrument is effective only if absorption declines faster than output.
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Conclusion
The Absorption Approach emphasizes real income in balance-of-payments and exchange-rate determination. The approach hypothesizes that relative changes in real income or output and absorption determine a nations balance-ofpayments and exchange-rate performance. It is not clear that expenditure switching and absorption instruments are effective.
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