Basic Theories of the Balance of Payments. Three Approaches. Three Approaches. 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.
= the responsiveness of quantity
demanded to changes in price
which is usually negative
PXPs & PY$
QXd & QYd
But prices do not adjust instantaneously.
Home demand for imports and foreign demand for exports
an improvement in BOP in the L-R
Y = C + I + G + (X – M)
Y – A = X – M
where A = C + I + G is the total domestic spending or absorption.
If Y < A, then X – M < 0 or BOT < 0.
Non-reserve capital account
Official reserve account money
Domestic Credit Currency
(Treasury securities, (Fed reserve notes
Discount loans, etc ) outstanding)
International Bank reserves
(Gold, SDR, other foreign
deposits and bonds)
where DC = domestic credit
IR = international reserves
CU = currency
R = bank reserves
MB = monetary base
Fed’s balance sheet
Foreign assets-$1 billion Currency -$1 billion
So, MB by $1 billion.
where m = money multiplier
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
MS = m (DC + IR) (3)
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.
P = E•P* (5)
where E = home currency price of the
P* = price level in the foreign country
Md = k•E•P*•L (6)
k•E•P*•L= m (DC + IR)
E^ + P*^ + L^ = w•DC^ + (1-w)•IR^
where k^ = m^ =0 because they are constants. w = DC/(DC + IR).
(1-w)• IR^ - E^ = P*^ + L^ - w•DC^ (7)
BOP^ = IR^ = [1/(1-w)]•(P*^ + L^)
- [w/(1-w)]•DC^ (8)
DC IR BOP
DC IR BOP
-E^ = P*^ + L^ - w•DC^ (9)
DC E (depreciation)
DC E (appreciation)
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