Ⅲ Absorption Approach

The elasticity approach shows that it ispossible for a country to improve its trade balance by a devaluation.

A. Absorption approach to the balance of trade

– a theory based on the relationship ofdomestic spending for domestic goods (absorption) relative to domestic output.

The absorption term represents the domesticspending by households, businesses, and government.

Absorption: A = C + I + G

             Y= A + X – M

          Y – A= X – M

If Y > A → X – M > 0 (trade surplus)

If Y < A → X – M < 0 (trade deficit)

B. Absorption Approach and Trade Deficit

A devaluation should improve balance of tradeif we allow A or Y to adjust appropriately.

Ⅳ The Monetary Approach

Monetary Approach – any balance of payments disequilibrium or exchange rate movements isbased on a monetary disequilibrium.

The monetary approach focuses on the factorsthat affect the money demand and money supply.