Some of the modern theory of balance of payment adjustment of a country are listed below:
(i) A Keynesian Approach:
Although the part played by income changes in BOP adjustment is Keynesian in approach and method, Keynes himself took no direct part in its formulation or development.
The new approach to income determination theory marked by the appearance of Keynes’ General Theory of Employment, Interest and Money in 1956 made possible the formulation of a new approach to adjustment process by Mrs. Joan Robinson, R.F. Harrod, Fritz Machlup and others.
This new approach showed that an imbalance in BOP involved an adjustment in income, employment and output irrespective of what changes took place in prices and of how the deficit was financed. It showed an interaction between the BOP and national income which was a dual one: the “adjustment process”, by which a BOP is adjusted by changes in the income levels of the home country and the rest of the world; and the “transmission process”, which shows how variations In the national income of one country may through their balances of payments cause variations in the national incomes of other countries.
Moreover, it enabled certain powerful analytic tools of income analysis, such as national income multiplier, to be applied to the adjustment process. Thus, with the development of income approach lo BOP adjustment, a marriage was effected between the theory of International trade and business cycle theory from which much could be expected. It explains not only the adjustment process but also the transmission process.
It shows that since deficits are adjustable by relative movements of national income, by reduction of income in the deficit country and increase of income in the surplus country, correction of a deficit must under static productivity conditions, necessarily involve a reduction in national income. The full condition of equilibrium for a country had now to be redefined as one in which total external receipts equaled total external payments at full employment.
This linkage of external equilibrium for a country with its level of Income and employment by the new approach enabled much clearer and most realistic view to be taken of 150P policy in the post-war period.
(ii) The Absorption Approach:
Sidney S. Alexander pioneered the development of the absorption to BOP adjustment in his article, “The effects of a Devaluation on the Trade Balance” which appeared in I.M.F. Staff Papers, vol. 2, no. 2, 1952. The novelty of the absorption approach lies in seeing the BOP, not as a relation between the country’s debits and credits on International account, but rather as an element in the relation between Die aggregate receipts and expenditures of the economy.
It concentrates “on the relationships of real expenditure to real income and on the relationships of both of these to the price levels. To Alexander, the foreign balance B, is the difference between total output of goods and services (Y), and the total absorption (A) of these floods and services by the home economy. Absorption here is the name given to the aggregate of domestic demand (C + Id + G), that is the amount of goods and services taken off the market domestically.
Thus, B =Y – A
where B is the balance of payments (net) and Y and A stand for total domestic output and expenditure respectively. If total output is larger than total expenditure, the country will have a surplus in its BOP and if the total expenditure is larger than the total output the country will have a deficit, and if output equals expenditure, the BOP will be in equilibrium. If a country has a deficit it can, in principle, close the deficit in one of two ways; by reducing expenditure or by increasing output.
It is often difficult to increase output in the short-run especially if the country already has full employment. Therefore, the chief means for reducing a deficit is usually an expenditure reducing policy. It is sometimes said that there are two main ways in which a deficit can be corrected: by expenditure reducing or expenditure switching policies.
Expenditure Reducing Policies:
Expenditure reducing policies can be divided into two broad categories:
Monetary policy and fiscal policy.
(i) Changes in interest rates and open market operations are the most important instruments for monetary policy. Monetary policy refers to the management of the expansion and the contraction of the volume of money for the attainment of some specific objectives.
The primary effect of an increase in interest rates is on investment. As it becomes more expensive to borrow money and as the availability of credit becomes more scarce, producers borrow and invest less. The effect of a tighter monetary policy on investment depends to a large extent on the general economic situation.
The standard means of regulating the supply of money and influencing the availability of credit is through open market operations. In open market operations the central bank sells or buys bonds and securities. The decrease in availability of credit, together with an increase in discounts, can have a negative influence on investment. Producers may now simply find it impossible to borrow money. If this is so, investment will obviously be curtailed.
Monetary policy has also proved to be a powerful instrument in the postwar period for correcting deficits in the BOP. The means aimed at curtailing investment have probably been most efficient. An increase in interest rates and a decrease in the availability of credit can hardly fail to affect investment. A decrease in the investment will, through a multiplier effect, lead to a decrease in income and a fall in imports. Similarly, policies that curtail consumption will also lead to a decrease in imports.
Thus, a tighter monetary policy is one way of implementing a policy of expenditure reduction. A “neutral” monetary policy will automatically work to curb a deficit, because a deficit implies that payments by residents of the country are larger than receipts by the residents. This means that residents are depleting their cash balances.
If the deficit continues, cash balances will eventually become depleted, and payments will be brought into line with receipts; the deficit will be self-correcting. This however, presupposes “neutrality” from the central bank, that is, that it refuses to increase the money supply, even though cash balances are being depleted.
Residents can only deplete their cash holdings by exchanging them for foreign reserves, and it is doubtful if the central bank has enough foreign reserves to be able to wait and let the self-correcting mechanism work itself out. Again, as cash holdings become more scarce, the interest rate increases, which will also work toward curing deficit.
If the central bank does not want to tolerate an increase in interest rates, it must increase the money supply, and the deficit is no longer self-correcting.
(ii) Fiscal policy can also be used to reduce expenditure. Fiscal policy refers to a policy under which the government uses its expenditure programmes, revenue programmes and debt programmes lo produce desirable effects and avoid undesirable effects on income, output, employment and BOP. The means of fiscal policy can be divided into two broad groups, depending on whether they are on the income or the spending side of the government budget.
The most important instrument on the income side is a change in taxation. An increase in direct taxes will reduce household incomes. Part of this decrease in income may lead to a reduction in savings, but part of it will most certainly lead to a reduction of consumption and a decrease in imports.
An increase in indirect taxes, for instance, of sales taxes, will produce much the same effect. Many countries have also used taxes against investment. A decrease in investment will, through the usual multiplier effect, lead to a decrease in the national income and to a fall in imports.
Another form of expenditure reducing policy is to cut government expenditure. A decrease in transfer payments will usually have immediate effect on consumption, as the groups benefiting from transfer payments are on the whole low income groups with a high marginal propensity to consume. A decrease in public investment produces much the some effect on national income as does a fall in private investment and leads to a fall in national income and imports.
Fiscal policy can, therefore, be viewed as an efficient means of implementing an expenditure reducing policy. In certain instances there is room for doubting the efficiency of monetary policy; there can be little doubt about the efficiency of fiscal policy. The balance of the budget is sometimes taken as a measure of the effectiveness of the
fiscal policy. If the government permits a deficit in the budget, it pursues an expansionary policy, and if it has a surplus, its policy is deflationary.
In summing up, we see that monetary and fiscal policies are the major means of implementing the expenditure reducing policy. If the country has a deficit in the BOP, it can pursue a tighter monetary and fiscal policy. This will have a deflationary effect on the national income and lead to a fall in imports, or at last act as a brake on the increase in imports. It will also have a position effect on exports and on import competing industries.
(iii) Expenditure-Switching Policies: Devaluation, the Elasticity Approach:
Expenditure switching policies primarily work by changing relative prices. The main form for such a policy is a change in exchange rates, that is, devaluation or a revaluation of a domestic currency. Direct controls can also be classified under this heading and are usually applied to restrict imports. Consumers will then try to buy domestic goods instead of imported goods, and hence direct controls can be viewed as a switching device. Devaluation is often used interchangeably with depreciation, and revaluation is often taken to be synonymous with appreciation.
The immediate effect of devaluation is a change in relative prices. If a country devalues by, for example, 20 percent, it means that import prices increase by 20 percent counted in home prices. An increase in import prices leads to a fall in the demand for imports. At the same time, import competing industries will be in a better competitive situation. Exporters will receive 20 percent more in home currency for every unit of foreign currency they earn.
They can, therefore, lower their prices counted in foreign currency and will become more competitive. By how much they are able to expand sales abroad depends primarily on the foreign demand elasticities for their goods.
The traditional approach to the effects of devaluation on the balance of trade runs in terms of elasticities. The core of traditional view is contained in the so called Marshall-Lerner condition, which states that the sum of the elasticities of demand for a country’s exports and of its demand for imports has to be greater than unity for a devaluation to have a positive effect on country’s trade balance. If the sum of these elasticities is smaller than unity, a country can instead improve its balance of trade by revaluation.
We have said above that devaluation will lead to an increase in the price of imports. What the effect of this price increase will be depends on the elasticity of demand for imports. The larger it is the greater will be the fall in the volume of imports. The value of the demand elasticity of imports depends, of course, on what types of goods the devaluing country imports.
When the exporters, because of devaluation receive more for every unit of foreign currency they earn, they can lower their prices quoted in foreign currency. When they lower their prices they should be able to sell more. By how much the quantity exported increased depends on the demand elasticity confronting the country’s exporters. Devaluation is viewed with suspicion, and it seems as if some economists are of the view that it should be used only as a measure of last resort. Devaluation has some side effects.
Devaluation can have an inflationary impact, on the economy. The effect on the price level depends primarily on the economic policy accompanying devaluation. If a tight monetary and fiscal policy is pursued jointly with devaluation, the inflationary impact could be limited.
Another consideration to take into account is the effect of devaluation on the income distribution. It is often stated that real wages will fall because of devaluation and that there will be redistribution of income away from the labour class to the non-labour class. Again a devaluation should result in a reallocation of resources away from the sector producing non-traded goods and into exports and import competing sectors. In general we can say that the factors of production employed in the export and import competing sectors will benefit from devaluation.
The Marshall-Lerner condition is built on some drastic simplifications. It assumes, roughly, that the supply elasticities are large (approaching infinity) and that the trade balance is in equilibrium when devaluation takes place. None of these two assumptions invalidate the spirit of the Marshall-Learner condition, which says that the larger the respective demand elasticities, the more favourable is the effect of a devaluation on the trade balance. An alternative approach to the effects of devaluation formulated in macro terms is the so called absorption approach which was first developed Sidney Alexander.
(iv) Devaluation: The Absorption Approach:
The absorption approach runs in macro terms. Its starting point lies in the fact that the balance of trade can be viewed as the difference between national income and total expenditure or as we have already stated,
B – Y-A………… (1)
Here the total absorption includes the demand created for all purposes: in other words, it includes demand both for consumption and investment purposes.
Using the simple national income identity, we say that
A = C + 1+G ……(2)
Devaluation affects the trade balance by either affecting real national income, Y, or by affecting total absorption. A; we can write the change in the trade balance as
dB = dK-dA ….(3)
Total absorption can be decomposed in two parts. First, we say that any change in the real income will induce a change in absorption. How greatly absorption will change depends on the propensity to absorb, which we shall call C. Second, we can say that devaluation has a direct effect on absorption, depending, among other things, on the level of real income at which devaluation takes place. This effect we shall call the direct effect on absorption, I
dA = C. dY + dD ….(4)
combining equation 3 and 4 gives
dB = (1 -C) dY – dD …(5)
Equation 5 is useful because it directs our attention to three basic factors important for the outcome of a devaluation. It says that the effects of a devaluation on the trade balance depend first on how devaluation affects the real income (Y), second on the propensity to absorb (C), and third on the effect on direct absorption (D). To deal with the effects of a devaluation we must distinguish between two main cases, one where there are idle resources and unemployment and one where there is full employment.
(i) If there are unemployed resources when the country devalues, then production can expand in the short-run. We will expect the expansionary process to start by an increase in exports, giving rise to an increase in national income via the multiplier process. They how much exports will expand depend”, greatly on whether, because of expansion, export prices in the devaluing country rise and on the capacity (and willingness) of the rest of the world to absorb exports from the devaluing country.
The net effect of the increase in income on the balance of trade does not comprise the total amount of increase in production, but the difference between this and the induced increase in total absorption. This difference between increase in real production and real absorption can be called real hoarding. The effect on the trade balance is, then equal to the amount of real hoarding which takes place in the economy.
Putting the effects on direct absorption aside, we see that the propensity to absorb, or the propensity to hoard, the other side of the same coin, is the all important factor in this case of the effects of a de-valuation on trade balance.
As long as C is less than unity, some hoarding will occur, and hence there is a positive effect on the trade balance. If C is larger than unity, then a de-valuation will have a negative effect on the trade balance because the induced effects on absorption will be larger than the original effects on production. If the propensity to absorb is less than unity, devaluation is quite an attractive policy for a country in depression, because it will have both a positive effect on the national income and improve the balance of trade.
It is often argued that devaluation will lead to deterioration in the terms of trade. If real income falls, because of adverse terms of trade so will absorption, and this will have a positive effect on the trade balance. Suppose t denotes the reduction in real income because of the deterioration in the terms of trade. Then the fall in absorption will equal ct. This does not constitute a net improvement in trade balance, however, because the adverse terms of trade imply an initial deterioration in the trade balance with t. Hence, the net effect on the trade balance is t-ct or (1 – c)t. Deterioration in the terms of trade will, therefore, also normally entail a deterioration in the trade balance only If C is larger than unity will a deterioration in the terms of trade produce a positive effect on the trade balance we have dealt with the case.
(ii) Now we will deal with the case in which there is already full employment when devaluation takes place. In a situation where the economy is already fully employed or the marginal propensity to absorb is larger than unity, the main favourable effect of devaluation on (he trade balance is through the direct effect on absorption. The direct effect on absorption is not connected with any change in real national income.
It depends on the fact that absorption out of a given real income may change as the price level changes:
The direct absorption effect (D) can be divided into
(i) A cash balance effect
(ii) An income redistribution effect
(iii) A money illusion effect, and
(iv) Miscellaneous direct absorption effect.
(I) The cash balance effect is well known. If the money supply is fixed, and if individuals wish to hold constant real cash balance, then they must increase their cash balances as prices rise.
This they can only do at the expense of their expenditures. For one individual, it might be possible to replenish his balance by selling assets, but for the economy as a whole this is not possible if the money supply is fixed. (It might be possible also to sell assets abroad. Repatriation of foreign-held capital is, however, is ruled out by Alexander). There is, therefore, a direct effect on absorption from the cash balance effect.
There is also an indirect effect in that by some sale of assets their price will have gone down, that is, the rate of interest will have risen. Such a rise in interest rate may have an indirect effect upon absorption (in the same direction as the direct effect) by reducing domestic investment and possibly government expenditures. One feature of cash balance effect which is worth noting is that, in so far as the reduction in absorption takes the form of a reduction of consumption, it may reduce employment.
If C is less than one, this adverse income effect would lead to a deterioration of the foreign balance which would, to some degree, offset the improvement stemming from the absorption effect.
(ii) Income redistribution may take place with devaluation. Prices will rise with devaluation and wages follow with the customary lag that gives a shift of income to profit earners. Fixed income groups, rentiers, and others are losers while, with a progressive Lax system, the state takes a larger share of income. If income is redistributed in favour of those with a high propensity to absorb, the foreign balance will worsen; if in favour of those with a low propensity, it will be improved by devaluation.
Since the propensity to absorb is influenced both by consumption and investment so that it is difficult to say a priori what the actual effect of a shift to profit will be. On the one hand, it may diminish consumption; on the other, it may encourage investment. In any event, to the extent that the net effect is to reduce absorption, the foreign balance will benefit.
(iii) The effects of money illusion upon absorption are so problematic as to make it hardly worthwhile to speculate what their net effect may be. Already the cash balance effect will, with rising prices, have drawn money from absorption to maintain habitual cash balances. If, in addition to this, at higher prices people consume less, then the effect on the foreign balance will be favourable. It is equally arguable that rising prices, even with rising money incomes, will erode the propensity to save that is, stimulate consumption; although empirical consumption savings patterns in the post war period does not give much support to this view.
(iv) Of the other direct absorption effects, some may work towards a favourable and some towards an unfavourable foreign balance. For example, short run expectations of the further price rises may follow devaluation and cause a consumer spending spree, thus temporarily raising absorption with deleterious short-run effects on the balance. Or again, where investment goods come mainly from abroad and rise in price with the devaluation, absorption may fall, with beneficial effects on the foreign balance.
It is difficult to make any assessment of the net on I, the direct absorption effects, of all these various factors, some favourable, some otherwise. Moreover, when we consider the time element, it is clear that some of these influences are likely to be very transitory in their effects, while some, such as those coming from income redistribution, are lagged in effect and gradual in influence.
Alexander’s own view appears to be that “under conditions of lull-employment, the favourable direct absorption effects are likely to be weak” and that it would be more effective “to operate on absorption directly through monetary and credit policy.”
The real contribution of Alexander’s paper is not, however, the conclusion to which the paper leads. These are, as the author is first to say, unoriginal and could have been reached by traditional methods using a supply and demand analysis. It is rather the change in method which is important, not only does the paper direct the policy maker, bent on improving the foreign balance and in particular on improving
II by devaluation to focus attention on the income absorption relationship, but it also arrays the main factors for examination. The whole approach lo the foreign balance problem becomes policy oriented around measures operating on the constituents of domestic absorption of national income.
(v) The Payments Approach:
A useful development of the absorption approach and a synthesis of the work done on its basis for balance of payments policy have been made by Harry Johnson.
Johnson begins by restarting the basic balance of payments equation
Where the balance (B) is equal to the difference between receipts by residents from foreigners (Rf) and payments by residents to foreigners (Pf). This can be restated by including in the basic equation receipts and payments between residents in the country. All payments by residents to residents are at the same time receipts by residents from residents; thus (Rr) – (Pr). We may now write the balance of payment equation
B = Rf+Rr-Pf-Pr-R-P
The equation shows what equation (1) did not, that the balance of payments is the difference between aggregate receipts and payments by residents, deficit implying an excess of P over R and an increase of R as a remedial measure, and the converse for a surplus. This restatement of the nature of a balance of payments deficit is the starting point for what Johnson calls the “payments approach” directing attention to two key aspects of any deficit: its monetary significance and its relation with the level of activity of the economy.
Let us first look at the implications of the excess of P over R. The first is that residents are reducing their cash balances as their payments. In domestic money, are transferred abroad. There is an end to this, for cash balances are soon reduced to the minimum that the community is prepared to hold. With this the disequilibrium cures itself through a rise in the rate of interest, tighter money conditions, and thus a reduction in aggregate expenditure.
How far in this process the monetary authorities are prepared to let matters go depends upon the size of the country’s monetary reserves. Most likely these form such a small part of the country’s monetary supply that they would be exhausted long before the corrective forces of dis-hoarding had completed their work.
The authorities would, in all likelihood, early reinforce the effects-dis-hoarding by direct policies to reduce demand and end the deficit. The larger the reserves are in relation to the domestic money supply “the less (is) the probability that the profit or utility maximizing decisions of individuals to move out of cash into commodities or securities will have to be frustrated by the monetary authorities for fear of a balance of payments crisis.”
But there is an alternative to this process. As the cash balances of residents are depleted by excessive foreign payments, they are renewed by open market operations by the monetary authority. Such open market operations might be the vehicle of a deliberate policy to peg interest rates, or they might result from the foreign-exchange authority lending on the home market its surplus of the home currency obtained from the sale of foreign currencies to support the exchange rate.
In any event, the correcting effect of the decline in cash balances described above would not be forthcoming, and the deficit in this cast- would go uncorrected as long as the foreign exchange reserves lasted. The corollary of the argument that a deficit, by depleting the money supply, will ultimately be self-correcting is that any prolonged deficit in a country’s balance of payments will require domestic credit creation to keep it going.
Further, it would appear that balance of payments disequilibria are monetary phenomena and spring from two causes:
(i) Too low a level ‘of international reserves in relation to money supply, so that the authorities cannot wait and rely upon the self-correcting monetary forces induced by the deficit; or
(ii) Policies by which the monetary authorities sustain the deficit by credit creation.
By presenting the BOP as a monetary problem, Johnson does not imply that deficits spring only from monetary causes. A deficit may be, and usually is, due to real factors, such as a change in the trade balance, and the monetary aspects may be passive.
This conclusion that BOP problems can be viewed monetarily throws new light on methods of correcting a deficit. Moreover, it integrates balance of payments theory with monetary theory and monetary management of the economy.
Johnson turns to the second aspect of the payments approach; its relation to the level of activity in the economy. Here he distinguishes between two sorts of decisions (by residents in the aggregate) leading to a balance of payments deficit: a “stock” decision, which is a decision to alter the composition of the community assets in so far as they are divided between goods, bonds and domestic money; and a “flow” decision, which involves a decision to spend more currently than is being received.
The balance of payments deficit resulting from either type of decision may manifest itself in either current or capital account since decisions to switch assets or to overspend may involve buying either goods or bonds. The main difference between stock and flow deficits in the balance of payments lies in the fact that a stock deficit is temporary and implies no worsening of the country’s basic economic position, while a flow deficit may be of longer duration and may involve a deterioration of the country’s economic position. For example, in the former case, a stock decision to move from money to stocks of goods means merely a deficit now as the additional goods are imported, and a surplus later as the stocks of goods are drawn down; it is “a once-for-all change in the composition of a given aggregate of capital assets”.
A flow deficit may reflect sustained overspending abroad and may continue until off satiny action is taken. Only if the foreign-exchange reserves of the country are small will remedial policies have to be followed in the case of stock deficit. A flow deficit, however, is almost certain to require remedial policies.
In analyzing the policy problems involved in countering a flow deficit, Johnson assumes the deficit to be located in the current account. This means that the balance of payments can be expressed as the difference between the value of the country’s national income and its total domestic expenditure, so that B = Y – A, and a deficit consists of an excess of real expenditure over real income.
This formulation poses the external balance problem in the same terms as those used by Alexander.
It concentrates attention on policies of two types for correcting current account deficits:
(i) Policies which aim at increasing income and
(ii) Those which aim at reducing expenditure. The distinction centres on the “effects” of the policies. Johnson is quick to point out this distinction applies to the initial policy step only. Since income and expenditure are interdependent, a decision to alter one will at a later stage have repercussions on the other.
Johnson prefers a policy which centres on the “methods” by which the effects are achieved. Since output can only be changed by changing the level of expenditure which creates , then with any given level of expenditure changes in output must involves switches of expenditure from foreign output to domestic output. We can, therefore, by reference to method, distinguish between expenditure switching policies and expenditure reducing policies.
Expenditure reducing policies are familiar. Monetary and fiscal policies and direct controls have all been used for the purpose. In general, the altitude towards such policies will depend on the current state of the economy with regard to employment. If the country is in a state of full-employment and incipient inflation, expenditure reducing policies will have the additional advantage of being counter inflationary.
If the country is underemployed or if the impact of expenditure reduction falls mainly on home produced goods, the deflationary effects of expenditure reducing policy may be intolerable. Finally, any expenditure reducing policy, if carried to great lengths, may be its deflationary effects reduce domestic prices within the country and, according to demand and supply elasticities, induce expenditure switching effects.
Expenditure switching policies are of two types general and selective. Devaluation is the prime example of the former. If aims at switching demand, both home and foreign, away from foreign goods and on to domestic output.
Direct controls on trade are the latter. Such controls are usually imposed on imports and are aimed at switching domestic demand from foreign goods to domestic output the ability of the economy to supply the additional output becomes crucial. Clearly only if the economy is underemployed can the switch be made without inflationary effects.
Suppose the economy is in a state of underemployment, then the additional output generated by the switch can be obtained by bringing formerly unemployed factors into employment.
This means that the switching policies achieve three desirable results at a stroke:
(i) They improve the foreign balance,
(ii) They increase income, and
(iii) They increase employment.
Theoretically, up to the point at which the economy reaches full employment, the supply of goods should be elastic. In practice, however, immobility of factors and inflexibilities in production will reduce this elasticity before the point of full-employment is reached.
If the economy is already fully employed, then expenditure twitching policy must be accompanied by the expenditure reducing policy. Hence, expenditure switching policies are inappropriate to a country in a condition of full-employment. The success of expenditure twitching policy depends not only in switching the demand on the right direction but also on the capacity of the economy to make available additional output to meet increased demand.
Johnson’s analysis carries the absorption approach of Alexander to higher level of sophistication and wider range of applicability. His distinction between “stock” and “flow” deficits, springing from different causes and each calling for different policy treatments, gives demonstration of the extensions possible to the original absorption approach. But the greatest merit of the analysis is its restatement of the problem of trade balance deficit in terms which enable it to be discussed in monetary and macro-economic terms.
By this, the whole problem of the foreign balance becomes integrated with national income analysis and divorced from the old elasticies approach, which was surely being stretched, in its application to such subjects as I If valuation, to and beyond the limits of its usefulness.
The criticisms against original absorption approach centre around centre aspects the analysis:
(i) The first difficulty lay in finding and assigning quantities to supplement the guidelines which were supplied for BOP policy. The main quantitative problem was to estimate values for the marginal propensity to absorb, which was the sum of the marginal propensities to consume and investment or the same problem could be approached in another way by estimating the marginal propensity to hoard (that is, not to absorb).
These were important quantities for it was necessary to link changes in output caused by devaluation with changes in absorption. The estimation required to bring the absorption approach up to “operational” level were just as formidable as those involved in the old elasticities approach. In the case of the absorption approach the relevant propensities had to be known before it was possible to say whether a devaluation would be beneficial to the trade balance.
(ii) A second criticism of the absorption approach came from Machlup. He argued that certain elasticity considerations in the model had been ignored. One of the acknowledged uses of absorption analysis was to explore the trade balance effects of devaluation in both fully employed and underemployed situation. Alexander had seen these situations in terms of different supply and demand conditions for commodities, which necessarily involved elasticities.
Elasticities also appeared in Alexander’s analysis of the impact of devaluation upon the level of absorption out of a given level of income. All this, it might be argued, gave the absorption approach a more hybrid appearance than Alexander who had played down the role of elasticity in his model, might care to admit. He had been too anxious, perhaps, to make a clean break with the past.
(iii) Finally, it was necessary to embody within the model the fact that an improvement in the balance of trade of a devaluing country involved opposite changes in the trade balance of the rest of the world; or in absorption terms, that the increase in domestic hoarding which an improvement of home trade balance involved, implied an equal decrease in hoarding abroad. Mow was this to be achieved? Alexander has assumed that the rest of the world was passive to the devaluation and to the trade balance change in the adjusting country.
The result of these criticisms of the original absorption approach was a reformulation which included elasticity effects and was more nearly a synthesis of the elasticity and the income approaches. In an article published in 1959, Alexander presented a new version of the approach which examined the sequential reactions of the home country and foreign countries to a devaluation, taking account of both price and income changes.