The Absorption Approach

The absorption approach to balance of payments is general equilibrium in nature and is based on the Keynesian national income relationships. It is, therefore, also known as the Keynesian approach. It runs through the income effect of devaluation as against the price effect to the elasticity approach.

The theory states that if a country has a deficit in its balance of payments, it means that people are ‘absorbing’ more than they produce. Domestic expenditure on consumption and investment is greater than national income. If they have a surplus in the balance of payments, they are absorbing less. Expenditure on consumption and investment is less than national income. Here the BOP is defined as the difference between national income and domestic expenditure.

This approach was developed by Sydney Alexander. The analysis can be explained in the following form Y = C + I_d + G + X-M … (1) where Y is national income, C is consumption expenditure, total domestic investment, G is autonomous government expenditure, X represents exports and M imports.

The sum of (C + I_d + G) is the total absorption designated as A, and the balance of payments (X – M) is designated as B. Thus Equation (1) becomes

Y = A + B

or B = Y-A … (2)

which means that BOP on current account is the difference between national income (Y) and total absorption (A). BOP can be improved by either increasing domestic income or reducing the absorption. For this purpose, Alexander advocates devaluation because it acts both ways. First, devaluation increases exports and reduces imports, thereby increasing the national income.

The additional income so generated will further increase income via the multiplier effect. This will lead to an increase in domestic consumption. Thus the net effect of the increase in national income on the balance of payments is the difference between the total increase in income and the induced increase in absorption, i.e.,

DB = DY-DA … (3)

Total absorption (DA) depends on the marginal propensity to absorb when there is devaluation. This is expressed as a. Devaluation also directly affects absorption through the change in income which we write as D. Thus

DA = a DY + DD … (4)

Substituting equation (4) in (3), we get

DB = DY-aDY-DD

or DB = (1 – a) DY-DD …(5)

The equation points toward three factors which explain the effects of devaluation on BOP. They are: (i) the marginal propensity to absorb (a), (ii) change in income (DY), and (iii) change in direct absorption (DD). It may be noted that since a is the marginal propensity (MP) to absorb, (1 – a) is the propensity to hoard or save. These factors, in turn, are influenced by the existence of unemployed or idle resources and fully employed resources in the devaluing country.

Effects of Devaluation on BOP:

1. MP to Absorb:

To take the MP to absorb, it is less than unity (a< 1), with idle resources in the country, devaluation will increase exports and reduce imports. Output and income will rise and BOP on current account will improve. If, on the other hand, a > 1, there will be an adverse effect of devaluation on BOP.

It means that people are absorbing more or spending more on consumption and investing more. In other words, they are spending more than the country is producing. In such a situation, devaluation will not increase exports and reduce imports, and BOP situation will worsen.

Under conditions of full employment if a > 1, the government will have to follow expenditure reducing policy measures along with devaluation whereby the resources of the economy are so reallocated as to increase exports and reduce imports. Ultimately, BOP situation will improve.

2. Income Effects:

Let us take the income effects of devaluation. If there are idle resources, devaluation increases exports and reduces imports of the devaluing country. With the expansion of export and import- competing industries, income increases. The additional income so generated in the economy will further increase income via the multiplier effect.

This will lead to improvement in BOP situation. If resources are fully employed in the economy, devaluation cannot correct an adverse BOP because national income cannot rise. Rather, prices may increase thereby reducing exports and increasing imports, thereby worsening the BOP situation.

3. Terms of Trade Effect:

The effect of devaluation on national income is also through its effects on the terms of trade. The conditions under which devaluation worsens the terms of trade, national income will be adversely affected, and vice versa. Generally, devaluation worsens the terms of trade because the devaluing country has to export more goods in order to import the same quantity as before. Consequently, the trade balance deteriorates and national income declines.

If prices are fixed in buyer’s (other country’s) currency after devaluation, the terms of trade improve because exports increase and imports decline. The importing country pays more for increased exports of the devaluing country than it receives from its imports. Thus the trade balance of the devaluing country improves and its national income rises.

4. Direct Absorption:

Devaluation affects direct absorption in a number of ways. It the devaluing country has idle resources, an expansionary process will start with exports increasing and imports declining. Consequently, income will rise and so will absorption. If the increase in absorption in less than the rise in income, BOP will improve. Generally, the effect of devaluation on direct absorption is not significant in a country with idle resources.

If the economy is fully employed and has also a BOP deficit, national income cannot be increased by devaluing the currency. So an improvement in BOP can be brought about by reduction in direct absorption. Domestic absorption can fall automatically as a result of devaluation due to real cash balance effect, money illusion and income redistribution.

5. Real Cash Balance Effect:

When a country devalues its currency, its domestic prices rise. If the money supply remains constant, the real value of cash balances held by the people falls. To replenish their cash balances, people start saving more. This can be possible only by reducing their expenditure or absorption. This is the real cash balance effect of devaluation.

If people hold assets and when devaluation reduces their real cash balances, they sell them. This reduces the prices of assets and increases the interest rate. This, in turn, will reduce investment and consumption, given the constant money supply. As a result, absorption will be reduced. This is the asset effect of real cash balance effect of devaluation.

6. Money Illusion Effect:

The presence of money illusion also tends to reduce direct absorption. When prices rise due to devaluation, consumers think their real incomes have fallen, even though their money incomes have risen. They have the money illusion under whose influence they reduce their consumption expenditure or direct absorption.

7. Income Re-distribution Effect:

Direct absorption falls automatically if devaluation redistributes income in favour of people with high marginal propensity to save and against those with high marginal propensity to consume. If the marginal propensity to consume of workers is higher than those of profit-earners, absorption will be reduced.

Further, when money incomes of lower income groups increase with devaluation, they enter the income tax bracket. When they start paying income tax, they reduce their consumption as compared with higher income groups which are already paying the ‘tax. This leads to reduction in absorption in case of the former.

Income redistribution also takes place between production sectors after devaluation. Those sectors whose prices rise more than their costs of production earn more profits than the other sectors whose costs rise more than their prices. Thus the effect of devaluation will be to redistribute income in favour of the former sectors.

Devaluation will also redistribute income in favour of sectors producing and selling traded goods and against non-traded goods sectors. Prices of traded goods rise more than that of non-traded goods. As a result, profits of producers and traders and wages of workers producing traded goods rise more as compared to those engaged in non-traded goods.

8. Expenditure-Reducing Policies:

Direct absorption is also reduced if the government adopts expenditure- reducing monetary-fiscal policies which are deflationary. They will make devaluation successful in reducing

BOP deficit. But they will create unemployment in the country.

Its Criticisms:

The absorption approach to BOP deficit has been criticised on the following grounds:

1. Neglects Price Effects:

This approach neglects the price effects of devaluation which are very important.

2. Calculation Difficult:

Analytically, it appears to be superior to the elasticity approach but propensities to consume, save and invest cannot be accurately calculated.

3. Ignores Effects on Other Countries:

The absorption approach is weak in that it relies too much on policies designed to influence domestic absorption. It does not study the effects of a devaluation on the absorption of other countries.

4. Not Operative in a Fixed Exchange Rate System:

The absorption approach fails as a corrective measure of BOP deficit under a fixed exchange rate system. When prices rise with devaluation, people reduce their consumption expenditure. With money supply remaining constant, interest rate rises which brings a fall in output along with absorption. Thus devaluation will have little effect on BOP deficit.

5. More Emphasis on Consumption:

This approach places more emphasis on the level of domestic consumption than on relative prices. A mere reduction in the level of domestic consumption for reducing absorption does not mean that resources so released will be redirected for improving BOP deficit.