The absorption approach to BOP and

exchange rate determination

Concepts and exemplification

 What is absorption?

A nation’s total expenditures on final goods and services

 The absorption approach: Concept

BOP is determined by real national income and its absorption

In other words, BOP is determined by how much is produced and

how much is consumed
 Definitions

Absorption (a):
a = c + inv + g + imp

Real income (y):

y = c + inv + g + exp
 Corollary

y-a = exp - imp = current account

The current account is determined by the difference

between income (how much is produced) and
absorption (how much is consumed internally)
 Important

When internal consumption surpasses national income

a current account deficit will result

When internal consumption is lower than national

income a current account surplus will result
 The impact of economic expansions and
contractions

During economic expansions both income and

absorption will increase.
The change in the current account depends on
which one will rise faster.

During economic contractions both income and

absorption will decrease.
The change in the current account depends on
which one will fall faster.
 Policy implications

Governments have incentives to fiddle with absorption by:

• changing the volume of the government expenditures
• limiting the absorption of the economy through taxes

Attention:
• Fiddling with government expenditures will affect private consumption
and vice-versa.
• Taxing people to death will also impact national income.
 Policy implications (2)

Governments have incentives to fiddle with imports through:

• trade restrictions
• currency depreciation

Attention:
• Fiddling with imports is futile if total income and absorption remain the
same.
• Trade barriers trigger retaliations
• Foreign exchange intervention often do not work.
 Summary

BOP and exchange rates are determined by how much

is produced relative to how much is consumed

A reduction in absorption does not always guarantee

the elimination of deficits

An increase in income does not always guarantee the

elimination of deficits either