Question

Three major approaches to analyzing the economic impact of currency depreciation are (a) the elasticities approach, (b) the absorption approach, and (c) the monetary approach. Distinguish among the three.

Short answer

The elasticities approach assesses impact by viewing effects on the trade balance through price elasticity of goods, the absorption method views currency depreciation as an adjustment mechanism between domestic output and absorption, while the monetary approach argues that currency depreciation is driven by monetary variables such as money supply and demand, and exchange rates. Each approach is applicable to different scenarios based on the country's economic landscape.

Step-by-step solution

Defining Each Approach

Start by expanding each methodology. For the elasticities approach, this model uses price elasticities of domestic and foreign goods to gauge how depreciation influences the balance of trade. The absorption approach views currency depreciation as a method to adjust the difference between domestic production and domestic absorption. Lastly, the monetary approach links currency depreciation to monetary factors, such as money supply, money demand, and exchange rates.

Highlight Key Differences

The primary distinction amongst these is primarily based on the variables they focus on. Elasticities approach concentrates on price elasticities and how they influence trade balance. The absorption approach emphasizes the adjustment of the balance between domestic output and absorption. The monetary approach, on the other hand, stresses the role of monetary variables.

Examples and Additional Differences

It will help to illustrate each approach with examples or scenarios. Additional attention could be given to each approach's pros and cons, or conditions where a certain approach would be more suitable to apply. For instance, the elasticities method could be more applicable to economies with significant export and import fluctuations, while the absorption method might be more applicable to countries with large production-consumption gaps, etc.

Key concepts

Elasticities Approach

The elasticities approach focuses on analyzing how currency depreciation impacts the balance of trade by utilizing the concept of price elasticity. Essentially, this method examines how sensitive the demand and supply for goods are to changes in price due to currency fluctuations. This approach assumes that depreciation will improve the trade balance only if the sum of the price elasticity of demand for exports and imports is greater than one—a condition known as the Marshall-Lerner condition.

Key aspects of this approach include:

• It focuses on the responsiveness of quantity demanded and supplied to price changes, due to exchange rate shifts.
• It particularly considers how a weaker currency makes domestic goods cheaper for foreign buyers, potentially boosting exports, while making foreign goods more expensive for domestic consumers, reducing imports.
• The effect is reliant on sufficient elasticity; without it, the trade balance might not improve as expected.

The elasticities approach is especially relevant in economies heavily reliant on trade, where small price changes can lead to sizable shifts in consumption patterns and trade flows.

Absorption Approach

The absorption approach provides a broader perspective by taking into account the overall balance between domestic production and domestic consumption (absorption). When currency depreciates, it might lead to changes in domestic and foreign demand in a way that adjusts the absorption relative to production.

This approach involves two main elements:

• If the economy produces more than it absorbs (consumes), depreciation can enhance economic welfare by expanding the market for excess production.
• Conversely, if absorption exceeds production, depreciation might not be as effective in improving the trade balance.
• It also recommends policy adjustments capable of influencing national savings and investments to rectify imbalances.

The absorption approach is particularly insightful for countries dealing with disparities between their economic output and their consumption, making it valuable for formulating policies addressing structural issues in the economy.

Monetary Approach

Rooted in monetary theory, the monetary approach addresses currency depreciation by focusing on the role of money supply, money demand, and exchange rates in influencing the balance of payments. Variations in the money supply and demand affect inflation and interest rates, which in turn influence exchange rates.

This approach is underpinned by several key elements:

• It emphasizes that long-term effects of depreciation are primarily driven by monetary factors rather than real economic parameters like output or consumption.
• Depreciation is viewed in relation to adjustments in national monetary equilibrium, where imbalances arise when money supply growth outpaces money demand.
• Monetary authorities may need to initiate policies that align money supply with demand to stabilize the exchange rate and balance of payments.

The monetary approach is particularly pertinent in economies where inflationary pressures and monetary policy play crucial roles in determining exchange rate dynamics, making it a critical tool for policymakers aiming to control inflation and maintain exchange rate stability.