Question

According to the absorption approach, does it make any difference whether a nation's currency depreciates when the economy is operating at less than full capacity versus at full capacity?

Short answer

According to the absorption theory, a depreciating currency does affect the economy differently depending on whether it is operating at less than full capacity or at full capacity. When operating below full capacity, depreciation can help improve the balance of payment by increasing production, whereas at full capacity, balance of payments might not improve due to inflation.

Step-by-step solution

Understanding the Absorption Approach

The Absorption Approach is a theory related to Balance of Payments (BoP) in an open economy. It states that a nation's balance of payment is determined by the difference between total national income and total domestic absorption, where absorption is the aggregate of consumption, investment, and government spending.

Depreciation and less than Full Capacity

When a nation's economy is operating at less than full capacity, depreciation of the currency has the potential to spur domestic production as imported goods become more expensive. This leads to a rise in total national income. As some idle resources (like labor and capital) can be utilized to increase production, an increase in absorption wouldn't fully neutralize the increase in income, thus improving the balance of payments.

Depreciation and Full Capacity

However, when the economy is at full capacity, further increasing production is hard. Thus, the depreciation of currency makes foreign goods costly leading to a rise in inflation. The increase in domestic income leads to an equivalent increase in absorption (as all resources are already fully utilized), thus no significant improvement in the balance of payments would occur. Rather, with inflation, it might even worsen.

Key concepts

Balance of Payments

The balance of payments (BoP) is a statement that summarizes a country's economic transactions with the rest of the world over a specific time period. This can include transactions such as imports and exports of goods and services, cross-border investments, and financial transfers. It's crucial because it can indicate the economic health of a country.

• If a country has a BoP surplus, it means it is exporting more than it is importing, thus gaining more resources than it is spending on the global market.
• A BoP deficit implies that a country is importing more than it is exporting, potentially leading to a reliance on foreign loans to bridge the gap.

The absorption approach, related to BoP, suggests that the balance is impacted by how a nation's total output (or income) compares to its total domestic expenditure (or absorption). If income exceeds absorption, there is a surplus, contributing positively to the BoP. Conversely, if a nation's absorption surpasses its income, a deficit arises.

Currency Depreciation

Currency depreciation occurs when the value of a nation's currency decreases compared to other currencies, making foreign goods more expensive and domestic goods cheaper for foreign buyers. This can influence trade balances by making a country's exports more competitive, potentially improving its BoP.

• When a currency depreciates, imported goods become pricier, encouraging consumers and firms to buy domestically produced goods.
• For economies operating below full capacity, this can stimulate growth as domestic industries ramp up production to meet increased demand.

However, the effects of depreciation vary based on the economic situation: - **Less than Full Capacity**: When there is unused labor and capital, increased production due to stimulated exports can lead to economic growth without necessarily increasing inflation. - **Full Capacity**: With all resources already in use, further production is difficult, and currency depreciation might lead to inflation without improving the BoP.

Economic Capacity Utilization

Economic capacity utilization refers to the extent to which a nation uses its available resources, like labor and capital, for production. It is a measure of how effectively an economy is operating relative to its potential output level.

• If an economy is operating below full capacity, it has room to grow. Idle resources can be employed to boost production when demand increases.
• An economy at full capacity has no unused resources; therefore, it struggles to expand output without investments in more resources or technology.

Understanding capacity utilization is crucial when discussing the impact of currency depreciation. If an economy is below capacity, depreciation can utilize these idle resources, increasing national income and potentially leading to a better BoP. Conversely, at full capacity, increased demand may lead to inflation without additional economic benefits, as available resources are already maximized.