(a) Discuss the elasticity approach and absorption approach for adjustments in balance of payments. (20 marks) (b) By using…

(a) Elasticity and Absorption Approaches to BOP Adjustment

The Elasticity Approach, rooted in the Marshall-Lerner condition, focuses on the relative price mechanism. A currency devaluation improves the trade balance only if the sum of price elasticities of demand for exports and imports exceeds unity (|ηₓ| + |ηₘ| > 1), assuming perfectly elastic supplies. In the short run, due to contractual rigidities and delivery lags, these elasticities are low (|ηₓ| + |ηₘ| < 1), leading to an initial deterioration of the trade balance before it improves, tracing out the J-curve effect.

In contrast, Sidney Alexander’s Absorption Approach emphasizes national income aggregates. Defining the current account balance as B = Y - A (where Y is domestic output and A = C + I + G is domestic absorption), a BOP deficit (B < 0) implies that total absorption exceeds domestic output (A > Y). Devaluation can correct a deficit only if it expands output relative to absorption (dY > dA). It can raise Y through the idle-resources effect (if there is unemployment, switching demand to home goods raises output) but may lower real income through a terms-of-trade loss. It can reduce A directly through the real-balance effect (higher prices cut the real value of money holdings), money illusion, and redistribution of income towards profit earners with a higher propensity to save. Under full employment, devaluation merely causes inflation unless supplemented by expenditure-reducing policies (fiscal and monetary contraction) alongside expenditure-switching policies (devaluation redirecting demand to domestic goods).

While the elasticity approach provides microeconomic, short-run price insights, the absorption approach provides macroeconomic, income-determined conditions. The elasticity approach ignores income and monetary effects; the absorption approach neglects relative prices. Economists such as Tsiang and Harry Johnson combined them: devaluation is an expenditure-switching policy that must be paired with expenditure reduction when the economy is near full employment. The later monetary approach treats a BOP deficit as a symptom of excess money supply.

(b) Stolper-Samuelson Theorem and Inequality in Developing Countries

The Stolper-Samuelson theorem, derived from the Heckscher-Ohlin framework, demonstrates that a rise in the relative price of a good increases the real return to the factor used intensively in its production, while lowering the real return to the other factor.

In developing countries, which are typically labor-abundant and capital-scarce, free trade should increase the relative price of labor-intensive goods. Theoretically, this raises real wages and reduces capital returns, thereby compressing income inequality.

However, empirical realities in developing nations often diverge due to structural frictions:

The factor endowment structure is non-homogenous. Distinguishing between skilled and unskilled labor shows that trade liberalization induces capital-goods imports embedded with skill-biased technical change, widening the skilled-unskilled wage premium. Furthermore, large informal sectors with labor market dualism prevent factor price equalization. For instance, in post-1991 India, trade liberalization coincided with a rising wage share for skilled white-collar labor and capital, while real wages in unorganized, unskilled segments stagnated, leading to widened income disparity rather than the convergence predicted by basic theory. The evidence is mixed: the East Asian economies that opened up in the 1960s and 1970s (South Korea, Taiwan) saw rising unskilled wages and falling inequality, as the theorem predicts, whereas Mexico, other Latin American countries and India after the 1980s–90s reforms saw the skill premium rise. Reasons include more than two factors of production, low mobility of labour between sectors, and the fact that pre-reform protection had been highest in unskilled-labour-intensive industries, so liberalisation lowered their prices.

(c) Elasticity of Demand for Foreign Exchange

The demand for foreign exchange (Q_fx) is derived from the demand for imports (M). Since imports represent the gap between domestic demand (D) and domestic supply of import-competing goods (S), we have M = D(P) - S(P).

With a fixed foreign price P*, the home price is P = R·P*, where R is the price of foreign currency, and the foreign exchange demanded is P*·M. Differentiating M with respect to P and multiplying by P/M gives the elasticity of import demand, which equals the elasticity of demand for foreign exchange (η_fx) because P* is constant: η_fx = η_d (D/M) + εₛ (S/M) where η_d is the price elasticity of total home demand for the importable good, εₛ is the price elasticity of home supply of import-competing goods, and D/M and S/M represent domestic demand and supply weighted against total imports.

Economically, as the exchange rate depreciates, domestic demand for imports contracts via η_d, while domestic import-competing firms expand output via εₛ. A higher domestic supply elasticity εₛ enables domestic producers to rapidly substitute foreign goods, steepening the reduction in foreign exchange demanded. Because D/M is greater than one, the demand for imports, and hence for foreign exchange, is always more elastic than home demand for the good itself; if the country produces no import substitutes (S = 0), η_fx simply equals η_d. The more elastic the demand for foreign exchange, the more a depreciation reduces the import bill, which helps satisfy the Marshall–Lerner condition.

For India, fostering domestic supply elasticity through production-linked incentives (PLI) reduces structural import dependence.