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

(b) By using Stolper-Samuelson theorem, discuss the possible effects of free trade on income inequalities in developing countries. (15 mar

Question

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

(b) By using Stolper-Samuelson theorem, discuss the possible effects of free trade on income inequalities in developing countries. (15 marks)

(c) Explain how the elasticity of demand for foreign exchange is influenced by the elasticity of home demand for imports and by the elasticity of home supply of import-competing goods. (15 marks)

UPSC Answer Check · Accepted Answer

Adjustments in the Balance of Payments (BOP) are traditionally analyzed through price, income, and monetary mechanisms.

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). 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. These are synthesized in the Monetary Approach, which treats BOP disequilibria as stock adjustments where real absorption shifts reflect excess money demand or supply.

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 scarce 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.

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).

Differentiating with respect to the exchange rate (R, price of foreign currency) yields the elasticity of demand for foreign exchange (η_fx): η_fx = η_d (D/M) + εₛ (S/M) where η_d is the price elasticity of home demand for imports, 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.

For India, fostering domestic supply elasticity through production-linked incentives (PLI) reduces structural import dependence. Combining high domestic supply responsiveness with targeted expenditure policies ensures that trade policy stabilizes foreign exchange demand while mitigating structural inequalities.

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

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