Unit 3 Basic Theories of BOP (How are the imbalances of BOP adjusted when they occur in a country?)

I. The Elasticity Approach ( 弹性论）

A. Price Elasticity in Economics i) price quantity demanded demand is elastic quantity demanded price quantity demanded demand is inelastic (little change) ii) price quantity supplied supply is elastic quantity supplied price quantity supplied supply is inelastic (little change)

Note: “When demand or supply is elastic, it means that quantity demanded or supplied will be relatively responsive to the change in price.” “An inelastic demand or supply indicates that quantity is relatively unresponsive to price changes.”

B. When a devaluation (price decreasing) occurs in a country, exports are stimulated because the price of its goods in foreign currencies has been reduced, and imports are retarded because the domestic cost of imported goods has risen. So, the imbalance of trade have been improved. But it depends on the size of devaluation and the price elasticity of demand. Note: the size of devaluation means how much the price goes down and the elasticity of demand includes two aspects: 1) foreign demand for domestic goods when the price changes (specifically, the devaluation occurs); 2) domestic demand for foreign goods when the price changes (specifically, the devaluation occurs).

i) For a country, devaluation of the currencies exports total payments of BOP trade deficits imports (little change due to inelastic demand) The exports increase from devaluation (although the price goes down, foreign demand for domestic goods increase) is not so much as imports (because imports are inelastic in short term), so, total payments increase and trade balance deteriorates. And in the long run, there is time to look for substitutes for higher priced goods. thus for the long run, the demand is elastic and the country’s trade balance is improved. (This is the J-curve effect.)

ii) For a country, the devaluation of currencies exports total payments trade surpluses imports (decrease greatly due to price elasticity) The devaluation of domestic currency cause more foreign demand of domestic goods and less domestic demand for foreign goods. a)The increase of exports and the decrease of imports caused by devaluation could improve trade balance; b)Or the increase of exports are more than the imports (although there is little change in imports), which could also improve trade balance.

Example: Plaza Accord Influence of Plaza Accord on Japanese Yen

II. Absorption Approach ( 吸收论 )

A. Definition of Absorption Approach It is a theory of the balance of trade that emphasizes how domestic spending changes relative to domestic output.

In the national income account, total outputs equal total expenditures. Total output or national income (Y) consists of four types of expenditures: consumption (C), investment (I), government expenditures (G), and net exports (X-M). So, Y = C + I + G + ( X - M ) Here X stands for exports and M stands for imports. Y + M = C + I + G + X （国民收入 + 进口 = 消费 + 投资 + 政府开支 + 出口） total supply total demand （总供给 ) ( 总需求 ) X - M ( 出口 - 进口） = Y - ( C + I + G ) B = Y-A “here we define domestic absorption (A) being equal to (C+I+G)” If, Y>A trade surplus Y<A trade deficits Y=A exports equal imports, reach trade equilibrium

B. Characteristics of Absorption Approach a) 吸收论是从总收入和总支出的相对关系来考察国际 收支失衡的原因，而不是从相对价格关系出发。此外， 吸收论是建立在凯恩斯的宏观经济学基础之上，采用 一般均衡的分析方法，而非具体价格分析方法。 b) 就货币贬值的效应来讲，吸收论是从贬值对国民 收入和支出的相对影响中考察国际收支失衡的原因。

III. Monetary Approach ( 货币论）

A. The basic premise of this theory is that any balance of payments disequilibrium is the result of a monetary disequilibrium, that is, differences existing between the amount of money people wish to hold and the amount supplied by the monetary authorities. “In very simple term, the excess demand for money would be satisfied by inflows of money from abroad, while on the other hand, the excess supply of money is eliminated by outflows of money to other countries.” Thus the monetary approach emphasizes the determinants of money demand and money supply also determine the BOP.

Now, we use a formula to explain that: Md ( 货币需求） = f (y, r) (y- 收入水平， r- 利率） income Md Md interest rate Md Md Ms ( 货币供给） = D + F = D + B （于额） domestic supply foreign supply ( 顺差，流入） Due to Md = Ms, Md = D + B( 国际收支平衡） B=Md ( 货币需求） - D （国内货币供给） If, Md > D Money comes in Trade surpluses Md < D Money goes out Trade deficits Md = D Imports=Exports, reach trade equilibrium.

B. Policy: Governments should control domestic money supply in order to balance BOP. a) 所有国际收支不平衡，在本质上都是货币造 成的，因此国际收支不平衡都可以由国内货币 政策来解决。 b ) 国内货币政策主要指国内货币供应政策，因 此松的货币政策 (loose monetary policy/credit policy) 可以减少国际收支顺差；紧的货币政策 (tight monetary policy/credit policy) 可以减少货 币收支逆差。