Absorption approach to BoP

Introduction
The absorption approach was developed in a famous paper in 1952 by Sydney Alexander. It looks at effects of devaluation on trade balance by analysing the macroeconomic effects of devaluation. More supply based approach as opposed to demand side approach in Elasticity approach. It is a much improved and complementary approached compared Elasticity approach, particularly when economy is at full employment. Elasticity approach fails to explain effect of devaluation when economy is at full employment

Model
Y= C+I+G+(X-M) Domestic Absorption A= C+I+G CAB= X-M= Y-A Trade balance is positive if income or output is more than expenditure dCAB= d(X-M)= dY-dA Trade balance or current account balance improves if any change in BoP policy instruments like devaluation increases income more than absorption.

 Explaining how devaluation affects both income and absorption is the main point in absorption approach. Absorption can be divided into two parts: income induced absorption and direct absorption resulting from devaluation. dA= adY+dAd a= Marginal propensity to absorb dCAB= (1-a)dy-dAd For Devaluation to improve trade balance, (1-a)dy>dAd.

Effect of Devaluation on national Income Foreign Trade multiplier and net exports effect Term of Trade Effect Effect of Devaluation on national Income Income redistribution effect Real Balance Effect