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Sem 5 Prep
← Open Economy MacroThe absorption approach

Formulas for this chapter

Absorption identity

Y = C + I + (X - M) A = C + I B = X - M Y = A + B so Y - A = B At full employment: dB = -dA

Any question about whether a depreciation will work, and any question that gives you output and spending rather than exports and imports.

Y
Real national production or income
A
Domestic absorption, C + I, everything the nation itself uses up
B
The foreign balance or trade balance, X - M

Net improvement in the trade balance with slack

net dB = gross shift in (X - M) - MPM x dY Equivalently dB = dY - dA

A nation below full employment. Use the first line when the question gives you a gross shift and an MPM, the second when it gives you output and absorption changes.

gross shift
The upward shift of the X - M function from the depreciation alone, before income effects
MPM x dY
The induced imports pulled in by the extra production, which erode the gross gain

Required fall in absorption at full employment

required fall in A = size of the deficit covered by: automatic effects + contractionary policy

Whenever the question says full employment. Output is fixed, so the deficit and the required cut in absorption are the same number.

automatic effects
The five forces: wage-to-profit redistribution, lower real expenditure, real balance effect, money illusion, higher tax brackets
contractionary policy
The remainder, which fiscal and monetary policy must supply
Step 1 of 24
The ideaTheory

You cannot eat more than you grow, unless somebody lends you the rest

A village produces 100 sacks of grain a year and eats 110. The extra 10 have to come from somewhere: a neighbouring village lends them.

The trade deficit is not a mysterious market failure. It is the arithmetic gap between what you produce and what you use up.

So if the village wants to stop borrowing, it has exactly two options: grow more, or eat less. Devaluing its currency changes prices, but it does not by itself change either number. That single observation is the absorption approach.

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