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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 2 of 24
The real wordsTheory

What the approach adds

Before the mid-sem you corrected a deficit by depreciating, and whether it worked depended on elasticities. That is the elasticity approach.

But a depreciation stimulates exports and discourages imports, which raises production and real income, which induces imports to rise, neutralising part of the improvement. Chapter 16 left those induced income changes out on purpose.

Absorption approachintroduced by Sidney Alexander in 1952. It integrates the induced income changes into the analysis of correcting a deficit by a change in the exchange rate.
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