The Elasticity Approach to Balance of Payments
The value of a country’s currency depends on the overall economy of the country. This includes manufacturing, foreign investments, employment, trade balance and many other economic indicators. All of the transactions that the country conducts with other countries represent part of the balance of payment. Economists use different tools to analyze and come up with methods for increasing, decreasing and balancing trade between countries.
What is Balance of Payments
The balance of payments is an economic indicator used to determine the economic and political stability of a country. The BOP gauges the goods and services, trade balance and financial imports and exports between one country and the rest of the world over a specified period of time. The BOP compares all imports and exports, including financial transactions, and compares the monetary difference between the transactions. If a country has a positive BOP it means the country has more money coming from international trade then going out. On the other hand, a negative BOP indicates a country has more money flowing out through international trade then coming in.
What is Elasticity?
Elasticity represents responsiveness. In economics, elasticity determines how demand changes when you change something about a product or service. In most cases, the concept of elasticity demonstrates how demand of a product or service will change as a result of a price increase or decrease. The elasticity approach to the balance of payments demonstrates how the change in the value of the currency affects a country's balance of payments.
The Elasticity Approach
The elasticity approach tries to predict the outcome policy changes will have on the balance of payments. For example, this approach illustrates how exchange rates will affect the balance. Further, the elasticity approach assumes that if the BOP is in equilibrium, devaluation can improve the balance of payments. However, for devaluation to function successfully, the total of the price elasticity of domestic and foreign demand for imports has to increase. When a country devalues a currency, it improves the balance of payments under ideal conditions. This ideal condition is known as the Marshall-Lerner condition.
The Marshall-Lerner Condition
Named after English economist Alfred Marshall and Romanian economist Abba Lerner, the Marshall-Lerner Condition states that a currency devaluation will eventually improve the balance of payments. In order to accomplish this increase in the BOP, however, the sum of demand elasticity for imports and exports has to increase. When a country devalues its currency, the price of exports will decrease. This, in theory, will increase the demand for these exports. However, for increased demand to occur, the exported products have to be elastic products.
- LES Economics: Elasticity Approach to the Balance of Payment
- "Principles of Economics"; N. Gregory Mankiw; 2011
Brian Bass has written about accountancy-related topics and accounting trends for "Account Today." He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Bass hold a master's degree in accounting from the University of Utah.