26 Jul Balance of Payment Adjustments: Alternative Approaches
Balance of Payment Adjustments: Alternative Approaches
UPSC Economics Optional – Paper 1 |
Introduction
The Balance of Payments (BoP) is a systematic record of a country’s economic transactions with the rest of the world over a specific period. Persistent imbalances, especially deficits in the current account, necessitate adjustment mechanisms. Economists have proposed multiple frameworks to explain how countries can restore external balance. These include the Elasticity approach, Absorption approach, Monetary approach, and others grounded in Keynesian or Classical thinking.
This article delves into each of these alternative adjustment mechanisms, their theoretical foundations, policy implications, and relevance in today’s global economy—especially from India’s perspective.
What Is BoP Adjustment?
BoP adjustment refers to the economic and policy processes that correct imbalances—particularly deficits—in a nation’s external accounts. These adjustments may occur through:
- Price mechanisms (exchange rate changes)
- Income adjustments (output/employment changes)
- Monetary adjustments (interest rates, reserves)
- Direct controls (quotas, tariffs)
1. The Elasticity Approach to BoP Adjustment
Key Idea:
This approach focuses on the price responsiveness (elasticity) of imports and exports to changes in exchange rates. Devaluation can improve a trade deficit only if the combined elasticity of demand for exports and imports is sufficiently high.
Marshall-Lerner Condition:
BoP will improve after devaluation if:
|ex| + |em| > 1
Where:
- ex = price elasticity of demand for exports
- em = price elasticity of demand for imports
Graphical Illustration:
Initially, depreciation worsens BoP due to inelastic short-term response (J-Curve), but over time, trade improves as quantities adjust.
Criticism:
- Assumes perfect competition
- Excludes capital flows and income effects
- Not effective if trading partners retaliate
2. The Absorption Approach
Key Idea:
Developed by Sidney Alexander, this approach emphasizes income and expenditure balance. BoP is a function of national income (Y) and domestic absorption (A = C + I + G):
B = Y – A
Where B is the balance of trade.
Implication:
- Devaluation must increase national income and/or reduce domestic absorption to improve BoP
Policy Prescription:
- Contractionary fiscal/monetary policy to reduce absorption
- Supply-side reforms to raise output
Criticism:
- Measurement difficulties in absorption
- Ignores monetary variables
- Inappropriate for open capital markets
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3. The Monetary Approach to BoP
Key Idea:
This model considers BoP disequilibrium as a monetary phenomenon. Imbalance arises when domestic money supply does not match demand. It assumes flexible exchange rates and perfect capital mobility.
Equation:
ΔR = ΔMd – ΔMs
Where:
- ΔR = change in reserves
- ΔMd = change in money demand
- ΔMs = change in money supply
Adjustment Mechanism:
- BoP surplus increases reserves → monetary base → inflation → reduces competitiveness → restores equilibrium
- BoP deficit leads to outflow → monetary contraction → recessionary pressure
Criticism:
- Highly idealistic assumptions
- Ignores fiscal policy and unemployment
- Not applicable in short-run scenarios with sticky prices
4. IS-LM-BoP (Mundell-Fleming) Model
Key Idea:
This model integrates internal and external equilibrium. It explains how monetary and fiscal policy work under fixed and flexible exchange rate regimes, assuming perfect capital mobility.
Policy Effects:
| Policy | Fixed Exchange Rate | Flexible Exchange Rate |
|---|---|---|
| Monetary | Ineffective | Highly effective |
| Fiscal | Effective | Ineffective |
Criticism:
- Oversimplifies capital flows
- Assumes perfect mobility
- Neglects real-world exchange rate frictions
5. Devaluation and BoP
Devaluation refers to deliberate downward adjustment of a fixed exchange rate. It makes exports cheaper and imports costlier.
Effectiveness:
- Depends on elasticity of trade
- Risk of imported inflation
- Competitor retaliation possible
J-Curve Effect:
Post-devaluation, trade balance initially worsens due to contractual obligations but improves over time as quantities adjust.
6. Exchange Rate Regimes and BoP Adjustments
- Fixed: BoP adjustments occur via reserves and interest rates
- Flexible: Adjustments via depreciation/appreciation of currency
7. Role of IMF and Adjustment Lending
- IMF provides conditional assistance to correct BoP deficits
- Structural Adjustment Programs (SAPs) aim to restore competitiveness
- Criticized for imposing austerity, reducing social sector spending
Case Study: India’s BoP Crisis of 1991
- Severe current account deficit, dwindling forex reserves (below $1 billion)
- IMF bailout + structural reforms
- Devaluation of rupee by ~20%
- Liberalization of trade and capital accounts
Current Scenario (2023–25): India BoP Snapshot
- CAD (Current Account Deficit) in 2023-24: ~2% of GDP
- Capital inflows (FDI/FPI) financing deficit
- Forex reserves stable at ~$600 billion
- Rupee depreciation kept in check by RBI interventions
UPSC Previous Year Questions
- 2020: Compare and contrast monetary and absorption approaches to BoP adjustments.
- 2017: Discuss the effectiveness of devaluation as a BoP adjustment tool.
- 2014: Explain the IS-LM-BoP framework in the context of India’s capital account management.
Probable Questions for UPSC
- How effective is the Marshall-Lerner condition in today’s global trade?
- Critically evaluate India’s BoP policy during the COVID-19 crisis.
- Discuss the relevance of the Mundell-Fleming model in the current flexible exchange rate regime.
- How do oil prices affect India’s BoP stability?
- Examine the challenges of using absorption approach in economies with large informal sectors.
Conclusion
Balance of Payment adjustments lie at the heart of macroeconomic policy in open economies. Each theoretical approach—elasticity, absorption, or monetary—provides valuable insight into the complex mechanisms through which trade balances are corrected. No single model is universally superior; their relevance depends on a country’s structure, capital mobility, exchange rate regime, and institutional strength.
For India, maintaining a stable BoP is essential for currency stability, investor confidence, and sustainable growth. UPSC aspirants must not only master the theoretical underpinnings but also analyze real-world implications in the context of evolving global economics.
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