International Economics Tutorial class

By: Mulugeta A.
May, 2026
 Chapter I: THE FOREIGN EXCHANGE MARKET

1.1. What is a Foreign Exchange Market?

Among the factors that make International Economics a distinct subject
is the existence of different national monetary units of account.
In Ethiopia, prices and money are measured interims of the birr.
The foreign exchange market refers to the trading of one currency
for another.

• The foreign exchange market refers to the organizational

setting with in which individuals businesses, governments
and banks buy and sell foreign currencies.

1 2
 Participants In The Exchange Market
State Bank of or Central Bank
Exchange Companies
Traders
Money Changers
Governments
All Commercial Banks (Authorized
Businesses
Dealers only).
Corporate Treasuries.
Inter Bank Brokerage Houses.
Public Sector/Government.
Resident

Non Residents

1 3
Characteristics of for foreign exchange market

Most Liquid Market in the World

Most Dynamic Market in the World

It is a Twenty-Four Hour Market

Market Transparency

International Network of Dealers

1 4
 The Functions of Foreign Exchange Markets
1. Transfer Function:

• The basic function of the foreign exchange market is to facilitate

the conversion of one currency into another, i.e., to accomplish
transfers of purchasing power between two countries.

2. Credit Function:

• Another function of the foreign exchange market is to provide

credit, both national and international, to promote foreign trade.

3. Hedging Function:

• Hedging means the avoidance of a foreign exchange risk.

1 5
 What is an Exchange Rate ?

Exchange Rate is the price of one country's currency

expressed in another country's currency.

In other words, the rate at which one currency can be

exchanged for another.

Exchange rate allow us to express the cost or price of a

good or service in a common currency

1 6
 Spot and Forward Exchange Rates
• The spot exchange rate is the quotation between two currencies for
immediate delivery.

o In other words, the spot exchange rate is the current exchange rate of
two currencies each other.

o In practice, there is normally a two-day lag between a spot purchase

or sale and the actual exchange of currencies to allow for verification,
paperwork and clearing of payments.

• The forward exchange rate. it is possible for economic agents to agree today
to exchange currencies at some specified time in the future, most commonly
for 1 month, 3 months, 6 months, 9 months and 1 year.

o The rate of exchange at which such a purchase or sale can be made is

known as the forward exchange rate
1 7
 Nominal Exchange Rates
• If someone in one country wants to buy goods, services, or
assets from someone in another country, normally she will
first have to exchange her currency for that of her trading
partner‟s country.

• The nominal exchange rate, or exchange rate, between two

currencies, is the number of units of foreign currency which
can be purchased with a unit of the domestic currency.

1 8
 Real Exchange Rate
• The real exchange rate is the number of foreign goods
someone gets in exchange for one domestic good.

• Real exchange rates are based on price indexes of

“baskets” of goods.

• We assume that each country produces a single good.

1 9
 E P*
e
P

 E: nominal exchange rate (domestic currency per unit of

foreign currency),
 P*: foreign price level (in foreign currency per foreign good),
 P: domestic price level (in domestic currency per domestic
good),
 e: real exchange rate (in units of domestic goods per foreign
good).

1 10
 Effective exchange rate
The effective exchange rate is a measure of whether or not
the currency is appreciating or depreciating against a
weighted basket of foreign currencies.
In order to illustrate how an effective exchange rate is
compiled, consider the hypothetical case of the UK
conducting 30% of its foreign trade with the US and 70%
of its trade with Europe.
This means a weight of 0.3 will be attached to the bilateral
exchange rate index with the dollar, and 0.7 to the euro.

1 11
 Real Effective Exchange Rate (REER)
 Real effective exchange rate is a useful tool for calculating the

strength of your nation‟s currency against the currencies of other

countries.

• REER = NEER × (P/P*)

 When REER increases, it indicates a loss in trade competitiveness.

 Hence, this calculation of the real effective exchange rate helps you

decide which currency to trade by considering the factors in favour

of the trade including trade competitiveness.

 REER is an important measure that is considered during policy-

making and when scrutinising the economic growth of a country.

1 12
Different Steps for the Construction of Effective Exchange Rates
 To construct the nominal and real effective exchange rates economist
follow certain number of steps.

 The main steps are:

 selection of trading partners

 selection of base period

 calculation of trade weights

 calculation of bilateral nominal exchange rates and indices

 calculation of bilateral real exchange rates and indices.

1 13
 Selection of Trading Partners: Selection of major trading
partners depends on:
1. the value of exports
2. the value of imports
3. the value of total trade (exports plus imports) of home
country with trading partners.
 Selection of Base Year: The value of exchange rate in the
base year is used to make the current exchange rate unit
free.
 The value of base year index is equal to 100 by definition.
 Usually the base year is selected considering normal
situation both in social and economic
1
arena. 14
What is a Foreign Exchange Transaction ?

– Any financial transaction that involves more than one currency is

a foreign exchange transaction.

– Most important characteristic of a foreign exchange transaction

is that it involves Foreign Exchange Risk.
FOREIGN EXCHANGE REGIMES
 An exchange rate regime is a way a monetary authority of a country
or currency union manages the currency about other currencies and
the foreign exchange market.
[Link] (or flexible)

2. Fixed (or pegged)

3. Managed Float Exchange Rate

1 15
 Under the Flexible Exchange Rate System:
• Depreciation of that currency. Appreciation of that
currency

Under the Fixed Exchange Rate System:

• Devaluation. Revaluation.

1 16
 The Demand for and the Supply of Foreign Exchange
• A nation‟s demand for foreign exchange is derived from, or
corresponds to, the debit items on its balance of payments.

• Foreign currencies are supplied by foreign households,

firms, and governments that wish to purchase goods,
services, or financial assets denominated in the domestic
currency.

1 17
Exchange rate
• Exchange rate SS
ex3

ex2

ex1
D 0
Q1 Q2 Q3 Q Q

1 18
 Equilibrium of foreign exchange market
SS
e

E*

DD
Q
Qe

1 19
Hedgers, Arbitrageurs, and Speculators

1 20
 Hedgers
Definition:
 Hedgers reduce or avoid risk caused by exchange rate
changes.
Example:
 An Ethiopian importer locks the exchange rate today to
avoid future losses if the birr depreciates.
Purpose:
 Risk reduction
 Protection from uncertainty
 Arbitrageurs
Definition:

 Arbitrageurs earn profit from price differences in different

markets.

Example:

 Buy USD where it is cheap and sell where it is expensive.

Purpose:

 Risk-free profit

 Market price equalization

 Speculators
Definition:

 Speculators take risks to earn profit from future price

changes.

Example:

 A trader buys USD expecting its value to rise in the future.

Purpose:

 Profit from market movements

 Accept high risk

 Foreign exchange rate determination
 The important question is thus “how can this rate (price)
be determined?”

 In free market economy equilibrium exchange rate is

determined by both demand and supply

5/29/2026 mulugeta A. 24
 Approaches to Exchange Rate Determination
 The equilibrium exchange rate between currencies of two nations
could be determined in a number of ways

 But, the three important ones the

 Balance of payments

 Purchasing power parity (PPP)

 Monetary approaches.

5/29/2026 mulugeta A. 25
 1. The Purchasing – Power Parity (PPP) Approach

 Determining the long – run equilibrium value of an exchange

rate

 For example, if a nation‟s exchange rate rises above the level

warranted by economic conditions, so that its currency
becomes overvalued, the nation‟s costs will no longer be
competitive and a trade deficit will likely occur.

 An undervalued currency tends to lead to a trade surplus.

 The PPP, therefore, can be used to make predictions about

exchange rates.
5/29/2026 mulugeta A. 26
 What are Parity Models?
 Parity is defined as a state of equilibrium.

 Foreign exchange parity models “estimate” what the

equilibrium spot exchange rate should be (under the model‟s
assumptions):

1. Is today‟s spot rate appropriate?

2. What might the spot rate be in the future (forecasting future

spot rates).

Generally involving a long term forecasting horizon.

5/29/2026 mulugeta A. 27
 Two Major Spot Foreign Excange Parity Models

• (1) Purchasing Power Parity (PPP)

– Model assumes relative rates of inflation (or relative prices)

between two countries as the major determinant of future
spot exchange rates.

• (2) International Fisher Effect (IFE)

– Model assumes relative rates of long term interest between

two countries as the major determinant of future spot
exchange rates.

5/29/2026 mulugeta A. 28
 Purchasing Power Parity Theory

 The Purchasing Power Parity (PPP) explains and

quantifies the relationship between inflation and spot
exchange rates.

 The theory states that the spot exchange rate between

two currencies should be equal to the ratio of the two
countries‟ price levels.

5/29/2026 mulugeta A. 29
 Two Forms of PPP
• Absolute PPP:

• At a point in time, the equilibrium spot exchange rate is that rate which
results in the prices of similar goods in two different countries being equal.

– This form of the PPP can be used to test how “appropriate” a current spot
exchange rate is and to indicate a future move in the exchange rate.

• Relative PPP:

• Over time, the change in the exchange rate between two currencies should
be equal to the rate of change in the prices of similar goods between the two
countries.

– This form of the PPP is used to forecast the equilibrium spot exchange
rate in the future and generally over a long time horizon.

5/29/2026 mulugeta A. 30
 Absolute PPP (Law of One Price)

 This is the simplest concept of the model of PPP.

 For analysis, it assumes the following:

 It is costless to transport commodities between nations; and

 There are no barriers to trade (such as tariffs).

 Given the assumptions, the law of one price asserts that

identical goods should be sold at a similar price or cost in all
nations.

5/29/2026 mulugeta A. 31
 This „Law of one price „is simply called the absolute version of
the PPP approach.
 According to this version, the exchange rate between any two
currencies is simply the ratio of the two countries‟ general price
levels.
 The absolute purchasing-power parity theory postulates that
the equilibrium exchange rate between two currencies is equal
to the ratio of the price levels in the two nations. Specifically:
𝑷
𝑹= 𝑷∗

 P and P∗ are, respectively, the general price level in the home

nation and in the foreign nation.

5/29/2026 mulugeta A. 32
 Relative Purchasing-Power Parity Theory
 The more refined relative purchasing-power parity theory postulates that
the change in the exchange rate over a period of time should be
proportional to the relative change in the price levels in the two nations
over the same time period.

 The theory predicts that the foreign exchange value of a currency tends to
appreciate or depreciate at a rate equal to the difference between foreign
and domestic inflation.

 A currency would be expected to depreciate by an amount equal to the

excess of domestic inflation over foreign inflation.

 It would appreciate by an amount equal to the excess of foreign inflation

over domestic inflation.

5/29/2026 mulugeta A. 33
 As we said before, the PPP theory can be used to predict

long–run exchange rates.

 The purchasing –power –parity theory can thus be given in

𝑷𝟏
𝑷𝟎
symbols as: 𝑹𝟏 =
𝒑𝟏 ∗
𝒑𝟎 ∗
. 𝑹𝟎

Example. The general price level in Ethiopia and in USA in 2026

was 100 and the birr price of the USD was birr 120 during this

period. Forecast the exchange rate that will prevail in 2027 if

the Ethiopian inflation rate rises by 100 percent and USA rate

remains unchanged by taking year 2026 as the base year.

5/29/2026 mulugeta A. 34
 The Demand for Currency Deposits
• What influences the demand for (willingness to buy)
deposits denominated in domestic or foreign currency?

• Factors that influence the return on assets determine the

demand for those assets.

mulugeta A. 13-35
 The Demand for Currency Deposits (cont.)
• Rate of return: the percentage change in value that an
asset offers during a time period.

– The annual return for $100 savings account with an

interest rate of 2% is $100 x 1.02 = $102

– the rate of return = ($102 - $100)/$100 = 2%

• (T/F) If the dollar interest rate is 10 percent and the euro

interest rate is 6 percent, then an investor should invest only in
dollars.

mulugeta A. 13-36
 The Demand for Currency Deposits (cont.)
 A currency‟s interest rate is the amount of a currency an individual
can earn by lending a unit of the currency for a year.

 The rate of return for a deposit in domestic currency

is the interest rate that the bank deposit earns.

 To compare the rate of return on a deposit in domestic currency

with one in foreign currency, consider:

 the interest rate for the foreign currency deposit

 the expected rate of appreciation or depreciation of the foreign

currency relative to the domestic currency.
mulugeta A. 13-37
 The Demand for Currency Deposits (cont.)
 Suppose the interest rate on a dollar deposit is 2% and the interest
rate on a euro deposit is 4%.

– Suppose today the exchange rate is $1/€1, and the expected

rate 1 year in the future is $0.97/€1.

 Does a euro deposit yield a higher expected rate of return?

– $100 can be exchanged today for €100.

– These €100 will yield €104 after 1 year.

– These €104 are expected to be worth $0.97/€1 x €104 =

$100.88.

mulugeta A. 13-38
 The Demand for Currency Deposits (cont.)
• The rate of return in terms of dollars from investing in euro
deposits is ($100.88-$100)/$100 = 0.88%.

• Let‟s compare this rate of return with the rate of return from a
dollar deposit.

– rate of return is simply the interest rate

– After 1 year the $100 is expected to yield $102:

($102-$100)/$100 = 2%

• The euro deposit has a lower expected rate of return: all

investors will prefer dollar deposits and none are willing to
hold euro deposits.
mulugeta A. 13-39
 The Demand for Currency Deposits (cont.)
• Note that the expected rate of appreciation of the euro is
($0.97- $1)/$1 = -0.03 = -3%.

• We simplify the analysis by saying that the dollar rate of

return on euro deposits approximately equals:

1. the interest rate on euro deposits

2. plus the expected rate of appreciation on

euro deposits

– 4% + -3% = 1% ≈ 0.88%

• R€ + (Ee$/€ - E$/€)/E$/€
mulugeta A. 13-40
 The Demand for Currency Deposits (cont.)

• The difference in the rate of return on dollar deposits

and euro deposits is
R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) =
R$ - R€ - (Ee$/€ - E$/€)/E$/€

interest rate
expected rate on euro expected current
of return = deposits exchange rate exchange rate
interest rate
on dollar expected rate of appreciation
deposits of the euro

expected rate of return on euro deposits

mulugeta A. 13-41
 The Demand for Currency Deposits (cont.)

When the difference is positive, dollar deposits

yield the higher expected rate of return  hold
dollar deposits

When the difference is negative, euro deposits

yield the higher expected rate of return  hold
euro deposits

mulugeta A. 13-42
 Dollar Deposits or Euro Deposits?
1) R$ =10%, R€ =6%,
expected rate of dollar depreciation = 0%
2) R$ =10%, R€ =6%,
expected rate of dollar depreciation = 4%
3) R$ =10%, R€ =6%,
expected rate of dollar depreciation = 8%
4) R$ =10%, R€ =12%,
expected rate of dollar depreciation = -4%

mulugeta A. 13-43
 The Demand for Currency Assets

mulugeta A. 13-44
 The Market for Foreign Exchange
• We use the
– demand for (rate of return on) dollar denominated deposits
– and the demand for (rate of return on) foreign currency
denominated deposits to construct a model of the foreign
exchange market.
• The foreign exchange market is in equilibrium when deposits of all
currencies offer the same expected rate of return: interest parity.
– interest parity implies that deposits in all currencies are deemed
equally desirable assets.

mulugeta A. 13-45
 The Market for Foreign Exchange (cont.)
• Interest parity says:

R$ = R€ + (Ee$/€ - E$/€)/E$/€

• Why should this condition hold? Suppose it didn‟t.

– Suppose R$ > R€ + (Ee$/€ - E$/€)/E$/€ .

– Then no investor would want to hold euro deposits, driving

down the demand and price of euros.

– Then all investors would want to hold dollar deposits, driving

up the demand and price of dollars.

– The dollar would appreciate and the euro would depreciate,

increasing the right side until equality was achieved.
mulugeta A. 13-46
 The Market for Foreign Exchange (cont.)

• How do changes in the current exchange rate affect

expected returns in foreign currency?

mulugeta A. 13-47
 The Market for Foreign Exchange (cont.)
• Depreciation of the domestic currency today lowers the
expected return on deposits in foreign currency.

– A current depreciation of domestic currency will raise the

initial cost of investing in foreign currency, thereby
lowering the expected return in foreign currency.

mulugeta A. 13-48
 The Market for Foreign Exchange (cont.)

• Appreciation of the domestic currency today raises

the expected return of deposits in foreign currency.

– A current appreciation of the domestic currency will

lower the initial cost of investing in foreign currency,
thereby raising the expected return in foreign currency.

mulugeta A. 13-49
 Expected Returns on Euro Deposits

Suppose Ee$/€ = $1.05/€ and R$ = R€ = 5%

1) E$/€ =1.07
2) E$/€ =1.05
3) E$/€ =1.03
4) E$/€ =1.02
5) E$/€ =1.00

mulugeta A. 13-50
mulugeta A. 13-51
 The Current
Exchange Rate
and
the Expected
Return on
Dollar Deposits

mulugeta A. 13-52
 The Current Exchange Rate and the Expected
Return on Dollar Deposits

Current exchange
rate, E$/€

1.07

1.05

1.03
1.02

1.00
0.031 0.050 0.069 0.079 0.100
R$ Expected dollar return
on dollar deposits, R$
mulugeta A. 13-53
Determination of the Equilibrium Exchange Rate

No one is willing to
hold euro deposits

No one is willing to
hold dollar deposits

mulugeta A. 13-54
 The Market for Foreign Exchange
• The effects of changing interest rates:
– an increase in the interest rate paid on deposits
denominated in a particular currency will increase the rate
of return on those deposits.
– This leads to an appreciation of the currency.
– A rise in dollar interest rates causes the dollar
to appreciate.
– A rise in euro interest rates causes the dollar
to depreciate.

mulugeta A. 13-55
 The Effect of a Rise in the
Dollar Interest Rate

A depreciation
of the euro is
an appreciation
of the dollar.

mulugeta A. 13-56
 The Effect of a Rise in the
Euro Interest Rate

mulugeta A. 13-57
 The Effect of an Expected Appreciation
of the Euro

People now
expect the
euro to
appreciate

mulugeta A. 13-58
 A Brief Review of the Money Market interest rate
and Exchange rate
• What is money?

• Control of the supply of money

• The demand for money

• A model of real money balances and

interest rates

• A model of real money balances, interest rates and exchange rates

• Long run effects of changes in money on prices, interest rates and

exchange rates

5/29/2026 mulugeta A. 59
 What Influences Individual Demand for Money?
1. Expected returns/interest rate on money relative to the expected returns on
other assets.

2. Risk: the risk of holding money principally comes from unexpected inflation,
thereby unexpectedly reducing the purchasing power of money.

– but many other assets have this risk too, so this risk is not very important in
money demand

3. Liquidity: A need for greater liquidity occurs when either the price of
transactions increases or the quantity of goods bought in transactions increases.

5/29/2026 mulugeta A. 60
What Influences Aggregate Demand for Money?
1. Interest rates: money pays little or no interest, so the interest rate is
the opportunity cost of holding money instead of other assets, like
bonds, which have a higher expected return/interest rate.
– A higher interest rate means a higher opportunity cost of holding money
 lower money demand.

2. Prices: the prices of goods and services bought in transactions will

influence the willingness to hold money to conduct those
transactions.
– A higher price level means a greater need for liquidity to buy the same
amount of goods and services  higher money demand.

5/29/2026 mulugeta A. 61
What Influences Aggregate Demand for Money? (cont.)
3. Income: greater income implies more goods and services can
be bought, so that more money is needed to conduct
transactions.

– A higher real national income (GNP) means more goods

and services are being produced and bought in
transactions, increasing the need for liquidity  higher
money demand.

5/29/2026 mulugeta A. 62
 A Model of Aggregate Money Demand
The aggregate demand for money can be expressed by:
Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates
L(R,Y) is the aggregate real money demand
Alternatively:
Md/P = L(R,Y)
Aggregate real money demand is a function of national
income and interest rates.

5/29/2026 mulugeta A. 63
A Model of Aggregate Money Demand (cont.)

For a given level of

income, real money
demand decreases
as the interest rate
increases.

5/29/2026 mulugeta A. 64
 A Model of
Aggregate Money Demand (cont.)

When income
increases, real money
demand increases at
every interest rate.

5/29/2026 mulugeta A. 65
 The Money Market
• The money market uses the (aggregate) money demand and
(aggregate) money supply.

• The condition for equilibrium in the money market is:

Ms = Md

• Alternatively, we can define equilibrium using the supply of real

money and the demand for real money (by dividing both sides by
the price level):

Ms/P = L(R,Y)

• This equilibrium condition will yield an equilibrium interest rate.

5/29/2026 mulugeta A. 66
 The Money Market (cont.)
• When there is an excess supply of money, there is an excess
demand for interest bearing assets.

– People with an excess supply of money are willing to acquire

interest bearing assets (by giving up their supply of money)
at a lower interest rate.

– Potential money holders are more willing to hold additional

quantities of money as the interest rate (the opportunity cost
of holding money) falls.

5/29/2026 mulugeta A. 67
 The Money Market (cont.)
• When there is an excess demand for money, there is an excess
supply of interest bearing assets.

– People who desire money but do not have access to it are

willing to sell assets with a higher interest rate in return for
the money balances that they desire.

– Those with money balances are more willing to give them up

in return for interest bearing assets as the interest rate on
these assets rises and as the opportunity cost of holding
money (the interest rate) rises.
5/29/2026 mulugeta A. 68
 Money Market Equilibrium

5/29/2026 mulugeta A. 69
 Changes in the Money Supply
A decrease in the
money supply raises
the interest rate for a
given price level.

An increase in
the money supply
lowers the interest
rate for a given
price level.

5/29/2026 mulugeta A. 70
 Changes in National Income

An increase in
national income
increases equilibrium
interest rates for a
given price level.

5/29/2026 mulugeta A. 71
Linking the Money Market to the Foreign Exchange Market

5/29/2026 mulugeta A. 72
 Linking the Money Market to the Foreign Exchange
Market (cont.)

Interest
rate, R
R1
Interest
rate, R Aggregate real
money supply

money supply
Aggregate real
MS
Aggregate real

P
R1 money demand,
L(R,Y)

holdings
Real money

L(R,Y)
money demand,
Aggregate real
MS Real money
P holdings

5/29/2026 mulugeta A. 73
Linking the Money
Market
to the Foreign
Exchange
Market (cont.)

5/29/2026 mulugeta A. 74
Changes in the
Domestic
Money Supply

5/29/2026 mulugeta A. 75
 Changes in the Money Supply
• An increase in a country’s money supply causes its
currency to depreciate.
• A decrease in a country’s money supply causes its
currency to appreciate.

mulugeta A.
5/29/2026 14-76
 Changes in the Foreign Money Supply

• How would a change in the euro money supply affect

the US money market and foreign exchange market?

• An increase in the EU money supply causes a

depreciation of the euro (appreciation of
the dollar).
• A decrease in the EU money supply causes an
appreciation of the euro (a depreciation of the
dollar).

mulugeta A.
5/29/2026 14-77
 Changes in the
Foreign Money
Supply (cont.)

mulugeta A.
5/29/2026 14-78
 Changes in the
Foreign Money Supply (cont.)
• The increase in the EU money supply reduces
interest rates in the EU, reducing the expected return
on euro deposits.
• This reduction in the expected return on euro
deposits leads to a depreciation of the euro.
• The change in the EU money supply does not change
the US money market equilibrium.

mulugeta A.
5/29/2026 14-79
 Long Run and Short Run
• In the short run, the price level is fixed at some level.
– the analysis heretofore has been a short run analysis.
• In the long run, prices of factors of production and of
output are allowed to adjust to demand and supply in their
respective markets.
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers
and other factors of production—by the economy’s productive
capacity—not by the supply of money.
– The interest rate depends on the supply of saving and
the demand for saving in the economy and the inflation rate—and
thus is also independent of the money
supply level.
mulugeta A.
5/29/2026 14-80
 Long Run and Short Run (cont.)
• In the long run, the level of the money supply does
not influence the amount of real output nor the
interest rate.
• But in the long run, prices of output and
inputs adjust proportionally to changes in the money
supply:
– Long run equilibrium: Ms/P = L(R,Y)
– Ms = P x L(R,Y)
– increases in the money supply are matched by
proportional increases in the price level.

mulugeta A.
5/29/2026 14-81
 Long Run and Short Run (cont.)
• In the long run, there is a direct relationship between
the inflation rate and changes in the money supply.
– Ms = P x L(R,Y)
– P = Ms/L(R,Y)
– P/P = Ms/Ms - L/L
– The inflation rate equals growth rate in money supply
minus the growth rate for money demand.

mulugeta A.
5/29/2026 14-82
mulugeta A.
5/29/2026 14-83
 Money and Prices in the Long Run
• How does a change in the money supply cause prices of
output and inputs to change?
1. Excess demand: an increase in the money supply implies
that people have more funds available to pay for goods and
services.
– To meet strong demand, producers hire more workers, creating a
strong demand for labor, or make existing employees work harder.
– Wages rise to attract more workers or to compensate workers for
overtime.
– Prices of output will eventually rise to compensate for higher costs.

mulugeta A.
5/29/2026 14-84
 Money and Prices in the Long Run (cont.)

– Alternatively, for a fixed amount of output and inputs, producers

can charge higher prices and still sell all of their output due to
the strong demand.
2. Inflationary expectations:
– If workers expect future prices to rise due to an expected money
supply increase, they will want to be compensated.
– And if producers expect the same, they are more willing to raise
wages.
– Producers will be able to match higher costs if they expect to
raise prices.
– Result: expectations about inflation caused by an expected
money supply increase leads to actual inflation.

mulugeta A.
5/29/2026 14-85
 Money, Prices and the
Exchange Rates and Expectations
• When we consider price changes in the long run,
inflationary expectations will have an effect in the
foreign exchange market.

• Suppose that expectations about inflation change as

people change their minds, but actual adjustment of
prices occurs afterwards.

mulugeta A.
5/29/2026 14-86
 Money, Prices and
the Exchange Rates
and Expectations (cont.)
Change in expected
return on euro deposits

The expected return on

euro deposits rises because
of inflationary expectations:
•The dollar is expected to
be less valuable when
buying goods and services
and less valuable when
buying euros.
•The dollar is expected to
depreciate, increasing the
return on deposits in euros.

5/29/2026 mulugeta A. 87
 Original
Money, Prices and the (long run)
return
Exchange Rates in the on dollar
Long Run deposits

As prices increases,
the real money
supply decreases
and the domestic
interest rate returns
to its long run rate.
mulugeta A.
5/29/2026 14-88
 Money, Prices and the
Exchange Rates in the Long Run (cont.)
• A permanent increase in a country’s money supply causes a
proportional long run depreciation of its currency.
– However, the dynamics of the model predict a large depreciation first
and a smaller subsequent appreciation.

• A permanent decrease in a country’s money supply causes a

proportional long run appreciation of its currency.
– However, the dynamics of the model predict a large appreciation first
and a smaller subsequent depreciation.

mulugeta A.
5/29/2026 14-89
mulugeta A.
5/29/2026 14-90
 Exchange Rate Overshooting
• The exchange rate is said to overshoot when its immediate
response to a change is greater than its long run response.
– We assume that changes in the money supply have immediate
effects on interest rates and exchange rates.
– We assume that people change their expectations about inflation
immediately after a change in the money supply.
• Overshooting helps explain why exchange rates are so
volatile.
• Overshooting occurs in the model because prices do not
adjust quickly, but expectations about prices do.

mulugeta A.
5/29/2026 14-91
 Exchange Rate Volatility
Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.

Exchange rates are

influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.

mulugeta A.
5/29/2026 14-92
 Summary
1. Money demand on an individual level is determined by
interest rates and liquidity, the latter of which is
influenced by prices and income.
2. Money demand on an aggregate level is determined by
interest rates, the price level and national income.
– Aggregate real money demand depends negatively on the
interest rate and positively on real national income.
3. Money supply equals money demand—or real money
supply equals real money demand—at the equilibrium
interest rate in the money market.

mulugeta A.
5/29/2026 14-93
 Summary (cont.)
4. Short run scenario: changes in the money supply
affect the domestic interest rate, as well as the
exchange rate.
– An increase in the domestic money supply
1. lowers the domestic interest rate,
2. lowering the rate of return on domestic deposits,
3. causing the domestic currency to depreciate.

mulugeta A.
5/29/2026 14-94
 Summary (cont.)
5. Long run scenario: changes in the level of the money supply
are matched by a proportional
change in prices, and do not affect real income and interest
rates.
– An increase in the money supply
1. causes expectations about inflation to adjust,
2. causing the domestic currency to depreciate further,
3. and causes prices to adjust proportionally in the long run,
4. causing interest rates return to their long run rate,
5. and causes a proportional long run depreciation in the exchange
rate.

mulugeta A.
5/29/2026 14-95
 Summary (cont.)
6. Expectations about inflation adjust quickly, but
prices adjust only in the long run, which results in
overshooting of exchange rate.
– Overshooting occurs when the immediate response of
the exchange rate due to a change is greater than its
long run response.
– Overshooting helps explain why exchange rates are so
volatile.

mulugeta A.
5/29/2026 14-96
mulugeta A.
5/29/2026 14-97
5/29/2026 mulugeta A. 98
 Chapter Three

Balance of Payment (BOP)

By: Mulugeta A.

Mulugeta A. 99
 BALANCE OF PAYMENTS
 Definition and Purposes of Balance of Payments

 The balance of payments accounts is a record of all

international transactions that are undertaken between
residents of one country and residents of other countries during
the year.

 The main purpose of the balance of payments is to inform the

government of the international position of the nation and to
help it in its formulation of monetary, fiscal, and trade policies.

Mulugeta A. 100
 Cont..
 Residents are broadly interpreted as all individuals, businesses, and
government agencies.

 Although a corporation is considered to be a resident of the country in which it

is incorporated, its overseas branch or subsidiary is not.

 Military staffs, government diplomats, tourists, and workers who emigrate

temporarily are considered residents of the country in which they hold
citizenship.

 International institutions such as the United Nations, the

 International Monetary Fund (IMF), the World Bank, and the World Trade
Organization (WTO) are not residents of the nation in which they are located.

Mulugeta A. 101
 Balance-of-Payments Accounting Principles
• Credits and Debits

• International transactions are classified as credits or debits.

• Credit transactions are those that involve the receipt of payments from

foreigners.

• Debit transactions are those that involve the making of payments to

foreigners.

• Credit transactions are entered with a positive sign, and debit transactions are

entered with a negative sign in the nation‟s balance of payments.

• Thus, the export of goods and services, unilateral transfers (gifts) received

from foreigners, and capital inflows are entered as credits (+) because they

involve the receipt of payments from foreigners.

Mulugeta A. 102
• On the other hand, the import of goods and services, unilateral
transfers or gifts made to foreigners, and capital outflows involve
payments to foreigners and are entered as debits (–) in the nation‟s
balance of payments.
• Financial inflows can take either of two forms: an increase in foreign
assets in the nation or a reduction in the nation’s assets abroad.
• For example, when a U.K. resident purchases a U.S. stock, foreign
assets in the United States increase. This is a capital inflow to the
United States and is recorded as a credit in the U.S. balance of
payments because it involves the receipt of a payment from a
foreigner.

Mulugeta A. 103
 The General Rule in BOP Accounting
A. If a transaction earns foreign currency for the nation, it is a
credit and is recorded as a plus item.

B. If a transaction involves spending of foreign currency it is a

debit and is recorded as a negative item.

Mulugeta A. 104
 A capital inflow can also take the form of a reduction in the nation‟s
assets abroad.
 For example, when a U.S. resident sells a foreign stock, U.S. assets
abroad decrease.
 This is a capital inflow to the United States (reversing the capital
outflow that occurred when the U.S. resident purchased the foreign
stock) and is recorded as a credit in the U.S. balance of payments
because it too involves the receipt of a payment from foreigners.
 On the other hand, financial outflows can take the form of either an
increase in the nation‟s assets abroad or a reduction in foreign assets
in the nation because both involve a payment to foreigners.

Mulugeta A. 105
 For example, the purchase of a U.K. treasury bill by a U.S. resident increases U.S. assets
abroad and is a debit because it involves a payment to foreigners.

 Similarly, the sale of its U.S. subsidiary by a German firm reduces foreign assets in the
United States and is also a debit because it involves a payment to foreigners. (The
student should study these definitions and examples carefully, since mastery of these
important concepts is crucial to understanding what follows.)

 To summarize, the export of goods and services, the receipt of unilateral transfers, and
financial inflows are credits (+) because they all involve the receipt of payments from
foreigners.

 On the other hand, the import of goods and services, unilateral transfers to foreigners,
and financial outflows are debits (–) because they involve payments to foreigners.

Mulugeta A. 106
 Double-Entry Bookkeeping
• In recording a nation‟s international transactions, the accounting procedure
known as double-entry bookkeeping is used.

• This means that each international transaction is recorded twice, once as a

credit and once as a debit of an equal amount. The reason for this is that
in general every transaction has two sides. We sell something and we
receive payment for it. We buy something and we have to pay for it.

• For example, suppose that a U.S. firm exports $500 of goods to be paid
for in three months.

• The United States first credits goods exports for $500 since this goods
export will lead to the receipt of a payment from foreigners. The payment
itself is then entered as a financial debit because it represents a financial
outflow from the United States. Mulugeta A. 107
 That is, by agreeing to wait three months for payment, the U.S. exporter is
extending credit to, and has acquired a claim on, the foreign importer.

 This is an increase in U.S. assets abroad and a debit.

 The entire transaction is entered as follows in the U.S. balance of

payments:

Mulugeta A. 108
Assume that transactions take place between, say, Ethiopian
residents and foreigners, and that all payments are financed in birrs.
 Given these assumptions, the following transactions are credits which lead to
the receipt of birr from foreigners from the Ethiopian perspective.

 Merchandise (goods and services) exports;

 Transportation and travel receipts;

 Income received from investments abroad;

 Gifts received from foreign residents;

 Aid received from foreign governments;

 Investments in Ethiopia by overseas residents.

Mulugeta A. 109
 Debits from Ethiopian view point, which involve payments to
foreigners? They include the following:

 Merchandise (goods and services) imports;

 Transportation and travel expenditures ;

 Income paid on investments of foreigners;

 Gifts to foreign residents!

 Aid given by the Ethiopian government!

 Overseas investment by Ethiopian residents.

Mulugeta A. 110
 The Balance of Payments (BoP) for a country is a record of all the financial
transactions that occur between it and the rest of the world
The BoP has two main sections:

 The current account: all transactions related to goods/services along with

payments related to the transfer of income

 The financial and capital account: all transactions related to savings,

investment and currency stabilisation.

 Money flowing into an account is recorded in the relevant account as a credit

(+) and money flowing out as a debit (-)

 If more money flows into an account than out of it, there is a surplus in the
account

 If more money flows out of an account than into it, there is a deficit in the
account

Mulugeta A. 111
• Goods are also referred to as visible exports/imports

• Services are also referred to as invisible exports/imports

• Net income consists of income transfers by citizens and corporations

• Credits are received from UK citizens who are abroad and

send remittances home

• Debits are sent by foreigners working in the UK back to their countries

• Current transfers are typically payments at government level between

countries e.g. contributions to the World Bank

Mulugeta A. 112
 Components of balance of payment
• BOP have four main components
 It is of a balancing entry and is
needed to offset the overstated
Errors &
or understated components.
Omissions

Current Official Reserves

account account

BOP  IMF
 Merchandise balance,  SDR( Special Drawing Right)
 Services balance and  Reserve and Monetary
 Unilateral Transfer Gold
balance. capital
account

 international purchases & sales of real

estate, stocks & bonds, government
securities and commercial bank deposits
Mulugeta A. 113
 Current Account

 BOP on current account refers to the inclusion of three balances

of namely – Merchandise balance, Services balance and
Unilateral Transfer balance.
 In other words it reflects the net flow of goods, services and
unilateral transfers (gifts).
 The net value of the balances of visible trade and of invisible
trade and of unilateral transfers defines the balance on current
account.

Mulugeta A. 114
Mulugeta A. 115
 Capital Account

 The capital account records all international transactions that involve

a resident of the country concerned changing either his assets with or
his liabilities to a resident of another country.
 Transactions in the capital account reflect a change in a stock –
either assets or liabilities.
 It is difference between the receipts and payments on account of
capital account.
 It refers to all financial transactions.
 The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium term to long
term borrowing/lending.

Mulugeta A. 116
Mulugeta A. 117
 The Reserve Account

 Three accounts: IMF, SDR, & Reserve and Monetary Gold are
collectively called as The Reserve Account.

 The IMF account contains purchases (credits) and re-purchase

(debits) from International Monetary Fund. Special Drawing
Rights (SDRs) are a reserve asset created by IMF and allocated
from time to time to member countries.

 It can be used to settle international payments between

monetary authorities of two different countries.

Mulugeta A. 118
Mulugeta A. 119
 Example

•The Current Account is often considered to be the most important

account in the BoP
•This account records the net income that an economy gains from
international transactions
An Example of the UK Current Account Balance for 2017

Component 2017
Balance of trade in goods (exports - imports) £-32.9bn
Balance of trade in services (exports -
£27.9bn
imports)
Sub-total trade in goods/services £-5bn
Net income (interest, profits and dividends) £-2.1bn
Current transfers £-3.6bn
Total Current Account Balance £-10.7bn
Current Account as a % of GDP 3.7%
Mulugeta A. 120
Example2 U.S. BALANCE OF PAYMENTS * (2007)
Current Account
1)U.S. goods exports............................................................................... $+1149
2)U.S. goods imports............................................................................... -1968
3)Balance on goods......(lines 1 + 2)............................................................. - 819
4)U.S. services exports............................................................................ + 497
5)U.S. services imports............................................................................ - 378
6)Balance on services........(lines 4 +5)....................................................................... + 119
7)Balance on goods and services.......(lines 3 + 6)......................................................... - 700
8)Net investment income..(net interest & dividend payments on foreign financial assets)..... + 82
9)Net transfers (foreign aid, pensions for US retirees living abroad, money sent home by immigrants) - 113
10)Balance on current account ...(lines 7 + 8+ 9)........................................................ - 731
Capital Account
11)Foreign purchases of assets in the U.S..(foreigners buying US assets) ...........+ 2058
12)U.S. purchases of assets abroad...(US citizens buying foreign assets).............- 1289
13)Balance on capital account..........(lines 11 + 12)..................................................... + 768
14)Balance on current and capital account (10 + 13) ....................................................... + 37
Official Reserves account
14)Official reserves (the amount the Federal Reserve must inject or subtract to bring the balance to 0) - 37

BALANCE OF PAYMENTS $0
*in billion of US dollars

Mulugeta A. 121
 Balance of Trade and Balance of Payments
• The Balance of Payment takes into account all the transaction
with the rest of the worlds
• The Balance of Trade takes into account all the trade
transaction with the rest of the worlds

Mulugeta A. 122
 Balance of Payments Disequilibria
• A disequilibrium in the balance of payment
means its condition of Surplus Or deficit.
• A Surplus in the BOP occurs when Total
Receipts exceeds Total Payments. Thus
𝐵𝑂𝑃 = 𝐶𝑅𝐸𝐷𝐼𝑇 > 𝐷𝐸𝐵𝐼𝑇
A Deficit in the BOP occurs when Total Payments
exceeds Total Receipts. Thus,
"BOP = CREDIT < DEBIT"

Mulugeta A. 123
National Income Accounting for an Open Economy
• The National Income Identity for an Open Economy
– It is the sum of domestic and foreign expenditure on the goods and services
produced by domestic factors of production:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐸𝑋 – 𝐼𝑀 (𝑒𝑞1)
where:
• Y is GNP
• C is consumption
• I is investment
• G is government purchases
• EX is exports
• IM is imports
– In a closed economy, EX = IM = 0.

Mulugeta A. 124
 The Current Account and Foreign Indebtedness
– Current account (CA) balance
• The difference between exports of goods and services and imports of goods and services (CA = EX
– IM)
• A country has a CA surplus when its CA > 0.
• A country has a CA deficit when its CA < 0.
• CA measures the size and direction of international borrowing.
– A country‟s current account balance equals the change in its net foreign wealth.

 CA balance is equal to the difference between national income and

domestic residents‟ spending:
𝑌 – (𝐶 + 𝐼 + 𝐺) = 𝐶𝐴

• CA balance is goods production less domestic demand.

• CA balance is the excess supply of domestic financing.

Mulugeta A. 125
• Saving and the Current Account

– National saving (S)

• The portion of output, Y, that is not devoted to household consumption, C, or

government purchases, G.

• It always equals investment in a closed economy.

– A closed economy can save only by building up its capital stock (S = I).

– An open economy can save either by building up its capital stock or by

acquiring foreign wealth (S = I + CA).

• A country‟s CA surplus is referred to as its net foreign investment.

Mulugeta A.
Slide 12-126
• Private and Government Saving

– Private saving (Sp)

• The part of disposable income that is saved rather than consumed

𝑆𝑝 = 𝐼 + 𝐶𝐴 – 𝑆𝑔 = 𝐼 + 𝐶𝐴 – (𝑇 – 𝐺) = 𝐼 + 𝐶𝐴 + (𝐺 – 𝑇) (𝑒𝑞 2)

– T is the government's “income” (its net tax revenue)

– Sg is government savings (T-G)

– Government budget deficit (G – T)

• It measures the extent to which the government is borrowing to finance

its expenditures.

Mulugeta A.
Slide 12-127
Mulugeta A. 128
 Net Foreign Investment and the Current Account Balance

o Note: The government’s surplus/deficit is 𝑇 − 𝐺

o current account surplus => excess of exports over imports => net supplier of funds
=> improves net foreign investment position

o current account deficit => excess of imports over exports => net demander of funds
=> decline in net foreign investment position

o net borrowing:

(𝑮 − 𝑻) + (𝑰 – 𝑺) = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑐𝑐𝑜𝑢𝑛𝑡

Government Deficit (net

Private saving
deficit bprrowing)

Mulugeta A. 129
 Is Current Account Deficit a Problem?

 A current account deficit has little to do with inherent inability

of a country to sell goods in world market.

 Rather, such a deficit indicates imports were needed to meet

the domestic demand for goods and services.

 Current account deficits are not reversed by trade policies

that attempt to alter the levels of import or exports.

 Resulting debt is less problematic if funds are used for

investment spending rather than consumption spending.

Mulugeta A. 130
 Causes of Disequilibrium In The Bop
 Cyclical fluctuations
 Short fall in the exports
 Economic Development
 Rapid increase in population
 Structural Changes
 Natural Calamites
 International Capital Movements
 random variation on trade
 seasonal fluctuation, the effects of weather on agricultural production
 Technology changes in the method of production
 Changes in the rate of exchange
Mulugeta A. 131
METHODS OF CORRECTING OR ADJUSTING DISEQUILIBRIUM
• When there as a deficit or surplus in the balance of payments of a country
adjustment is brought about automatically through price and income changes or by
adopting certain policy measures like devaluation and direct controls.

• Persistent disequilibrium in the balance of payments particularly the deficit balance

is undesirable because it:

1. Weakness the country‟s economic position at the international level. And

2. Affects the progress of the economy adversely.

 It might be cured by taking appropriate measure.

 There are money methods to correct disequilibrium in the balance of payments.

Mulugeta A. 132
 How to correct the Balance of Payment?
1. Monetary measures :

A. Deflation: Deflation means falling prices. Deflation has been used as a measure to correct

deficit disequilibrium.

 A country faces deficit when its imports exceeds exports.

 Deflation is brought through monetary measures or through fiscal measures like higher

taxation, reduction in public expenditure, etc.

 Deflation would make our items cheaper in foreign market resulting a rise in our exports.

 At the same time the demands for imports fall due to higher taxation and reduced income.

 This would build a favourable atmosphere in the balance of payment position.

 However Deflation can be successful when the exchange rate remains fixed.
Mulugeta A. 133
 Cont..
• A current account deficit occurs when the value of imports (of
goods/services/inv. incomes) is greater than the value of exports.
• Policies to reduce a current account deficit involve:
1. Devaluation of exchange rate (make exports cheaper – imports
more expensive)
2. Reduce domestic consumption and spending on imports (e.g. tight
fiscal policy/higher taxes)
3. Supply side policies to improve the competitiveness of domestic
industry and exports.

Mulugeta A. 134
 B. Devaluation

 This involves reducing the value of the currency against others.

 If there is a devaluation of the currency, the price of imported goods

increases and therefore the quantity demanded of imports falls.

 Exports will become cheaper, and there will be an increase in the

quantity of exports.

 Therefore, assuming demand is relatively price elastic, we would

expect a devaluation to lead to an improvement in (X-M) and

therefore the current account on the balance of payments.

 However, it does depend upon the elasticity of demand for exports

and imports. Mulugeta A. 135

 The Marshall Learner Condition
 This states that a devaluation will improve the balance on the
current account, on the condition that the combined elasticity‟s
of demand for imports and exports is greater than one.

 If (PED x + PED m > 1) then a devaluation will improve the

current account.

 If (PED x + PED m > 1) then an appreciation will worsen the

current account.

Mulugeta A. 136
 Devaluation also suffers from certain defects
1. Devaluation is a clear reflection on the country‟s economic
weakness.
2. It reduces the confidence of the people in other country‟s
currency and this may tend to speculative out flow of
capital
3. It encourages inflationary tendency in the home country.
4. It increases the burden of foreign debt.

Mulugeta A. 137
 C. EXCHANGE CONTROL
• Exchange controls refer to the control over the use of foreign
exchange by the control bank.

• Under this method all the exporters are directed by the central
bank it surrenders their foreign exchange earnings.

• Foreign exchange is licensed among the licensed importers,

only essential importers are permitted.

Mulugeta A. 138
 Non-Monetary Measures
A. Export Promotion: –

 The government can adopt export promotion measures to

correct disequilibrium in the balance of payments. This includes

substitutes, tax concessions to exporters, marketing facilities,

credit and incentives to exporters, etc.

 The government may also help to promote export through

exhibition, trade fairs; conducting marketing research & by

providing the required administrative and diplomatic help to

tap the potential markets

Mulugeta A. 139
 B. Quotas
• Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period.

• By restricting imports through the quota system, the deficit is reduced and the
balance of payments position is improved.

C. Tariffs:
 Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the
prices of imports would increase to the extent of tariff. The increased prices will
reduced the demand for imported goods and at the same time induce domestic
producers to produce more of import substitutes.

 Non-essential imports can be drastically reduced by imposing a very high rate

of tariff.
Mulugeta A. 140
 THE EFFECT OF EXCHANGE RATE ON THE BALANCE OF
PAYMENT

• foreign exchange rate has a significant positive impact on the

balance of payment.

 The top three approaches of balance of payments are:

1. The Elasticity Approach

2. The Absorption Approach

3. The Monetary Approach.

Mulugeta A. 141
 1. The Elasticity Approach:
• Marshall-Lerner Condition:

• The elasticity approach to BOP is associated with the Marshall-Lerner condition

which was worked out independently by these two economists.

• It studies the conditions under which exchange rate changes restore equilibrium in

BOP by devaluing a country‟s currency.

• This approach is related to the price effect of devaluation.

• Assumptions:

• This analysis is based on the following assumptions:

• 1. Supplies of exports are perfectly elastic.

• 2. Product prices are fixed in domestic currency.

• 3. Income levels are fixed in the devaluing country.

Mulugeta A. 142
4. The supply of imparts are large.

5. The price elasticity's of demand for exports and imports are arc elasticity's.

6. Price elasticity's refer to absolute values.

7. The country‟s current account balance equals its trade balance.

• Given these assumptions, when a country devalues its currency, the domestic prices of its
imports are raised and the foreign prices of its exports are reduced.

• Thus devaluation helps to improve BOP deficit of a country by increasing its exports and
reducing its imports.

• But the extent to which it will succeed depends on the country’s price elasticity's of
domestic demand for imports and foreign demand for exports.

• This is what the Marshall-Lerner condition states: when the sum of price elasticity's of
demand for exports and imports in absolute terms is greater than unity, devaluation will
improve the country’s balance of payments, i.e. ex + em > 1

Mulugeta A. 143
• where ex is the demand elasticity of exports and em is
the demand elasticity for imports.

• On the contrary, if the sum of price elasticity's of demand

for exports and imports, in absolute terms, is less unity,
𝑒𝑥 + 𝑒𝑚 < 1

 devaluation will worsen (increase the deficit) the BOP.

 If the sum of these elasticity's in absolute terms is equal

to unity, 𝑒𝑥 + 𝑒𝑚 = 1, devaluation has no effect on the
BOP situation which will remain unchanged.
Mulugeta A. 144
 The J-Curve Effect:
• Empirical evidence shows that the Marshall- Lerner condition is satisfied in

the majority of advanced countries.

• But there is a general consensus among economists that both demand-supply

elasticity's will be greater in the long run than in the short run.

• The effects of devaluation on domestic prices and demand for exports and

imports will take time for consumers and producers to adjust themselves to

the new situation.

• The short-run price elasticity's of demand for exports and imports are lower

and they do not satisfy the Marshall-Lerner condition.

• Therefore, to begin with, devaluation makes the BOP worse in the short- run

and then improves it in the long-run.

Mulugeta A. 145
• This traces a J-shaped curve through time. This is known as the J-curve effect of

devaluation.

• The Absorption Approach

• The absorption approach to balance of payments is general equilibrium in nature

and is based on the Keynesian national income relationships.

• It is, therefore, also known as the Keynesian approach.

• It runs through the income effect of devaluation as against the price effect to the

elasticity approach.

• The theory states that if a country has a deficit in its balance of payments, it means

that people are „absorbing‟ more than they produce.

• Domestic expenditure on consumption and investment is greater than national income.

Mulugeta A. 146
 If they have a surplus in the balance of payments, they are absorbing less.

 Expenditure on consumption and investment is less than national income.

 Here the BOP is defined as the difference between national income and

domestic expenditure.

 This approach was developed by Sydney Alexander. The analysis can be

explained in the following form

 𝑌 = 𝐶 + 𝐼𝑑 + 𝐺 + 𝑋 − 𝑀 … (1)

 where Y is national income, C is consumption expenditure, total domestic

investment, G is autonomous government expenditure, X represents exports

and M imports.

Mulugeta A. 147
• The sum of (C + Id + G) is the total absorption designated as A, and the
balance of payments (X – M) is designated as B.
 Y = A + B or B = Y-A …(2)
 First, devaluation increases exports and reduces imports, thereby
increasing the national income.

Mulugeta A. 148
 The Monetary Approach:
• The monetary approach to the balance of payments is an
explanation of the overall balance of payments.
• It explains changes in balance of payments in terms of the
demand for and supply of money.
• According to this approach, “a balance of payments deficit
is always and everywhere a monetary phenomenon.”
• Therefore, it can only be corrected by monetary measures.

Mulugeta A. 149
• This approach is based on the following assumptions:

1. The Taw of one price‟ holds for identical goods sold in different countries, after allowing for

transport costs.

2. There is perfect substitution in consumption in both the product and capital markets which

ensures one price for each commodity and a single interest rate across countries.

3. The level of output of a country is assumed exogenously.

4. All countries are assumed to be fully employed where wage price flexibility fixes output at full

employment.

5. It is assumed that under fixed exchange rates the sterilisation of currency flows is not possible

on account of the law of one price globally.

Mulugeta A. 150
6. The demand for money is a stock demand and is a stable function of income, prices, wealth

and interest rate.

7. The supply of money is a multiple of monetary base which includes domestic credit and the

country‟s foreign exchange reserves.

[Link] demand for nominal money balances is a positive function of nominal income.

 Given these assumptions, the monetary approach can be expressed in the form of the

following

relationship between the demand for and supply of money:

 The demand for money (MD) is a stable function of income (Y), prices (P) and rate of

interest (i)

𝑀𝐷 = 𝑓(𝑌, 𝑃 , 𝑖) , , , , , , , , , , , , , , , , , , , (1)

 Since in equilibrium the demand for money equals the money supply, Md = Ms

Mulugeta A. 151
 The money supply (Ms) is a multiple of monetary base (m)
which consists of domestic money (credit) (D) and country‟s
foreign exchange reserves (R).

 Ignoring m for simplicity which is a constant,

𝑀𝑠 = 𝐷 + 𝑅 . . (2)

Mulugeta A. 152