Absorption is defined as a nations total expenditure on final good and services. The absorption approach emphasizes that changes in real domestic income as a determinant of a nations BOP and exchange rate.
Consider this:
AD=AE = Y = C + I + G + X – M (1)
We can re-express equation (1) as:
CA = X – M = Y – A (2)
Where:
CA: current account balance
A: domestic absorption, C + I + G.
Equation two indicates that the CA is in surplus when domestic output is greater than domestic absorption and the current account is in deficit if the level of domestic absorption exceeds domestic output.
If we take the first difference of equation (2) we get:
dCA = dY – dA (3)
And (3) can be used to imply that the current account will improve or change only if there is a change in the domestic output and domestic absorption. As such domestic output must increase more than domestic absorption or there must b a simultaneous change in both.
So in order to change absorption a policy must be established to reduce expenditure on foreign goods and encourages the purchase of domestic goods for e.g. would be devaluation or import restrictions also called switching policy.
As such if an economy devalues and the domestic income reacts more sensitively than domestic absorption then the CAB of the economy would increase/ improve. But if the devaluation has a greater impact on domestic absorption than domestic income then the CAB will deteriorate.
dA = a(dY) + f(dA) (4)
and substituting (4) into (3) we get
dCA = (1 – a)dY – f(Ad) (5)
From equation (5), a devaluation will reduce the current account balance if (1 – a)dY < f(Ad) but will improve the current account balance of (1 – a)dY > f Ad.
Policies which can be used by a country to affect both output and absorption directly are called expenditure...