Elasticity Approach to Balance of Payments

1. Introduction to the Elasticity Approach

The Elasticity Approach is a traditional theory that analyzes how exchange rate changes affect a country's trade balance (exports minus imports). It focuses on the price responsiveness (elasticity) of demand for exports and imports when the exchange rate fluctuates.

• Primarily used to assess whether currency devaluation/depreciation can correct a trade deficit.
• Based on microeconomic principles of demand and supply.
• Most relevant for floating exchange rate regimes, but also applicable in managed/fixed regimes under certain conditions.

2. Core Mechanism: How Exchange Rate Changes Affect Trade

When a country's currency depreciates:

• Exports become cheaper for foreign buyers → Demand for exports rises.
• Imports become more expensive for domestic consumers → Demand for imports falls.

However, the actual impact on the trade balance depends on:

• Price Elasticity of Exports (Ex): How much export demand increases when prices fall.
• Price Elasticity of Imports (Em): How much import demand decreases when prices rise.

3. The Marshall-Lerner Condition

The key condition determining whether depreciation improves the trade balance is:

If E_x + E_m > 1, then devaluation improves the trade balance.

Where:

• E_x = Price elasticity of demand for exports
• E_m = Absolute value of price elasticity of demand for imports

Interpretation:

• If E_x + E_m > 1: Depreciation improves trade balance (elastic demand).
• If E_x + E_m = 1: No effect on trade balance (unitary elasticity).
• If E_x + E_m < 1: Depreciation worsens trade balance (inelastic demand).

4. The J-Curve Effect

Even if the Marshall-Lerner condition holds, the trade balance may initially worsen before improving—a phenomenon called the J-Curve Effect.

Phases of the J-Curve:

1. Short Run (0-6 months):
   • Import and export volumes adjust slowly due to contracts, habits, and delays.
   • Import bills rise (since imports are now costlier in domestic currency).
   • Export revenues don't rise immediately.
   • Result: Trade deficit worsens temporarily.
2. Medium to Long Run (6+ months):
   • Export demand increases (as foreign buyers respond to lower prices).
   • Import demand declines (as domestic consumers shift to local goods).
   • Result: Trade balance improves, forming a "J" shape.

5. Assumptions of the Elasticity Approach

1. Ceteris Paribus (Other factors constant):
   • No changes in income, inflation, or trade policies.
2. Elastic Demand:
   • Export and import demand must be price-sensitive.
3. No Capital Flows:
   • Focuses only on the current account, ignoring financial flows.
4. Perfect Exchange Rate Pass-Through:
   • Changes in exchange rates fully reflect in import/export prices.
5. No Supply Constraints:
   • Exporters can increase production if demand rises.

6. Criticisms and Limitations

1. Ignores Income Effects:
   • Higher import prices reduce real income, affecting consumption.
2. Short-Run vs. Long-Run Elasticities:
   • Demand is often inelastic in the short run but elastic in the long run.
3. Neglects Capital Flows:
   • Modern economies have large financial flows, not just trade.
4. Global Supply Chains:
   • Many goods are imported for re-export, complicating elasticity calculations.
5. Fixed Exchange Rate Constraints:
   • Countries like Nepal (pegged to INR) cannot freely devalue.

7. Relevance for Nepal

Since Nepal has a fixed exchange rate (pegged to the Indian rupee), the elasticity approach has limited direct policy applicability. However:

Key Observations:

• Trade with Non-India Partners (USA, China, EU):
  • If NPR depreciates against USD/EUR, Nepal's exports may become more competitive.
  • But Nepal's exports are low elasticity (few manufactured goods).
• Import Dependence:
  • Nepal imports fuel, machinery, and electronics—demand is inelastic (necessary goods).
  • Depreciation could increase import bills without reducing demand much.
• Policy Alternatives:
  • Since Nepal cannot devalue, it must focus on:
    • Improving export quality (not just price competitiveness).
    • Reducing import dependency (local production).
    • Trade diversification (reducing reliance on India).

9. Conclusion

The Elasticity Approach explains how exchange rate depreciation affects the trade balance through price elasticities. The Marshall-Lerner condition (E_x + E_m > 1) determines whether depreciation works, while the J-Curve Effect explains short-run deterioration before improvement.

For Nepal:

• Limited policy uses due to fixed exchange rate.
• Must focus on non-price competitiveness (quality, infrastructure).
• Works better for trade with non-India partners (USA, China).

Overall, while the Elasticity Approach has limitations, it remains a fundamental tool for understanding trade balance adjustments, especially when combined with the Absorption and Monetary Approaches.