Absorption approach to Balance of Payments

The Balance of Payments (BOP) is a systematic record of all economic transactions between a country and the rest of the world over a specific period, usually a year or a quarter. It includes transactions related to trade in goods and services, income flows, capital transfers, and financial investments.

The BOP is divided into two main accounts:

• Current Account – Records exports and imports of goods and services, income receipts and payments, and unilateral transfers like remittances.
• Capital and Financial Account – Includes capital transfers, foreign direct investment (FDI), portfolio investment, and changes in reserves.

A BOP deficit means the country is spending more foreign currency than it earns, which can deplete foreign exchange reserves. A surplus indicates the opposite.

Understanding the causes and remedies of BOP imbalances is crucial for economic policymaking, especially in countries like Nepal that are highly dependent on remittances and imports.

Absorption Approach to Balance of Payments

The Absorption Approach offers a macroeconomic explanation of BOP imbalances. Developed by Sidney Alexander in the 1950s, this approach focuses on the relationship between national income and domestic expenditure—referred to as "absorption".

Unlike elasticity or monetary approaches, the absorption approach links trade balances with total domestic spending and income, making it particularly relevant for policy analysis.

National Income Identity

The approach begins with the basic national income identity:

Y = C + I + G + (X - M)

Where:

• Y = National income
• C = Consumption
• I = Investment
• G = Government spending
• X = Exports
• M = Imports

Let A = C + I + G, representing total domestic absorption. Then,

X - M = Y - A

This shows that the trade balance equals the difference between national income and domestic absorption. A surplus occurs when income exceeds absorption; a deficit occurs when absorption exceeds income.

Implications for BOP Adjustment

To improve the BOP, especially under a fixed exchange rate, a country must:

• Increase national income (Y), or
• Reduce domestic absorption (A)

For example, devaluing the currency can improve exports and reduce imports, thereby raising income. But if it also raises inflation and spending, the net effect may be zero. Hence, macroeconomic policy coordination is essential.

Macroeconomic Policy and the Absorption Approach

The absorption approach emphasizes that exchange rate changes alone are insufficient. Policy must manage income and expenditure together:

• Expansionary policies (like deficit spending or lower interest rates) may worsen the trade balance unless output increases substantially.
• Contractionary policies (like tax hikes or spending cuts) may reduce absorption and improve the BOP but might also reduce growth.

Limitations of the Absorption Approach

• It does not explain how price changes affect exports and imports (elasticity).
• It assumes national output can adjust easily, which may not always be true.
• It overlooks capital flows and focuses only on the current account.
• Absorption is conceptually sound but hard to measure accurately in real time.

Relevance for Nepal

1. Curb Excessive Consumption

Nepal imports a high volume of consumer goods. Policies to encourage domestic alternatives and limit luxury imports can reduce unnecessary absorption.

2. Boost Domestic Production

Raising output through investment in agriculture, manufacturing, and tourism will help national income grow faster than absorption, improving the trade balance.

3. Cautious Fiscal Policy

Public spending should prioritize productive investments over consumption. Populist subsidies can worsen the trade deficit if they raise absorption without raising output.

4. Smart Use of Remittances

Remittances raise income, but if they mainly fuel import-heavy consumption, they don’t improve the structural trade balance. Channeling remittances into investment is more beneficial.

5. Monitor Inflation and Exchange Rate Link

Since Nepal has a fixed exchange rate with India, inflation differentials must be monitored. If Nepal’s inflation is consistently higher, real appreciation could harm exports and worsen the trade deficit.

Conclusion

The absorption approach provides a useful macroeconomic framework to understand the causes of BOP imbalances. It highlights the importance of aligning income and spending, rather than focusing solely on currency values.

For Nepal, sustainable balance of payments improvement depends on managing domestic demand, increasing productive capacity, and channeling external inflows into investment. The lesson is clear: external balance is deeply linked to internal economic behavior.