2.2 The absorption approach to the balance of paym...
One of the major defects of the elasticity approach is that it is based upon the assumption that all other things are equal.However, changes in export and import volumes will by definition have implications for national income and consequently income effects need to be incorporated in a more comprehensive analysis of the effects of a devaluation.Alexander (1952)gave an important evaluation of this effect, focusing on the fact that a current account imbalance can be viewed as the difference between domestic output and domestic spending (absorption).
Taking the equation for national income:

And defining domestic absorption as A=C+I+G, then we can get:

This equation says that the current account (CA)represents the difference between domestic output and domestic absorption.A current account surplus means that domestic output exceeds domestic spending, while a current account deficit means that domestic output is less than domestic spending.Transforming equation (2.2)into a different form yields:

Equation (2.3)implies that the effects of a devaluation on the current account will depend upon how it affects national income relative to domestic absorption.If a devaluation raises domestic income relative to domestic absorption, the current account improves.If, however, devaluation raises domestic absorption relative to domestic income the current account deteriorates.Understanding how devaluation affects both income and absorption is therefore central to the absorption approach to balance of payments analysis.
Absorption can be divided into two parts: A rise in income will lead to an increase in absorption which is determined by the marginal propensity to absorb, a.There will also be a “direct effect” on absorption which is all the other effects on absorption resulting from devaluation denoted by Ad.Thus the change in total absorption, dA, is given by:

Substituting (2.4)into (2.3)yields:

Equation (2.5)reveals that there are three factors that need to be examined when considering the impact of devaluation.(1)Is the marginal propensity able to absorb greater or less than unity? (2)Does devaluation raise or lower national income? (3)Does devaluation raise or lower direct absorption? The condition for a devaluation to improve the current account is (1-a)dY >dAd; that is, any change in income not spent on absorption must exceed any change in direct absorption.
Initially, it was believed that the absorption approach was an alternative to the elasticity approach, the latter concentrating on price effects while the absorption approach concentrated on income effects.However, authors such as Tsiang (1961)and Alexander (1959)showed that the two models are not substitutes, but rather are complementary to each other.
Despite their simplistic assumptions, ambiguous conclusions and deficiencies, the two approaches have remained influential because they contain clear and useful messages for policy-makers.A devaluation is more likely to succeed when elasticity of demand for imports and exports are high and when it is accompanied by measures such as fiscal and monetary restraint that boost income relative to domestic absorption.
The overwhelming weight of empirical estimates suggests that at two years and above horizon the Marshall-Lerner conditions are fulfilled, and that exchange-rate adjustments are an influential tool in eliminating current account deficits.One should not expect a devaluation to work in the same manner for all countries.It will in part be determined by whether or not the economy is at or below full employment and on the structural parameters of the particular economy under consideration.Finally, it should be remembered that both models assume that foreign countries do not react to the competitive advantage gained by the country of currency devaluation.To the extent that they react by devaluing their currencies this will undermine the effectiveness of a devaluation policy.