PKT message, The Absorption Approach

The only thing I have at hand on the "absorption" approach (not being an
academic economist) are the following opening paragraphs an "Introductory
Survey" by (then) IMF staff members Rudolf R. Rhomberg and H. Robert Heller
(later Federal Reserve Governor) as editors of "The Monetary Approach to the
Balance of Payments", a collection of IMF staff papers published by the IMF
in 1977.

"The methods employed in analyzing the effects of economic changes on a
country's balance of payments have undergone drastic revision in the course
of the last 50 years. The evolution of economic ideas and analytical
methods generally follows, although sometimes with a considerable lag, the
emergence of economic problems requiring solution. Balance of payments
analysis, too, has been influenced directly by the changing character of
international economic problems; in addition, however, it has also been
affected by changing methodological fashions in the mainstream of economic
thought.

"In the period following World War I, when the problems of resource
allocation occupied the center of the stage, the tools of value theory -
demand and supply schedules and their elasticities - were applied to the
then new problem of exchange devaluation. After World War II, economic
theory was dominated by the memory of the Great Depression of the 1930s and
by Keynes's method of analyzing it. In particular, partial equilibrium
analysis of the labor market and of the determination of wage rates had come
to be regarded as faulty and misleading, since a change in the wage rate -
the most important price in the economy - would have macroeconomic
repercussions leading to shifts in the labor demand and supply schedules.
Applying this methodological point to balance of payments analysis, it was
easy to see that the "elasticities approach" to analyzing the effects of a
change in the exchange rate - for many economies, another very important
price - was subject to a similiar criticism. A devaluation tends to affect
not only the relative prices of traded and domestic goods but also aggregate
income and expenditure. The second effect induces shifts in the demand and
supply schedules and thus invalidates the basic supposition of the simple
"elasticities approach," namely, unchanging demand and supply schedules.

"This difficulty was avoided by following a method that was much more in
keeping with the Keynesian framework of macroeconomic analysis. This
approach, which developed largely on the basis of research in the Fund
conducted under the guidance of E. M. Bernstein, views the balance of
payments on current account as the difference between national income and
national expenditure (or absorption). The effect of any economic change -
for instance, a devaluation - on the current balance is, therefore, best
assessed by ascertaining its effects on output (income) and on absorption,
and by subtracting the latter from the former. This "income-absorption
approach" has been criticized on two grounds: first, like the elasticities
approach, it does not deal with the balance of payments as a whole but only
with the current account; second, while it lends itself readily to an
analysis of the effects on the current account of changes directly affecting
income and absorption - for instance, of an increase in government
expenditure - it is much less suited for an assessment of changes affecting,
in the first instance, exchange rates and prices." (pp. 1-2)

Of course, when "the balance of payments on current account [is viewed] as
the difference between national INCOME and national EXPENDITURE (or
absorption)," it is immediately clear that NON-current-INCOME-related
purchasing power - CREDIT of some sort - MUST fill the gap between the two.

Yet, as evidenced by the statements by Greenspan and Davidson on which I
have commented on PKT in the past few days, the self-evident is no longer so
once the concept of "income" is defined to include both Factor Income and
what, for analytical purposes, I have termed Final Demand Inflation - the
"source" in the US economy of both Entrepreneurial Profits and the Current
Account Deficit of $500 billion per annum.

Gunnar

The Absorption Approach - Background