The Elasticity Approach to the Balance of Payments

As indicated in the last chapter the elasticity approach to the analysis of balance-of-payments adjustment based on the Marshall-Lerner condition rests on several restrictive assumptions. First, the analysis is founded upon partial equilibrium in the sense that it considers only the effect of exchange-rate variations in the market for exports and imports, and everything else is held constant, so that the position of the demand curves for exports and imports themselves are held constant. In practice everything else will not remain constant. Exchange-rate changes will have price effects elsewhere in the system which will shift the demand curves for exports and imports. Income will also change, affecting the demand curves for exports and imports. A second restrictive assumption is that all relevant elasticities of supply of output are assumed to be infinite so that the price of exports in the home currency does not rise as demand increases, the price of foreign goods that compete with exports does not fall as demand for them fails, the price of imports in foreign currency does not fall as the demand for imports falls, and the price of domestic goods competing with imports does not rise as the demand for import substitutes increases. There are four elasticities of supply to consider: the elasticity of supply of exports; the elasticity of supply of foreign goods that compete with exports; the foreign elasticity of supply of imports; and the elasticity of supply of home goods that compete with imports.