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Chapter 13: Problem 6

According to the absorption approach, does it make any difference whether a nation's currency depreciates when the economy is operating at less than full capacity versus at full capacity?

Short Answer

Expert verified
According to the absorption theory, a depreciating currency does affect the economy differently depending on whether it is operating at less than full capacity or at full capacity. When operating below full capacity, depreciation can help improve the balance of payment by increasing production, whereas at full capacity, balance of payments might not improve due to inflation.

Step by step solution

01

Understanding the Absorption Approach

The Absorption Approach is a theory related to Balance of Payments (BoP) in an open economy. It states that a nation's balance of payment is determined by the difference between total national income and total domestic absorption, where absorption is the aggregate of consumption, investment, and government spending.
02

Depreciation and less than Full Capacity

When a nation's economy is operating at less than full capacity, depreciation of the currency has the potential to spur domestic production as imported goods become more expensive. This leads to a rise in total national income. As some idle resources (like labor and capital) can be utilized to increase production, an increase in absorption wouldn't fully neutralize the increase in income, thus improving the balance of payments.
03

Depreciation and Full Capacity

However, when the economy is at full capacity, further increasing production is hard. Thus, the depreciation of currency makes foreign goods costly leading to a rise in inflation. The increase in domestic income leads to an equivalent increase in absorption (as all resources are already fully utilized), thus no significant improvement in the balance of payments would occur. Rather, with inflation, it might even worsen.

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Most popular questions from this chapter

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