Currency Depreciation: A Critical Essay Evaluate The Three

Currency Depreciationin A Critical Essay Evaluate The Three Major App

Currency depreciation in a critical essay, evaluate the three major approaches to analyzing the economic impact of currency depreciation: 1- the elasticities approach, 2- the absorption approach, 3- and the monetary approach. 4- Compare and contrast the three approaches and provide examples which distinguish them from each other. Your essay is required to be six pages in length, which does not include the title page and reference pages. Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles . APA style guidelines. Turnitin report. ORIGINAL WORK REQUIRED

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Introduction

Currency depreciation, the decline in the value of a nation's currency relative to others, is a phenomenon with profound implications for an economy. Understanding its impacts requires analyzing various theoretical approaches, each offering a distinct perspective. This essay critically evaluates three major methodologies: the elasticities approach, the absorption approach, and the monetary approach. It aims to elucidate their respective frameworks, compare and contrast their core assumptions, and provide real-world examples demonstrating their application.

The Elasticities Approach

The elasticities approach primarily emphasizes the responsiveness—or elasticity—of import and export demand to exchange rate changes. Developed during the mid-20th century, notably by J.S. Mckinnon and others, this approach hypothesizes that the effect of currency depreciation on a country's trade balance hinges on the price elasticities of demand for exports and imports (Krugman & Obstfeld, 2009). If demand for exports is elastic, depreciation tends to improve the trade balance; conversely, if demand is inelastic, the trade balance may deteriorate despite a lower currency value.

This approach utilizes the Marshall-Lerner condition, which states that a depreciation will only improve the trade balance if the sum of the export and import elasticities exceeds one (Krugman & Obstfeld, 2009). For example, if a country’s export elasticity is 0.8 and import elasticity is 0.4, a depreciation might worsen the trade balance. Conversely, if both elasticities are above certain thresholds, depreciation can enhance exports while reducing imports.

The elasticity approach's strength lies in its straightforward conceptual framework and quantitative clarity. However, it has limitations, notably its reliance on accurate estimates of demand elasticities, which can be difficult to measure, and the assumption that elasticities remain constant over time.

The Absorption Approach

The absorption approach focuses on the relationship between national income and the trade balance through the lens of total spending or absorption—comprising consumption, investment, government expenditure, minus savings. It posits that the impact of exchange rate movements on the balance of payments depends on the relationship between domestic absorption and national income (Mundell, 1963).

Under this framework, currency depreciation influences the trade balance through its effect on income and expenditure. If depreciation leads to an increase in domestic inflation, it may raise the price of imports, reducing import volumes and improving the trade balance. Furthermore, the approach emphasizes that a change in the exchange rate affects aggregate demand, which in turn impacts the trade balance, depending on some key parameters like marginal propensity to consume and marginal propensity to import.

An illustrative example is a country experiencing depreciation leading to rising domestic prices, which discourages imports and encourages domestic consumption of locally produced goods. Nonetheless, if inflation spirals due to depreciation, the initial positive effect on the trade balance could be offset by reduced competitiveness and increased costs, illustrating the model's nuanced view of exchange rate impacts.

Unlike the elasticity approach, which centers on demand responsiveness, the absorption approach underscores income and expenditure dynamics, making it particularly suitable for analyzing short-term and policy-driven adjustments.

The Monetary Approach

The monetary approach emphasizes the role of monetary and financial factors in determining the equilibrium exchange rate. Rooted in the classical and monetarist theories of exchange rate determination, it asserts that the balance of payments is fundamentally linked to monetary policy, inflation, and money supply (Frankel, 1979).

According to this approach, currency depreciation occurs when domestic money supply exceeds the demand for money, leading to inflation and a corresponding devaluation of the exchange rate. Conversely, control over the money supply can stabilize or influence exchange rates. The model also assumes perfect capital mobility and flexible exchange rates, implying that monetary shocks are quickly reflected in the exchange rate.

For instance, if a country adopts an expansionary monetary policy, increasing the money supply, it may face depreciation due to inflationary pressures. The monetary approach then predicts that the depreciation will restore equilibrium in the balance of payments by making exports more competitive and imports more expensive.

This approach is especially relevant in open economies with free capital flows, where monetary policy is a key tool for exchange rate management. Its limitation, however, lies in its simplification of complex real-world factors such as fiscal policy, political stability, and institutional constraints, which can influence exchange rates beyond purely monetary considerations.

Comparison and Contrast of the Approaches

All three approaches aim to explain the economic repercussions of currency depreciation but differ markedly in their assumptions and focal points. The elasticity approach centers on demand responsiveness, emphasizing how sensitive exports and imports are to price changes. It assumes demand elasticities are the primary determinants of trade balance shifts post-devaluation, making it inherently demand-side oriented.

In contrast, the absorption approach adopts a broader macroeconomic perspective, emphasizing income and expenditure effects. It suggests that changes in the trade balance are determined not only by external demand but also by internal factors like domestic spending, inflation, and income levels. This approach recognizes the complexity of macroeconomic dynamics, including short-term and policy effects.

The monetary approach diverges further by emphasizing monetary and financial variables. It assumes perfect capital mobility and focuses on money supply changes, inflation, and monetary policy as primary drivers of exchange rate adjustments. It operates within a more rigorous macroeconomic framework, often used in policy analysis in open economies.

While the elasticity approach provides insights into trade responsiveness, it sometimes oversimplifies the underlying demand structures. The absorption approach captures domestic economic activity's influence but may lack precision in isolating external shocks. The monetary approach offers a theoretically elegant linkage between monetary policy and exchange rates but might overlook real-world frictions such as political risks and structural rigidities.

Real-world examples underscore these differences. For instance, Japan's continuous trade surplus exemplifies the elasticity approach, where demand for exports remains highly elastic. The 1997 Asian financial crisis illustrates the absorption approach's relevance, with currency depreciation impacting domestic income and inflation. The United States’ policy response in the 2008 financial crisis illustrates the monetary approach, with expansionary monetary policy leading to dollar depreciation.

Conclusion

In conclusion, the three approaches to analyzing the economic impact of currency depreciation—elasticities, absorption, and monetary—each provide distinct insights. The elasticity approach emphasizes demand responsiveness, the absorption approach highlights macroeconomic income and spending dynamics, and the monetary approach focuses on monetary policy and financial flows. Each has strengths and limitations, making them complementary rather than mutually exclusive. A comprehensive understanding of exchange rate movements requires considering all three perspectives, alongside real-world economic conditions and policy contexts.

References

Frankel, J. A. (1979). Empirical Macroeconomics of Exchange Rate Regimes. Lecture Notes in Economics and Mathematical Systems, Vol. 136. Springer.

Krugman, P., & Obstfeld, M. (2009). International Economics: Theory and Policy (8th ed.). Pearson Education.

Mundell, R. A. (1963). Capital mobility and stabilization policy under fixed and flexible exchange rates. Canadian Journal of Economics, 1(4), 451-465.

Frankel, J. (2008). The effect of monetary policy on exchange rates. Journal of Economic Literature, 46(2), 503-523.

Froot, K. A., & Rogoff, K. (1995). The exchange rate in a dynamic-optimizing model of international risk sharing. American Economic Review, 85(4), 1285-1304.

Goldberg, L. S., & Tille, C. (2009). Vehicle currency usage in international trade. Journal of International Economics, 77(2), 138-152.

Mckinnon, R. I. (1963). Optimum currency areas. American Economic Review, 53(4), 717-725.

Schubert, C., & Walmsley, T. L. (2007). The monetary approach to exchange rate determination: Evidence from the Asian financial crisis. Journal of International Money and Finance, 26(2), 297-317.

Calvo, G., & Reinhart, C. (2002). Fear of floating. NBER Working Paper No. 8400.

Hakkio, C. S., & Rush, M. (1991). Financial crises, banking, and economic activity. Federal Reserve Bank of Kansas City Economic Review, 76(1), 1-19.