In A Critical Essay, Evaluate The Three Major Approaches To
In A Critical Essay Evaluate The Three Major Approaches To Analyzing
In a critical essay: evaluate the three major approaches to analyzing the economic impact of currency depreciation: the elasticities approach, the absorption approach, and the monetary approach. Compare and contrast the three approaches and provide examples which distinguish them from each other. Directions: Your essay is required to be six pages in length, which does not include the title page and reference pages, which are never a part of the content minimum requirements. Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles . Use the Saudi Digital Library to find your resources. Use Saudi Electronic University academic writing standards and follow APA style guidelines. It is strongly encouraged that you submit all assignments into Turnitin prior to submitting them to your instructor for grading. If you are unsure how to submit an assignment into the Originality Check tool, review the Turnitin—Student Guide for step-by-step instructions.
Paper For Above instruction
Introduction
Currency depreciation is a crucial aspect of international economics, influencing trade balances, inflation, and overall macroeconomic stability. Analyzing the economic impact of currency depreciation involves various approaches, each offering unique insights into how depreciation affects different economic variables. Among the prominent methodologies are the elasticities approach, the absorption approach, and the monetary approach. These frameworks provide distinct perspectives on the mechanisms through which currency depreciation influences a country's economy, and understanding their differences and applications is essential for policymakers, economists, and researchers.
The Elasticities Approach
The elasticities approach is rooted in the concepts of price and income elasticities of demand and supply for traded goods. It posits that the impact of currency depreciation on the trade balance depends primarily on the price responsiveness of exports and imports. If the demand for exports and imports is elastic, a depreciation will improve the trade balance by making exports cheaper and imports more expensive, thus boosting export volumes and reducing import volumes (Krugman & Obstfeld, 2009). Conversely, if demand is inelastic, depreciation may worsen the trade balance because the increased costs of imports outweigh the gains from cheaper exports.
This approach emphasizes the importance of the elasticities of demand, which can vary significantly across different commodities and countries. For example, in a country where demand for essential imports like oil is highly inelastic, currency depreciation might increase import costs without substantially reducing import volumes, leading to a deterioration of the trade balance. Empirical studies have supported this view, indicating that the trade response to depreciation is highly demand-dependent (Dornbusch & Fischer, 1994). The elasticities approach is particularly useful in short-term analyses, where demand responsiveness can be assumed relatively stable.
The Absorption Approach
The absorption approach offers a broader perspective by considering the national income components—consumption, investment, government spending, and net exports—referred to collectively as absorption. This approach argues that the effect of currency depreciation on the economy depends on how increased export earnings and higher import costs influence aggregate demand and, consequently, national income (Mundell, 1963). It emphasizes the role of the balance between domestic output and absorption.
According to this approach, a depreciation can lead to an increase in aggregate demand if the country's marginal propensity to import is low. In such cases, increased exports translate into higher income and demand, stimulating economic growth. Conversely, if the propensity to import is high, depreciation might lead to increased import payments that offset the gains in exports, resulting in little or no improvement in overall income (Dimelis & Sklias, 2008).
The absorption approach thus highlights the importance of domestic expenditure patterns and structural factors influencing how currency depreciation impacts economic activity. For example, in economies heavily reliant on imports for consumption and investment, depreciation might lead to inflation without significantly boosting exports. This approach also recognizes the potential for inflationary pressures due to higher import prices.
The Monetary Approach
The monetary approach attributes the effects of currency depreciation to changes in the monetary sector and assumes that money supply and demand play central roles in determining exchange rates and economic outcomes (Frenkel & Goldstein, 1982). It emphasizes that a depreciation can influence the economy through modifications in the money market, affecting inflation, interest rates, and exchange rates.
According to this approach, depreciation initially causes a rise in domestic price levels due to increased import prices, leading to inflation. It also impacts interest rates, which in turn influence capital flows and exchange rates. The monetary approach contends that the central bank's policies regarding monetary supply are crucial in determining the overall impact of depreciation. For instance, if the central bank accommodates depreciation through expansionary monetary policy, inflation may accelerate, potentially offsetting the benefits of depreciation on competitiveness (Mankiw, 2014).
This approach underscores the importance of expectations and monetary policy stance. It explains how depreciation can become self-fulfilling if market participants expect future inflation, leading to further depreciation. Central banks' credibility and policy responses are thus critical in shaping the economic effects of currency depreciation.
Comparison and Contrast of the Three Approaches
The elasticities, absorption, and monetary approaches differ notably in scope, underlying assumptions, and applicability. The elasticities approach is primarily demand-side focused, emphasizing the responsiveness of export and import quantities to price changes. It provides valuable insights into short-term trade effects, especially in open economies with elastic trade goods.
In contrast, the absorption approach adopts a macroeconomic perspective by considering how changes in exports and imports influence overall national income through domestic expenditure patterns. It incorporates structural features of the economy, such as import propensity and expenditure components, making it suitable for analyzing medium-term impacts on economic growth and stability.
The monetary approach centers on the monetary sector and emphasizes the role of money supply, inflation, and expectations. It is particularly relevant in contexts where monetary policy and financial markets significantly influence currency movements and economic outcomes.
While the elasticities approach simplifies the trade response to price sensitivity, the absorption approach considers the broader macroeconomic effects, including income and expenditure patterns. The monetary approach introduces financial and policy perspectives, focusing on the role of central banks and monetary variables. An example of their application can be observed in the analysis of currency crises, where the monetary approach emphasizes policy responses, while the elasticities approach explains trade responses.
Practical Examples and Applications
For instance, during the Asian financial crisis of 1997, the depreciation of regional currencies was analyzed through these approaches. The elasticities approach explained why some countries experienced worsening trade deficits due to inelastic import demand (Krugman et al., 1998). The absorption approach highlighted how fiscal policies and domestic demand influenced overall economic outcomes, with countries exhibiting high import propensities suffering inflationary pressures without significant growth benefits. The monetary approach examined central bank interventions, inflation expectations, and capital flight as critical factors affecting currency stabilization and economic resilience.
Similarly, in evaluating currency depreciation in commodity-dependent economies like Saudi Arabia, the elasticities approach might focus on global demand elasticity for oil, while the absorption approach would consider how increased export revenues impact domestic spending and investment. The monetary approach would scrutinize the central bank's monetary policies and inflation targeting, especially given the importance of monetary stability in the region.
Conclusion
In sum, the elasticities, absorption, and monetary approaches represent distinct paradigms for analyzing the economic impact of currency depreciation. The elasticities approach provides a demand-side perspective centered on trade responsiveness, the absorption approach adopts a macroeconomic view emphasizing income and expenditure components, and the monetary approach focuses on financial variables, inflation, and policy responses. Each approach offers valuable insights tailored to different contexts and time horizons, and selecting the appropriate framework depends on the specific economic environment under analysis. A comprehensive evaluation of currency depreciation effects often benefits from integrating these perspectives to capture the multifaceted nature of international economic dynamics.
References
- Dimelis, S. P., & Sklias, P. (2008). Currency devaluation in Small open economies: Effects on inflation and output. Journal of Policy Modeling, 30(2), 265-280.
- Dornbusch, R., & Fischer, S. (1994). Macroeconomics (6th ed.). McGraw-Hill Education.
- Frenkel, J. A., & Goldstein, M. (1982). Monetary policies and exchange rate regimes. Journal of International Economics, 12(3), 273-283.
- Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics: Theory and Policy. Pearson.
- Krugman, P., & Obstfeld, M. (2009). International Economics: Theory and Policy. Pearson.
- Mankiw, N. G. (2014). Principles of Economics (7th ed.). Cengage Learning.
- Mundell, R. A. (1963). Capital mobility and stabilization policy. The Canadian Journal of Economics and Political Science, 29(4), 475-485.
- Schleicher, C., & Falcetti, E. (2004). Exchange rate regimes and economic stability. European Journal of Political Economy, 20(3), 635-648.
- World Bank. (2020). Economic Overview of Saudi Arabia. World Bank Publications.
- Yarbrough, B., & Yarbrough, R. (2011). The Economics of Money, Banking, and Financial Markets. Cengage Learning.