Chapter 16
Theories of the Current Account
This chapter gives students their first exposure to theories of exchange rate determination and the balance
of payments. The emphasis in this chapter is on explaining the trade balance and balance of payments
determination through the elasticities approach, absorption approach, and the intertemporal model.
It is important to point out that the balance of trade theories are not balance of payments theories. It is also
important to give a patient review of elasticity since many students have not had microeconomics
principles within their memory span.
◼ Chapter Outline
Introduction
The Elasticities Approach to the Current Account
1. What does a J curve refer to, and how does it arise?
2. Suppose that εD = 0.75 and = 0.5 for a given country:
a. Are import demands elastic or inelastic in this case?
b. Does the Marshall-Lerner condition hold? How do you know?
c. Suppose that domestic price of this country’s imports rise by 10% following a
devaluation. What will happen to the quantity that it imports?
d. Suppose that the foreign currency price of this country’s exports falls by 10 percent
following a devaluation. What will happen to the quantity of exports?
70 Husted/Melvin • International Economics, Ninth Edition
e. Given the circumstances detailed in parts c and d, if initially this country had initially been
3. How do the implications of the absorption approach differ depending on whether or not there is full
employment?
4. In a small open economy,
NSd = $10 billion + $100 billion×rw
Id = $15 billion - $100 billion×rw
Y = $45 billion
G = $8 billion
rw = .05
a. Find the country’s national saving, investment spending, current account balance, desired consumption, and
absorption.
5. Suppose that there are two large open economies in the world, countries A and B. Suppose that
initially, both countries have a zero current account balance and the world real interest rate is 5%.
Suppose now that there is a technological innovation in country A (only). Draw a graph to portray
Chapter 16 Theories of the Current Account 71
this situation. What will happen to the current account balances in A and B? What will happen to
the world real interest rate? Explain.