Elasticity, Absorption, Keynesian Multiplier, Keynesian Policy, and Monetary Approaches to Devaluation Theory: A Simple Geometric Exposition

The history of balance-of-payments theory since the early 1930's has been one of successive approaches of increasing degrees of theoretical sophistication. Five stages of analysis (conceptually if not always chronologicallv) may be distinguished: the simple elasticity approach following the classic paper by Joan Robinson, the absorption approach, the Keynesian multiplier approach, the Keynesian policy approach pioneered by James Meade, and most recently the monetary approach stemming from the work of Robert Mundell. Differences between these approaches have occasionally been the focus of sharp controversy, most notably in the case of the elasticity and absorption approaches, and recentlv in the case of the monetary approach as contrasted with other approaches that have in common an emphasis on elasticities or the influence of exchange rate changes on trade flows via relative price changes and international elasticities. The purpose of the present note is to bring out the key differences between these alternative approaches, as exemplified by a simple case that can be illustrated by a simple diagram. The simple case is that of devaluation by a single country in a world economy so large that macro-economic repercussions of devaluation on real incomes, world money demand relative to supply, and the prices of imported goods can be ignored. A further simplification is the assumption that export supply is perfectly elastic in response to domestic currency price (cost of production is constant) short of full employment, interpreted as a specific level of total output, after which point supply is perfectly inelastic. For simplicity, also, where the analysis involves full-emplovment conditions the initial equilibrium point is assumed to coincide with exact full employment. Finally, international security transactions are assumed absent, all capital movements taking the form of money flows; and all money is assumed to be international money, to avoid problems (important in reality) of substitution between international reserve assets and domestic credit. The last assumption raises the problem that a devaluation alters the amount of domestic money valued in foreign currency, and vice versa; this problem is ignored until the end of the exposition. Figure 1 graphs income earned from export sales X plus domestic purchase of homeproduced goods cE against domestic expenditure E, both measured in domestic unit values of domestic product (at some point below it will be convenient to assume measurement in terms of foreign currency unit