ECS3703 JUN/JULY 2021
EXAM MEMO
QUESTION 1 [10 marks]
Explain, with reference to a graph, the importance of the elasticity of the demand and
supply curves for foreign exchange when a currency is devalued with the aim of
correcting a deficit in a nation’s balance of payments. Refer to a graph in the prescribed
book and name the graph.
You do not have to draw the graph. [10]
The Marshall–Lerner condition postulates a stable foreign exchange market if the sum of the
price elasticities of the demand for imports and the demand for exports exceeds 1 in absolute
value. However, the sum of these two elasticities will have to be substantially greater than 1
for the nation’s demand and supply curves of foreign exchange to be sufficiently elastic to
make a depreciation or devaluation feasible (i.e., not excessively inflationary) as a method of
correcting a deficit in the nation’s balance of payments. Thus, it is very important to
determine the real-world value of the price elasticity of the demand for imports and exports
If no other change (such as a change in tastes for U.S. exports) occurs, then the estimated
foreign demand curve of U.S. exports is inelastic, as shown by DX in Figure 16.4. However,
equilibrium points E and E∗ are also consistent with elastic demand curve D’X, which shifts
down to D’’X as a result, for example, of reduced foreign tastes for U.S. exports. Regression
analysis will always measure the low elasticity of demand DX even if the true demand is
elastic and given by D’X and D”X, that is, regression techniques fail to identify demand
curves D’X and D’’X. Since shifts in demand due to changes in tastes or other unaccounted
forces frequently occur over time, estimated elasticities are likely to greatly underestimate
true
elasticities.
QUESTION 2 (10 marks)
, Briefly explain the “Swan” diagram. You can refer to the relevant graph in the
prescribed book and do not have to draw the graph. [10]
The Swan analysis looks at how a nation can simultaneously attain internal and external
balance with expenditure-changing and expenditure-switching policies.
An Illustration of the Swan diagram is given on figure 18.1 in the textbook. The EE curve
shows the various combinations of exchange rates and real domestic expenditures, or
absorption, that result in external balance. The EE curve is positively inclined because a
higher R (due to a devaluation) improves the nation’s trade balance (if the Marshall–Lerner
condition is satisfied) and must be matched by an increase in real domestic absorption (D) to
induce imports to rise sufficiently to keep the trade balance in equilibrium and maintain
external balance.
Zone I External surplus and internal unemployment
Zone II External surplus and internal inflation
Zone III External deficit and internal inflation
Zone IV External deficit and internal unemployment
From the figure we can now determine the combination of expenditure-changing and
expenditure-switching policies required to reach point F. For example, starting from point C
(deficit and unemployment), both the exchange rate (R) and domestic absorption (D) must be
increased to reach point F. By increasing R only, the nation can reach either external balance
(point C on the EE curve) or, with a larger increase in R, internal balance (point C on the YY
curve), but it cannot reach both simultaneously. Similarly, by increasing domestic absorption
only, the nation can reach internal balance (point J on the YY curve), but this leaves an
external deficit because the nation will be below the EE curve. Note that although both point
C and point H are in zone IV, point C requires an increase in domestic absorption while point
H requires a decrease in domestic absorption to reach point F. The crossing of the EE and YY
curves defines the four zones of external and internal imbalance and helps us determine the
appropriate policy mix to reach external and internal balance simultaneously at point F.
QUESTION 3 [15 marks] Explain the “absorption approach” [15]
EXAM MEMO
QUESTION 1 [10 marks]
Explain, with reference to a graph, the importance of the elasticity of the demand and
supply curves for foreign exchange when a currency is devalued with the aim of
correcting a deficit in a nation’s balance of payments. Refer to a graph in the prescribed
book and name the graph.
You do not have to draw the graph. [10]
The Marshall–Lerner condition postulates a stable foreign exchange market if the sum of the
price elasticities of the demand for imports and the demand for exports exceeds 1 in absolute
value. However, the sum of these two elasticities will have to be substantially greater than 1
for the nation’s demand and supply curves of foreign exchange to be sufficiently elastic to
make a depreciation or devaluation feasible (i.e., not excessively inflationary) as a method of
correcting a deficit in the nation’s balance of payments. Thus, it is very important to
determine the real-world value of the price elasticity of the demand for imports and exports
If no other change (such as a change in tastes for U.S. exports) occurs, then the estimated
foreign demand curve of U.S. exports is inelastic, as shown by DX in Figure 16.4. However,
equilibrium points E and E∗ are also consistent with elastic demand curve D’X, which shifts
down to D’’X as a result, for example, of reduced foreign tastes for U.S. exports. Regression
analysis will always measure the low elasticity of demand DX even if the true demand is
elastic and given by D’X and D”X, that is, regression techniques fail to identify demand
curves D’X and D’’X. Since shifts in demand due to changes in tastes or other unaccounted
forces frequently occur over time, estimated elasticities are likely to greatly underestimate
true
elasticities.
QUESTION 2 (10 marks)
, Briefly explain the “Swan” diagram. You can refer to the relevant graph in the
prescribed book and do not have to draw the graph. [10]
The Swan analysis looks at how a nation can simultaneously attain internal and external
balance with expenditure-changing and expenditure-switching policies.
An Illustration of the Swan diagram is given on figure 18.1 in the textbook. The EE curve
shows the various combinations of exchange rates and real domestic expenditures, or
absorption, that result in external balance. The EE curve is positively inclined because a
higher R (due to a devaluation) improves the nation’s trade balance (if the Marshall–Lerner
condition is satisfied) and must be matched by an increase in real domestic absorption (D) to
induce imports to rise sufficiently to keep the trade balance in equilibrium and maintain
external balance.
Zone I External surplus and internal unemployment
Zone II External surplus and internal inflation
Zone III External deficit and internal inflation
Zone IV External deficit and internal unemployment
From the figure we can now determine the combination of expenditure-changing and
expenditure-switching policies required to reach point F. For example, starting from point C
(deficit and unemployment), both the exchange rate (R) and domestic absorption (D) must be
increased to reach point F. By increasing R only, the nation can reach either external balance
(point C on the EE curve) or, with a larger increase in R, internal balance (point C on the YY
curve), but it cannot reach both simultaneously. Similarly, by increasing domestic absorption
only, the nation can reach internal balance (point J on the YY curve), but this leaves an
external deficit because the nation will be below the EE curve. Note that although both point
C and point H are in zone IV, point C requires an increase in domestic absorption while point
H requires a decrease in domestic absorption to reach point F. The crossing of the EE and YY
curves defines the four zones of external and internal imbalance and helps us determine the
appropriate policy mix to reach external and internal balance simultaneously at point F.
QUESTION 3 [15 marks] Explain the “absorption approach” [15]
