Which is true regarding the absorption approach?

Question

BlackTom AI · Accepted Answer

The absorption approach states that the trade balance (net exports, NX) equals national income (Y) minus domestic absorption (A): NX = Y − A, where absorption A = C + I + G (consumption, investment, government spending). This identity and its comparative-static implication are the core knowledge points.

Step-by-step reasoning:
1. Write the basic identity: NX = Y − A.
2. Consider a currency depreciation. It can affect both Y and A: a real depreciation tends to raise net exports and thus income Y, but it can also raise domestic absorption through higher nominal incomes, wealth effects, or inflation-induced spending changes.
3. The change in the trade balance after depreciation is ΔNX = ΔY − ΔA. For the trade balance to improve, ΔY must exceed ΔA (ΔY > ΔA). If absorption rises by as much or more than income, the trade balance will not improve and can even worsen.
4. Numeric example (intermediate steps): Suppose initially Y = 100, A = 110 ⇒ NX = −10. After depreciation, suppose exports rise and Y increases by 6 → Y = 106 (ΔY = +6). But domestic spending responds and absorption increases by 8 → A = 118 (ΔA = +8). Then new NX = 106 − 118 = −12 (ΔNX = −2), so the deficit worsens despite depreciation.
5. Therefore the absorption approach provides an explicit reason why a depreciation may fail to improve a trade deficit: if domestic absorption rises sufficiently, it offsets any income gains from improved competitiveness.

Why other options are incorrect:
- “It highlights the relationship between price level and demand for money.” That describes monetary theory and liquidity preference, not the absorption approach.
- “all of these” is wrong because not all listed statements are true.
- “It contradicts the conclusions of the elasticity approach.” Incorrect: the absorption approach doesn’t inherently contradict the elasticity approach; it offers an alternative viewpoint emphasizing spending responses and income effects—both approaches can be consistent when their assumptions and short-run dynamics are considered.

Conclusion: The correct answer is “It provides another reason why a depreciation may not improve a trade deficit.” This matches the provided answer.

Which is true regarding the absorption approach?Single choice

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