Marshall-Lerner Condition Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The Marshall-Lerner condition, named after British economist Alfred Marshall (1842–1924) and American economist Abba Lerner (1903–82), is an often asserted economic statement that specifies the circumstances under which a downward movement of the exchange rate, arising from either market-determined depreciation or monetary authority devaluation, will exert a favorable influence on a nation’s balance of trade.

A decrease in the value of the domestic currency with respect to a specified foreign currency will alter the relative price of imports and exports. The price of imports will increase, relative to domestically produced goods, while the price of exports will fall relative to other countries. Such price movements will result in a switching of domestic and foreign expenditure, with domestic consumers buying fewer imports and foreign consumers buying more exports. The net influence of these movements on a country’s balance of trade will be determined by the price elasticities of demand for both exports and imports.

As a general definition, the price elasticity of demand is a descriptive statistic that represents the relative responsiveness (or sensitivity) of demand to changes in price. It is calculated as the percentage change in the quantity demanded divided by the percentage change in price. If the price elasticity of demand for a particular good is given as 2.7, it implies that a 1 percent reduction in price will, all other things being equal, lead to a 2.7 percent increase in the quality demanded (and visa versa).

Assuming that the economy begins in trade balance, the Marshall-Lerner condition states that, all other things being equal, depreciation/devaluation will improve a country’s balance of trade, providing that the sum of the price elasticities of demand for the country’s imports and exports, in absolute terms, is greater than one. A simple example will illustrate the condition. A nation’s trade balance, BT, may be defined as BT = X – pM, where X = the value of exports, M = value of imports, and p = the ratio of the prices of imported goods to domestically produced goods. The value pM indicates that any alteration in the relative price of foreign to home goods will alter the cost of goods imported. All values are expressed in terms of the domestic currency for the nation. Assume that, prior to devaluation/depreciation, the economy is in trade balance with X = 100 and pM = 100. Assume also that the elasticity for demand for imports is 0.9, and the elasticity of demand for exports is 0.8. Following devaluation/depreciation, what will be the effect of a 1 percent rise in the price of imported goods to domestically produced goods? The respective elasticities dictate that imports will fall by 0.9 per cent to 99.1, while exports will rise by 0.8 per cent to 100.8. Total expenditure on imports will also increase given the alteration in the relative price of foreign to home goods. The new balance of trade will therefore show an improvement, BT = 100.8 – (1.01 x 99.1) = 0.709.

Now let us violate the Marshall-Lerner condition by setting the sum of the elasticities for exports and imports, in absolute terms, to less than one. Assume, for example, that the elasticity of demand for imports is 0.3, and the elasticity of demand for exports is 0.4. Allow also, as before, for the nation to be initially in trade balance, and for a similar 1 percent rise in the price of imported goods to domestically produced goods. Under these conditions, the new trade balance will show a deterioration, BT = 100.4 – (1.01 x 99.7) = – 0.297.

Although the Marshall-Lerner condition highlights the ways in which depreciation/devaluation could improve a nation’s balance of trade, a number of complicating factors must be taken into account. For example, underlying the condition is the assumption that depreciation/devaluation will lead to an immediate switch of domestic production to satisfy both increased domestic demand and increased foreign demand. Yet in the short run, there will probably be insufficient spare capacity within the home country to successfully switch production in order to satisfy the increases in domestic and foreign demand. Furthermore, we cannot ignore factors that undermine the assumption of an immediate increase in domestic and foreign demand. The existence of long-term contracts, for example, would cause the home country’s short-run elasticity of demand for imports to be relatively unresponsive to price changes, implying that the nation’s imports would not immediately tend to decline. A similar consideration must be given to the short-run demand for exports, for if this demand is also relatively unresponsive to price changes, foreign consumers would take time to switch toward cheaper imports.

Given that the effects surrounding export creation and import substitution will not be instantaneous, but will only take effect over time, the initial effect of depreciation/devaluation would tend to be a worsening of the balance of trade. However, as circumstances adjust over time, the nation would gradually experience an improvement in the balance of trade. This initial deterioration and subsequent improvement is referred to as the “J curve” effect.

Bibliography:

Dennis Appleyard and Alfred J. Field, Jr., “A Note on Teaching the Marshall-Lerner Condition,” Journal of Economic Education (1986);
Derick Boyd, Guielmo Maria Caporale, and Ron Smith, “Real Exchange Rate Effects on the Balance of Trade: Cointegration and the Marshall-Lerner Condition,” International Journal of Finance and Economics (v.6/3, 2001);
O. Clement, R. L. Pfister, and K. J. Rothwell, Theoretical Issues in International Economics (Houghton Mifflin, 1967);
P. Lerner, The Economics of Control (Macmillan, 1944).

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