Marshall-Lerner Condition Essay

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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:  

  1. Dennis Appleyard  and  Alfred J. Field, Jr.,  “A  Note  on  Teaching   the  Marshall-Lerner   Condition,” Journal of Economic Education (1986);
  2. 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);
  3. O. Clement, R. L. Pfister, and K. J. Rothwell, Theoretical Issues in International Economics (Houghton  Mifflin, 1967);
  4. P. Lerner, The Economics of Control (Macmillan, 1944).

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