WHAT IS THE MARSHALL-LERNER CONDITION? Cedric Chehab 09 Nov, 2013 Definition: How changes in the exchange rate may affect a country’s current account (CA) balance, which is made up primarily of imports and exports. In other words: How the depreciation or appreciation of a country’s currency improves or lessens the CA balance, which is dependent on the elasticity of net exports with respect to the real exchange rate Why is this important? This condition helps us to understand how a country is impacted by a change in exchange rates. Marshall-Lerner Condition Remember, the CA measures the balance of trade in goods and services in a country. So, if a country’s currency depreciates (loses value), foreigners are more likely to import that country’s goods because to them those goods are cheaper, so the CA balance increases (check out the section on exchange rates if this is confusing). While this is generally the case, the Marshall-Lerner condition (MLC) proves that this is not always what happens. Elasticity The assumption that a depreciation of a currency will increase imports and decrease exports is dependent on the response of export and import volumes to real exchange rate changes. In other words, the effect of a depreciation or appreciation of a country’s currency on the CA balance is contingent on two things: the responsiveness of consumers within the nation who are importing goods and the foreign consumers of that country’s exported goods. We’re talking about the responsiveness of consumers, which means we’re referring to price elasticity of demand, which is the degree to which demand of a good is affected by its price (EDP = % change in QD / % change in P). When a currency depreciates, the goods are cheaper relative to foreign goods so the effect on demand is the same as if the price had dropped. In this case, it is the price elasticity of the demand for net export, which can be written as EDPNX. If the price elasticity of demand for net exports (EDPNX) > 1, then a depreciation of the currency will improve of the CA balance of that country, which is what we would expect. On the other hand, if EDPNX < 1, then a depreciation of the currency would lessen the CA balance for that country. So if demand for net exports is inelastic, then if the currency loses value, the net exports won’t increase. This makes sense if we remember what we know about elasticities. If demand for a good is inelastic (or insensitive to price changes), lowering the price won’t get the producers more income because quantity sold won’t increase enough to compensate for the reduction in price. When a currency depreciates, it is like the price went down to consumers in foreign countries. Economics > International Economics > Marshall-Lerner Condition Page 1 of 4 WHAT IS THE MARSHALL-LERNER CONDITION? Cedric Chehab 09 Nov, 2013 Here's an example: Let’s look at dollars and Japanese yen. Let’s say Japan has consuming more American goods than America has been consuming Japanese goods. In order to buy more U.S. goods, Japanese households must exchange their yen for dollars. As a result, there are more yen in the U.S. So, the supply of Japanese yen increase, shifting the supply line down and right, lowering the price in dollars for yen so increasing the amount of yen demanded. In other words, the yen depreciates against the dollar. More yen are demanded because cheaper yen means Japanese goods are cheaper. Now remember that the CA is comprised of net exports. So a decrease in the price of the Yen will decrease the price of net exports and increase the quantity of goods exported: Economics > International Economics > Marshall-Lerner Condition Page 2 of 4 WHAT IS THE MARSHALL-LERNER CONDITION? Cedric Chehab 09 Nov, 2013 The demand curve in this graph represents foreign consumers of Japanese goods and Japanese consumers of foreign goods, or net exports. We can see that as prices decrease (from P1 to P2) foreign demand for Japanese goods increases (because the goods are now cheaper relative to U.S. goods) and Japanese demand for foreign goods decreases (because U.S. goods are now more expensive to the Japanese) leading to an overall increase in quantity of net exports. But we want to look at the total revenue of net exports, not just quantity. This depends on the elasticity of demand for net exports. If net exports is elastic, the change in price will be less than the change in quantity sold. In other words, if the % change in quantity is larger than the % change in price, then EDPNX is greater than 1, or elastic. If this is the case, a depreciation in the currency will lead to an increase in the CA balance. In order for the MLC to be met, the % change in quantity demand must be greater than the % change in price, which will lead to an increase in total revenue and an improvement of the CA balance. On the other hand, if EDPNX is less than 1, or inelastic, the % change in price would be greater than the % change in quantity demanded of NX. In this case, a depreciation in the currency would lead to a decrease in total revenues of NX and a worsening of the CA balance. Thus, the MLC is not met. We know from studying elasticities in earlier econ courses, that the elasticity of a demand curve changes as you move down the curve. The upper portion of the demand curve tends to be elastic while the lower portion tends to be inelastic. Economics > International Economics > Marshall-Lerner Condition Page 3 of 4 WHAT IS THE MARSHALL-LERNER CONDITION? Cedric Chehab 09 Nov, 2013 Therefore, the initial drop in price of the currency (P1 to P2) will lead to an increase in Total Revenue from Net Exports (TRNX) however as the price keeps dropping and we keep moving down the demand curve, say from P4 to P5, the curve will become inelastic, leading to a decrease in TRNX. Economics > International Economics > Marshall-Lerner Condition Page 4 of 4