The Marshall-Lerner condition
Go to worked example of the Marshall-Lerner condition
The Marshal-Lerner condition relates to the impact of a change in the value of a currency on a country's net exports, and the current account of the balance of payments.
An increase in the exchange rate will reduce import prices and increase export prices. However, the effect of this on import spending an export revenue is not certain. The impact of this depends upon the price elasticity of demand for imports and exports.
The Marshall-Lerner condition states that a change in the exchange rate of a currency will only impact the trade account the sum of price elasticities of demand for imports and exports is greater than 1.0. We tend to assume that this condition is met, and hence a fall in the exchange rate will stimulate exports and constrain imports to the extent that net trade increases, and aggregate demand increases.
In the short run, domestic demand for imports and overseas demand for exports tends to be inelastic and slow to respond to price changes. In this case, the Marshall-Lerner condition may not be satisfied.
However, in the longer run, consumer demand tends to adjust more to price changes, and the Marshall-Lerner condition is more likely to be satisfied.
This explains the ‘J-curve’ path following a devaluation, indicating the Marshall-Lerner condition is not met in the short-run, and devaluation (or depreciation) causes any trade deficit to worsen. In the graph, a devaluation during 2019 (at point 'a') leads to a worsening of the current account in 2020 (at point 'b'). However, by 2023 a current account balance is achieved (at point 'c'). The impact of this analysis on trade policy is to raise concerns about the effectiveness of devaluation on the current account, suggesting that it is not a policy that works in the short-run - indeed, it may be counter-productive.
Although not conclusive, a good deal of research has been undertaken, which supports the general conclusion that, at least in the long-run, the Marshall-Learner conditions is satisfied (see research on exchange rates in India).
Other criticisms of devaluation
- Other countries may see a devaluation as an artificial attempt to gain a competitive advantage and devalue their own currency as a form of retaliation.
- While devaluation could stimulate export-led growth there is a danger of inflation - firstly because import prices will rise, and secondly as a result of economic growth.
- Devaluation could result in speculation against the currency that devalues if speculators feel that the new rate is not sufficiently low enough to have the desired policy effect.
Worked example of the Marshall-Lerner hypothesis
In this simple example we consider one country, country A, which trades with country B. Country A produces one good, which it exports to B, and imports one good from country B. Both countries use different currencies, which initially have a par value (of 1 - 1).
In scenario 1, country A has a trade balance with B. In scenario 2, country A devalues its currency by 10%, but consumers in both A and B do not react to the price changes that follow devaluation. In scenario 3, the same 10% devaluation results in changes in demand for imports in country A, and changes in country B for A's exports.
Scenario 1 - Where country A's trade is in balance
We will assume the following about country A:
A's imports from B
The volume of imports from B are 100 units;
The price of these imports in country A is 20 units of A's currency;
The expenditure on imports (M) by A is the price of imports times the quantity imported, which is = 2000.
A's exports to B
The volume of exports to country B is 100 units of output;
The price of exports is 20 units of A's currency;
The value of exports (X) is the price of exports times the quantity, which is = 2000.
Therefore:
Trade is in BALANCE between A and B, at M=2000 and X=2000, where the exchange rate is 1 for 1.
Scenario 2 - Where country A devalues, but there is no consumer response (PED is perfectly inelastic)
Country A now devalues its currency by 10%, but in this scenario we assume there is no change in volumes of imports and exports given we assume price elasticity of demand for imports and exports in both countries is zero, therefore:
A's imports from B
The volume of imports remains at 100 units of output;
However, the price of imports increases by 10%, to 22 units of currency (which are needed to purchase 20 units of B's currency) following the devaluation;
This means that the value of imports (M) (which is the price of imports times the quantity imported) now increases to (100 x 22) = 2200.
A's exports to B
On the export side, there is no change in volume, and no change in the price received by the exporters - they still charge 20 units of their own currency. Consumers in country B now face reduced prices of 10% (with the relatively higher exchange rate of B's currency) but, given the assumption of perfect inelasticity, there is no response by B's consumers. Hence:
The volume of exports is still 100 units of output;
However, the price of exports is still 20 units of 'A's currency;
Hence, the value of exports (X) remains at = 2000.
The result is that:
Country A has a trade DEFICIT of 200 (M=2200, X=2000).
Conclusion - when PED's of imports and exports are perfectly inelastic, any devaluation simply raises import prices with no effect on export revenue - hence, worsening the trade balance.
Scenario 3 - Where country A devalues, and there is a combined price-elastic consumer response in country A and B
To understand the Marshall-Lerner hypothesis, we will take the same currency devaluation (10%) and introduce individual PED responses of (-) 0.6 for both price elasticity of demand for imports (PEDm) from country B, and exports (PEDx) to country B . This makes the combined PED's of (-) 1.2, which satisfies the Marshal-Lerner condition. We can predict that country A's trade account should improve. Let's see how this works:
A's imports from B
The volume of imports from 'B' will fall by 6% - which follows if we apply the PED equation (PEDm = %Δ quantity of imports/%Δ price ), as follows:
If PEDm from country B is (-) 0.6, we can rearrange the equation to find the change in quantity demanded within country A, which is [?/+10 = (-) 0.6], and becomes [? = (-) 0.6 x10] = - 6%. Therefore, the quantity of imports demanded from country B falls by 6% to 94 units.
The price of imports from B increases by 10%, to 22 units of A's currency, following the devaluation;
Hence, the value of imports from country B becomes (94 x 22) = 2068.
A's exports to B
On the export side, there is also a PED response of (-) 0.6, which means that the devaluation by country A reduces the price of its exports to country B by 10%, but, crucially, there is no change in the price received by the exporters in country A - they still charge 20 units of their own currency. Consumers in country B now see the benefit of the devaluation of country A's goods, and they respond by purchasing 6% more than before the devaluation.
So, the volume of exports increases by 6%, which follows from applying the PED equation, where PEDx = %Δ quantity of imports/%Δ price, as follows:
If PEDx is given as (-) 0.6, we can rearrange the equation to find the change in quantity of exports demanded - (?/(-)10 = (-) 0.6) which is: ? = (-) 0.6 x (-)10 = + 6%. Therefore, the quantity of exports demanded by country B increases by 6% to 106 units.
Therefore, the volume of exports from country A increases to 106 units;
The price received by country A's exporters, however, remains at 20 units of country A's currency;
Hence, the value of country A's exports increases to = 2120.
Therefore:
Country A's trade is now in SURPLUS - at 52 (2120 - 2068).
We can conclude that, as a result of devaluing when the sum of elasticities is greater than 1, and the Marshall-Lerner condition (that ∑PEDx and PEDm is greater than (-) 1.0) is satisfied, the trade account for an economy will move towards a surplus.
Try it yourself with combined figures closer to 1, or with figures less than one, as below:
Question
Use the same data above with a change in PEDm to (-) 0.2, and PEDx to (-) 0.4. with a currency devaluation of 10%, and find the impact on trade.
Mv (volume of imports) = 98 (PEDm = -2/10) therefore, import volume falls by 2%; Mp (price of imports) = 22 rises by 10% (following devaluation of 10%); M (pxq) = 2156 (new import spending); And: Xv (volume of exports) = 104 (PEDx = -4/10) - there is only a ‘fall’ in the price abroad!; Xp (price of exports) = 20 (domestic firms still receive 20 in local currency); X (pxq) = 2080 (new export revenue)
Trade deficit = 76 - devaluing worsens trade because the sum of elasticities is less than 1;
In this case it is (-) 0.6 [(-) 0.2 and (-) 0.4]; Marshall-Lerner condition is not satisfied!!