Marshall lerner condition

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• Macroeconomics
• International Trade
• Exchange Rate
• Trade Balance
• Currency Devaluation
• Demand Elasticity
• Supply and Demand
• Price Elasticity of Demand
• Economic Policy
• Monetary Policy
• Fiscal Policy
• Current Account
• Balance of Payments
• Economic Growth
• Monetary Economics

What Is the Marshall-Lerner Condition?

The Marshall-Lerner condition is a concept in International Trade that describes the relationship between a country's Exchange Rate and its Trade Balance. It states that a Currency Devaluation or depreciation will improve a country's trade balance only if the sum of the absolute values of the Demand Elasticity for its exports and imports is greater than one. This condition is fundamental to understanding how changes in a nation's currency value impact its external trade position within the broader field of Macroeconomics. If the Marshall-Lerner condition is met, a depreciation makes exports cheaper for foreign buyers and imports more expensive for domestic consumers, leading to an improvement in the trade balance³⁴.

History and Origin

The Marshall-Lerner condition is named after two prominent economists: British economist Alfred Marshall (1842-1924) and Russian-born American economist Abba P. Lerner (1903-1982)³³. Alfred Marshall's foundational work on Price Elasticity of Demand laid the groundwork for understanding how changes in price affect demand. Abba Lerner later refined and extended these principles to international trade, particularly in the context of currency devaluations. Lerner's book, The Economics of Control: Principles of Welfare Economics (1944), further developed the criterion, explaining how a nation's Balance of Payments could be affected by exchange rate changes³¹, ³². The condition emerged from a period of intense intellectual development in Monetary Economics and international trade theory in the early to mid-20th century.

Key Takeaways

• The Marshall-Lerner condition dictates when a currency devaluation or depreciation will improve a country's trade balance.
• It requires the sum of the absolute price elasticities of demand for exports and imports to be greater than one.
• If the condition is not met, a currency depreciation could worsen the trade balance in the short term, a phenomenon known as the J-curve effect.
• The condition highlights the importance of how responsive international buyers and sellers are to price changes resulting from exchange rate fluctuations.
• Policymakers consider the Marshall-Lerner condition when evaluating the potential impact of exchange rate policies on a nation's external accounts.

Formula and Calculation

The Marshall-Lerner condition can be expressed using the following inequality:

$\left| \eta_x \right| + \left| \eta_m \right| > 1$

Where:

• (\eta_x) represents the Price Elasticity of Demand for exports.
• (\eta_m) represents the price elasticity of demand for imports.
• The vertical bars (| \cdot |) denote the absolute value, as price elasticities of demand are typically negative.

This formula signifies that for a currency depreciation to improve the Current Account, the combined responsiveness of export and import quantities to changes in their respective prices must be sufficiently high³⁰.

Interpreting the Marshall-Lerner Condition

Interpreting the Marshall-Lerner condition involves understanding the responsiveness of trade volumes to exchange rate changes. If the sum of the absolute price elasticities of demand for exports and imports is greater than one, it means that the percentage increase in export volumes and decrease in import volumes, due to the depreciation, collectively outweigh the initial adverse price effects.

For instance, if a country's currency depreciates, its exports become cheaper in foreign currency terms, and its imports become more expensive in domestic currency terms. If demand for these goods is sufficiently elastic, the quantity of exports will rise significantly, and the quantity of imports will fall significantly. This adjustment in quantities, as explained by principles of Supply and Demand, is what drives the improvement in the trade balance. Conversely, if the sum of elasticities is less than one, the change in quantities will not be enough to offset the negative price effect, leading to a worsening of the trade balance²⁹.

Hypothetical Example

Consider a hypothetical country, "Econoland," that is experiencing a trade deficit. The government decides to devalue its currency, the "Econo."

Before devaluation:

• Price elasticity of demand for Econoland's exports = -0.4 (inelastic)
• Price elasticity of demand for Econoland's imports = -0.3 (inelastic)

In this scenario, the sum of the absolute elasticities is (|{-0.4}| + |{-0.3}| = 0.4 + 0.3 = 0.7). Since 0.7 is less than 1, the Marshall-Lerner condition is not met. If Econoland devalues its currency, its trade balance would likely worsen initially, as the low responsiveness of export and import quantities to price changes would mean the value effect (exports become less valuable, imports become more expensive) dominates the volume effect.

Now, consider a different scenario for "Econoland":

• Price elasticity of demand for Econoland's exports = -0.8 (elastic)
• Price elasticity of demand for Econoland's imports = -0.7 (elastic)

In this case, the sum of the absolute elasticities is (|{-0.8}| + |{-0.7}| = 0.8 + 0.7 = 1.5). Since 1.5 is greater than 1, the Marshall-Lerner condition is met. If Econoland devalues its currency, its trade balance would be expected to improve, as the higher responsiveness of both exports and imports to price changes would lead to a significant increase in export volumes and a decrease in import volumes, outweighing the adverse price effects. This demonstrates how the condition guides predictions about the effectiveness of Economic Policy related to exchange rates.

Practical Applications

The Marshall-Lerner condition is a critical concept in international economics, particularly for policymakers assessing the impact of exchange rate movements on a nation's external accounts.

• Monetary and Fiscal Policy: Central banks and governments consider this condition when implementing Monetary Policy or Fiscal Policy that could influence the exchange rate. For example, if a country faces a persistent trade deficit, a central bank might consider allowing currency depreciation to stimulate exports and curb imports, provided the Marshall-Lerner condition holds²⁷, ²⁸. However, as the Federal Reserve has noted, the trade balance response to exchange rate changes can be affected by various factors, including the international role of a currency and how prices are set for trade²⁵, ²⁶.
• Trade Balance Adjustment: The condition is directly applied to understand how a country's Trade Balance will react to changes in its currency's value. If the condition is met, a depreciation is expected to improve the trade balance; otherwise, it may worsen it. The International Monetary Fund (IMF) frequently analyzes this condition in its country assessments, examining how exchange rate adjustments might affect trade flows and external stability²³, ²⁴.
• Analyzing the J-Curve Effect: The Marshall-Lerner condition is intrinsically linked to the J-curve effect. The J-curve describes a situation where, after a currency depreciation, the trade balance initially worsens before eventually improving²². This initial deterioration occurs when the short-run elasticities of demand for exports and imports are less than one, meaning the Marshall-Lerner condition is not met in the short term. Over time, as demand becomes more elastic, the condition is met, and the trade balance improves²⁰, ²¹. This time lag in responsiveness is crucial for understanding the dynamic effects of exchange rate changes¹⁹.

Limitations and Criticisms

While the Marshall-Lerner condition provides a valuable framework for understanding the relationship between exchange rates and trade balances, it has several limitations and has faced criticisms:

• Short-Run vs. Long-Run Elasticities: A primary criticism revolves around the time horizon for the elasticities. In the short run, the demand for exports and imports may be relatively inelastic due to existing contracts, consumer habits, and production rigidities¹⁸. This often leads to the J-curve effect, where a currency depreciation initially worsens the trade balance before an improvement is seen in the long run as elasticities become higher¹⁶, ¹⁷. The Marshall-Lerner condition, in its simplest form, assumes that the relevant elasticities apply immediately, which may not always be the case in the real world.
• Supply-Side Considerations: The condition primarily focuses on demand elasticities and implicitly assumes that the supply of exports and imports is perfectly elastic¹⁵. In reality, supply constraints, especially for developing countries or specific industries, can limit the ability to increase export volumes even with a cheaper currency¹⁴. This can lead to a situation where the benefits of a depreciation are not fully realized, even if the demand elasticities are favorable.
• Other Factors Affecting Trade Balance: The trade balance is influenced by numerous factors beyond exchange rates and elasticities, such as domestic and foreign income levels, tariffs, non-tariff barriers, and global economic growth¹², ¹³. The Marshall-Lerner condition isolates the exchange rate effect, but in practice, these other factors can significantly influence the actual outcome of a currency depreciation. For example, a study on the Turkish economy noted that while the real effective exchange rate is an important determinant of trade flows, its effect is not always symmetric and is often dwarfed by income growth differentials¹¹.
• Pass-Through Effects: The degree to which exchange rate changes are passed through to the prices of exports and imports can also affect the outcome. If firms do not fully adjust their prices in response to exchange rate movements (e.g., due to strategic pricing or dollar invoicing), the impact on quantities traded, and thus the trade balance, may be reduced⁹, ¹⁰.

Despite these criticisms, the Marshall-Lerner condition remains a foundational concept in international economics, offering a starting point for analyzing the complex interplay between exchange rates and trade.

Marshall-Lerner Condition vs. J-Curve Effect

The Marshall-Lerner condition and the J-curve effect are closely related concepts in international economics, often discussed together because they describe different phases of a currency depreciation's impact on the trade balance.

The J-curve effect is essentially a dynamic illustration of how the Marshall-Lerner condition plays out over time⁸. In the short run, the responsiveness of trade volumes to price changes (elasticities) may be low, meaning the Marshall-Lerner condition is not met. This leads to an initial worsening of the trade balance. However, as time passes and economic agents adjust to the new exchange rates, the elasticities increase, eventually satisfying the Marshall-Lerner condition and leading to an improvement in the trade balance⁷.

FAQs

What happens if the Marshall-Lerner condition is not met?

If the Marshall-Lerner condition is not met (i.e., the sum of the absolute price elasticities of demand for exports and imports is less than one), a currency depreciation would actually lead to a deterioration of the Trade Balance. This means the value of imports would rise more than the value of exports, increasing the trade deficit or reducing the surplus⁶.

Is the Marshall-Lerner condition always met in the real world?

No, the Marshall-Lerner condition is not always met, especially in the short run. Various factors, such as existing trade contracts, consumer habits, and slow adjustments by firms, can lead to low price elasticities immediately after a Currency Devaluation. However, in the long run, as economic agents adjust, the elasticities tend to increase, making the condition more likely to be met⁵.

How does the Marshall-Lerner condition relate to the J-curve?

The Marshall-Lerner condition explains why the J-curve effect occurs. The initial downward slope of the J-curve, representing a worsening trade balance after depreciation, happens because short-run elasticities are typically low, meaning the Marshall-Lerner condition is not met. The subsequent upward slope, showing an improvement, occurs as elasticities increase over time and eventually satisfy the condition³, ⁴.

Why is the Marshall-Lerner condition important for policymakers?

The Marshall-Lerner condition is crucial for policymakers because it helps them predict the likely effectiveness of Exchange Rate adjustments as a tool to influence the Current Account and overall external balance. Understanding whether the condition holds for their economy can inform decisions regarding Monetary Policy and other economic strategies².

Does the Marshall-Lerner condition consider supply?

The standard Marshall-Lerner condition primarily focuses on the Demand Elasticity of exports and imports, implicitly assuming that supply is perfectly elastic or can adjust easily. However, in more advanced analyses, supply-side factors and their elasticities are also considered, as supply constraints can influence the overall impact of exchange rate changes on the trade balance¹.