The Marshall-Lerner condition
When evaluating the impact of a currency fluctuation on the balance of trade we should consider the Marshall-Lerner condition.
We normally assume that when a currency depreciates imports fall and exports increase and therefore balance of trade improves. When a currency appreciates we normally assume exports fall and imports increase and thus our balance of trade worsens.
Therefore to improve our balance of trade we want a weak or depreciating currency.
However, this analysis ignores the impact of price elasticity of demand for imports and exports. The Marshall-Lerner condition makes us consider those price elasticities.
The Marshall-Lerner condition is set to hold when the sum of price elasticity of demand for imports and exports is greater than 1.
What does that mean?
It basically means that the change in demand for imports and exports needs to be greater than the change in value of the currency.
So, if the currency depreciates by 10% the sum price elasticity of demand for imports and exports needs to be greater than 10% (that is elastic; greater than 1)for the depreciation to improve the balance of trade.
If we go through a hypothetical example it may help.
Imagine our currency depreciates by 10%. The depreciation of our currency makes are exports 10% cheaper and imports 10% more expensive.
If those exports have a price elasticity of demand that is greater than 1 then it is said to have an elastic response. That means exports will increase by more than 10%.
At the same time if the imports of the country also have an elastic price elasticity of demand then demand for imports will fall by more than 10%. Our balance of trade will therefore improve.
The Marshal-Lerner condition ‘holds’ in this example and balance of trade will improve as a result of depreciation. This is very simple but very important evaluation point.
What are the implications?
Imagine you are in charge of an economy and you want to promote trade and help expand the economy etc, etc. One thing you may consider is a deliberate devaluation of the currency. That should help right?
Well it may, but only if the Marshal-Lerner condition holds for your economy. If you devalue your currency then the net elasticity for imports and exports must be greater than 1 for you to see an improvement.
For example if we devalue the $ by 10% and American demand for imports then fell by 20% that would be a strong elastic response. If export demand also increased by 20% that is again a strong elastic response. Overall there has been a net elastic response and therefore devaluation will help America improve its balance of trade.
By contrast if Saudi Arabia devalued the Riyal y 10% it may find its exports only increasing by 1%, an inelastic response. Its imports may also only fall by, say, 3%, another elastic response. Overall the response to the depreciation is inelastic and Saudi balance of trade will have worsened. They are now spending more on imports and getting less from exports. In this case they shouldn’t devalue; indeed they should hope their currency appreciates.
So if you are importing or exporting inelastic good and services such as energy, food and raw materials, your consumers are unlikely to import significantly less in the face of a devalued currency. So you may want to think twice about devaluation.
By contrast if the goods and service you are trading are quite elastic with lots of substitutes, such as textiles, tourism and basic manufactured goods than depreciation will improve your balance of trade.
This explain why China likes to have a weak Yuan (exporting elastic products such as electronics) while Australia is not that fussed by its strong Dollar (exporting inelastic raw materials)
When the Marshall-Lerner condition is met, and the sum price elasticity of demand for imports and exports is greater than 1, then the balance of trade will improve when a currency depreciates
When the Marshall-Lerner condition is not met, and the sum price elasticity of demand for imports and exports is less than 1, then the balance of trade will worsen when a currency depreciates.
This is the sort of evaluation examiners love.