State the Marshall-Lerner condition.

The Marshall-Lerner condition states that a depreciation of a currency will improve a country's current account only if the sum of the price elasticity of demand for its exports and the price elasticity of demand for its imports, both taken as positive numbers, is greater than one. If the sum is less than one the depreciation will worsen the current account, and if it equals one the effect is approximately neutral.

Explain the economic reasoning behind the Marshall-Lerner condition.

A depreciation has two opposing effects on the current account. It improves the balance through volumes, because cheaper exports sell in greater quantity and dearer imports are bought in smaller quantity. It worsens the balance through prices, because every unit still imported now costs more in domestic currency, a straightforward deterioration in the terms of trade. The elasticities measure how strongly volumes respond, so the condition is simply the statement that the volume effects must be large enough, taken together, to outweigh the adverse price effect.

A country's exports are worth 200 billion pounds and its imports 200 billion pounds, so its trade is balanced. The currency depreciates by 10 per cent. The price elasticity of demand for exports is 0.4 and for imports is 0.5. Calculate the new trade balance in domestic currency.

The sum of the elasticities is 0.9, which is less than one, so the condition is not met. Export volumes rise by 0.4 multiplied by 10 per cent, which is 4 per cent, and since export prices in domestic currency are unchanged, export revenue becomes 200 multiplied by 1.04, which is 208 billion pounds. Import volumes fall by 0.5 multiplied by 10 per cent, which is 5 per cent, but each unit costs 10 per cent more in domestic currency, so import spending becomes 200 multiplied by 0.95 multiplied by 1.10, which is 209 billion pounds. The balance moves from zero to minus 1 billion pounds, so the current account has worsened.

Using the same starting position of exports and imports each worth 200 billion pounds and a 10 per cent depreciation, calculate the new trade balance if the price elasticity of demand for exports is 0.8 and for imports is 0.7.

The sum of the elasticities is 1.5, which exceeds one, so the condition is met. Export revenue becomes 200 multiplied by 1 plus 0.8 multiplied by 0.10, that is 200 multiplied by 1.08, which is 216 billion pounds. Import spending becomes 200 multiplied by 1 minus 0.7 multiplied by 0.10, all multiplied by 1.10, that is 200 multiplied by 0.93 multiplied by 1.10, which is 204.6 billion pounds. The balance improves from zero to plus 11.4 billion pounds.

A country exports 250 billion pounds and imports 280 billion pounds. Its currency depreciates by 12 per cent. The price elasticity of demand for exports is 0.6 and for imports is 0.9. Calculate the new balance.

The sum of the elasticities is 1.5, so the condition is met. Export revenue becomes 250 multiplied by 1 plus 0.6 multiplied by 0.12, that is 250 multiplied by 1.072, which is 268 billion pounds. Import spending becomes 280 multiplied by 1 minus 0.9 multiplied by 0.12, all multiplied by 1.12, that is 280 multiplied by 0.892 multiplied by 1.12, which is 279.73 billion pounds. The deficit narrows from 30 billion pounds to 11.73 billion pounds, an improvement of 18.27 billion pounds.

A country exports 150 billion pounds and imports 150 billion pounds. Its currency depreciates by 10 per cent, and the price elasticities of demand for exports and imports are 0.2 and 0.3. Calculate the new balance and comment.

The sum of the elasticities is 0.5, well below one, so the condition fails badly. Export revenue becomes 150 multiplied by 1.02, which is 153 billion pounds. Import spending becomes 150 multiplied by 0.97 multiplied by 1.10, that is 150 multiplied by 1.067, which is 160.05 billion pounds. The balance moves from zero to a deficit of 7.05 billion pounds, so the depreciation has made the current account substantially worse.

CCEA A-Level Economics 4410

Key Economic Concepts

Topic overview The four factors of production Positive statements and normative judgements Economic agents and what they are trying to achieve Capital goods and consumption goods Product markets and factor markets

The Basic Economic Problem of Scarcity and Choice

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Demand and Supply in Product Markets

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Markets and Equilibrium

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Elasticity of Demand and Supply

Topic overview Price elasticity of demand: measuring and interpreting Income and cross elasticity: normal, inferior, substitutes and complements Price elasticity of supply What determines the value of an elasticity Elasticity and total revenue How useful is elasticity for firms and government?

Factor Markets: Labour

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Market Failures and Imperfections

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Government Intervention in Markets

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Measuring National Income

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Aggregate Demand

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Macroeconomic Equilibrium

Topic overview How aggregate demand and aggregate supply determine equilibrium Applying AD-AS analysis to growth and unemployment Applying AD-AS analysis to inflation

Macroeconomic Objectives

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Inflation

Topic overview Inflation, deflation and disinflation: what the words actually mean Measuring the rate: the CPI and the RPI Working with index numbers Building a price index: the basket and the significance of weights Demand-pull and cost-push inflation The costs and consequences of inflation and deflation The policy response to inflation

Unemployment

Topic overview The claimant count and the ILO measure of unemployment Calculating and interpreting unemployment statistics Unemployment and economic inactivity: a distinction that changes the numbers The types of unemployment and what distinguishes them The causes of unemployment and of economic inactivity The costs and consequences of unemployment and inactivity Policies for unemployment and intervention in the labour market

Economic Growth

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Fiscal Policy and Its Effects

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Monetary Policy

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Supply-Side Policies

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Perfect Competition

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Monopoly

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Monopolistic Competition

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Oligopoly

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Contestable Markets

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Trade and Globalisation

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Balance of Payments

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Exchange Rate Systems and Competitiveness

Topic overview How foreign exchange markets operate The influences on currency demand and supply Monetary policy, intervention and other influences on the exchange rate Fixed and floating exchange rate systems The Marshall-Lerner condition and the J-curve The effect of exchange rate changes on the current account Trade-weighted exchange rate indices Purchasing power parity and comparing competitiveness Evaluating exchange rate policy

European Union (EU)

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Monetary Policy and the Financial Sector

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Fiscal Deficits and the National Debt

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Macroeconomic Policies and Objectives in a Global Economy

Topic overview Comparing the performance of different economies Global events and how they reach the domestic economy Responding to external demand and supply shocks Problems and constraints facing policymakers How the priority given to macroeconomic objectives has changed Comparing policies against one another

Quantitative Skills in Economics

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Exchange Rate Systems and Competitiveness

The Marshall-Lerner condition and the J-curve

1 thing to know
Unit A2 2

Overview

Marshall-Lerner condition, J-curve effect and why the current account worsens immediately after a depreciation.

What you need to know

Answer each one before you reveal it.

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Key term

Why are the price elasticities of demand for exports and imports typically low in the short run?

Questions from this subtopic

Each one with the model answer underneath.

1
State the Marshall-Lerner condition.
Model answer
The Marshall-Lerner condition states that a depreciation of a currency will improve a country's current account only if the sum of the price elasticity of demand for its exports and the price elasticity of demand for its imports, both taken as positive numbers, is greater than one. If the sum is less than one the depreciation will worsen the current account, and if it equals one the effect is approximately neutral.
2
Explain the economic reasoning behind the Marshall-Lerner condition.
Model answer
A depreciation has two opposing effects on the current account. It improves the balance through volumes, because cheaper exports sell in greater quantity and dearer imports are bought in smaller quantity. It worsens the balance through prices, because every unit still imported now costs more in domestic currency, a straightforward deterioration in the terms of trade. The elasticities measure how strongly volumes respond, so the condition is simply the statement that the volume effects must be large enough, taken together, to outweigh the adverse price effect.
3
A country's exports are worth 200 billion pounds and its imports 200 billion pounds, so its trade is balanced. The currency depreciates by 10 per cent. The price elasticity of demand for exports is 0.4 and for imports is 0.5. Calculate the new trade balance in domestic currency.
Model answer
The sum of the elasticities is 0.9, which is less than one, so the condition is not met. Export volumes rise by 0.4 multiplied by 10 per cent, which is 4 per cent, and since export prices in domestic currency are unchanged, export revenue becomes 200 multiplied by 1.04, which is 208 billion pounds. Import volumes fall by 0.5 multiplied by 10 per cent, which is 5 per cent, but each unit costs 10 per cent more in domestic currency, so import spending becomes 200 multiplied by 0.95 multiplied by 1.10, which is 209 billion pounds. The balance moves from zero to minus 1 billion pounds, so the current account has worsened.
4
Using the same starting position of exports and imports each worth 200 billion pounds and a 10 per cent depreciation, calculate the new trade balance if the price elasticity of demand for exports is 0.8 and for imports is 0.7.
Model answer
The sum of the elasticities is 1.5, which exceeds one, so the condition is met. Export revenue becomes 200 multiplied by 1 plus 0.8 multiplied by 0.10, that is 200 multiplied by 1.08, which is 216 billion pounds. Import spending becomes 200 multiplied by 1 minus 0.7 multiplied by 0.10, all multiplied by 1.10, that is 200 multiplied by 0.93 multiplied by 1.10, which is 204.6 billion pounds. The balance improves from zero to plus 11.4 billion pounds.
5
A country exports 250 billion pounds and imports 280 billion pounds. Its currency depreciates by 12 per cent. The price elasticity of demand for exports is 0.6 and for imports is 0.9. Calculate the new balance.
Model answer
The sum of the elasticities is 1.5, so the condition is met. Export revenue becomes 250 multiplied by 1 plus 0.6 multiplied by 0.12, that is 250 multiplied by 1.072, which is 268 billion pounds. Import spending becomes 280 multiplied by 1 minus 0.9 multiplied by 0.12, all multiplied by 1.12, that is 280 multiplied by 0.892 multiplied by 1.12, which is 279.73 billion pounds. The deficit narrows from 30 billion pounds to 11.73 billion pounds, an improvement of 18.27 billion pounds.
6
A country exports 150 billion pounds and imports 150 billion pounds. Its currency depreciates by 10 per cent, and the price elasticities of demand for exports and imports are 0.2 and 0.3. Calculate the new balance and comment.
Model answer
The sum of the elasticities is 0.5, well below one, so the condition fails badly. Export revenue becomes 150 multiplied by 1.02, which is 153 billion pounds. Import spending becomes 150 multiplied by 0.97 multiplied by 1.10, that is 150 multiplied by 1.067, which is 160.05 billion pounds. The balance moves from zero to a deficit of 7.05 billion pounds, so the depreciation has made the current account substantially worse.

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Key Economic Concepts

The Basic Economic Problem of Scarcity and Choice

Demand and Supply in Product Markets

Markets and Equilibrium

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