Marshall Lerner condition
This refers to the proposition that the devaluation of a country’s currency will lead to an improvement in its balance of trade with the rest of the world only if the sum of the price elasticities of its exports and imports is greater than one. For instance, if total export revenue falls due to inelastic demand for a country’s exports and total import expense rises due to inelastic demand for its imports, this will lead to a further worsening of the country’s trade deficit. So devaluing its currency may not always be the best way forward for a country looking to reduce its trade deficit. The Marshall-Lerner condition is named after British economist Alfred Marshall and Russian economist Abba P. Lerner.
POINT TO REMEMBER
Marshall-Lerner condition The Marshall-Lerner condition refers to the impact of a depreciation, or devaluation, of a currency on the current account of the balance of payments. The condition states that the current account will improve, after a depreciation, if the sum of the price elasticities of demand for imports and exports is greater than 1. The further above 1 the sum of the elasticities is, the greater the improvement in the current account will be.
Empirical evidence suggests the elasticity of demand for exports and imports tends to be inelastic in the short run, but more elastic in the long run. Therefore a devaluation often worsens the current account in the short term but improves it in the long-term.
J-curve Evidence around the world suggests that the Marshall-Lerner condition does not hold in the shortrun, but does in the medium- to long-run. This is because in the short-run, there will be few extra exports sold when prices fall – people overseas do not react immediately and so export demand will take time to change. Generally this is due to exports being on contracts and these need renegotiating.
However, extra money will have to be paid for imports immediately contracted amounts stay the same and so the current account will tend to deteriorate.
In the medium/long term, however, the lower export prices will lead to an increase in demand for exports and so the current account will start to improve. The price elasticity of demand for exports is lower in the short-run, but will be higher in the long-run. This leads to the pattern shown in Figure below – an initial deterioration of the trade balance followed by an improvement.