The Marshall Lerner Condition

This study note for A-Level and IB Economics covers the Marshall-Lerner condition.

The Marshall-Lerner Condition is a crucial concept in international economics that describes the conditions under which a change in the exchange rate will improve a country's trade balance. It states that a depreciation (or devaluation) of a country's currency will improve its trade balance if the sum of the price elasticities of exports and imports is greater than one.

Key Components of the Marshall-Lerner Condition

1. Price Elasticity of Demand
   • Elasticity of Exports (εx): Measures how the quantity demanded of exports responds to changes in the exchange rate.
   • Elasticity of Imports (εm): Measures how the quantity demanded of imports responds to changes in the exchange rate.
   • The condition can be expressed as: ∣ϵx∣+∣ϵm∣>1∣ϵx​∣+∣ϵm​∣>1
   • If the sum of these elasticities is greater than one, a depreciation of the domestic currency will improve the trade balance.
2. Impact of Currency Depreciation
   • Depreciation: A fall in the value of a country's currency relative to another currency.
   • Improved Trade Balance: When the sum of the elasticities is greater than one, the increase in export volumes and the decrease in import volumes (due to higher prices in domestic currency) will more than offset any price changes, leading to an improved trade balance.

Application of the Marshall-Lerner Condition

• Real-World Example: The United Kingdom
  • During the 1992 Sterling Crisis, the UK left the European Exchange Rate Mechanism (ERM), leading to a significant depreciation of the pound. Following this depreciation, the UK's trade balance improved, consistent with the Marshall-Lerner Condition.
• Developing Economies
  • Many developing countries have used currency devaluation as a tool to improve trade balances. For instance, Egypt’s devaluation in 2016 was aimed at improving its trade deficit.

Timeline of Key Economic Events and Policy Responses

• 1923: Alfred Marshall's work on elasticity is published in "Money, Credit and Commerce".
• 1944: Abba Lerner publishes "The Economics of Control", where he elaborates on the elasticity approach to the balance of payments.
• 1971: End of the Bretton Woods system, leading to more frequent currency adjustments and applications of the Marshall-Lerner Condition.
• 1992: UK's Sterling Crisis exemplifies the real-world application of the condition.
• 2016: Egypt devalues its currency to address trade imbalances.

Critique of the Model

• Short-Term vs Long-Term Effects: The condition assumes that elasticities are stable and can be applied in both the short and long term. However, in the short term, contracts and consumer habits may not adjust quickly.
• J-Curve Effect: Following a depreciation, the trade balance may initially worsen before improving, as prices adjust faster than quantities.
• Assumption of Perfect Competition: The condition assumes markets are perfectly competitive, which may not hold in reality due to monopolistic practices, trade barriers, and other distortions.

Glossary

• Depreciation: A decrease in the value of a country's currency relative to another currency.
• Elasticity of Exports: The responsiveness of the quantity demanded of exports to a change in price.
• Elasticity of Imports: The responsiveness of the quantity demanded of imports to a change in price.
• Exchange Rate: The price of one currency in terms of another.
• J-Curve Effect: A situation where a country's trade deficit initially worsens following a depreciation before it improves.
• Price Elasticity of Demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good.
• Trade Balance: The difference between a country's exports and imports of goods and services.

Essay-Style Questions

1. Explain the Marshall-Lerner Condition and discuss its significance for exchange rate policy.
2. Evaluate the short-term and long-term effects of currency depreciation on a country's trade balance using the Marshall-Lerner Condition.
3. Discuss the limitations of the Marshall-Lerner Condition in predicting the outcomes of currency devaluation in modern economies.
4. Analyze the impact of the J-Curve effect on the effectiveness of the Marshall-Lerner Condition in the short term.
5. Compare and contrast the Marshall-Lerner Condition with other theories of international trade balance adjustment.

Recommended Articles and Papers

1. Marshall, A. (1923). "Money, Credit and Commerce." Macmillan.https://www.amazon.com/Money-C...
2. Lerner, A. P. (1944). "The Economics of Control: Principles of Welfare Economics." Macmillan.https://www.amazon.com/Economi...
3. Robinson, J. (1947). "Essays in the Theory of Employment." Blackwell Publishing.https://www.amazon.com/Essays-...
4. Strange, S. (1986). "Casino Capitalism." Blackwell Publishing.https://www.amazon.com/Casino-...
5. Krugman, P. (1991). "Exchange-Rate Instability." MIT Press.https://mitpress.mit.edu/books...

These notes provide a comprehensive overview of the Marshall-Lerner Condition, its key components, applications, critiques, and contributions from notable economists. They also offer additional resources, potential essay questions, and a glossary to deepen students' understanding of the topic.