The MARSHALL-LERNER CONDITION IB ECONOMICS A Course Companion. P298-300

The Marshall Lerner Condition Theoretically if a country’s currency depreciates or is devalued then this will lead to an increase in exports (they become less expensive in foreign markets) and a decrease in imports (they become more expensive domestically) This should result in an improvement in a country’s CAD, but this is not always the case.

The Marshall Lerner Condition Price Elasticity of Demand The effect of a price change on spending or revenues depends on price elasticity of demand. The price of exports might fall because of depreciation of the currency and according to the law of demand, the quantity demanded will increase, BUT whether or not this leads to increase in export revenues depends on foreigners price elasticity of demand for exports

The Marshall Lerner Condition Price Elasticity of Demand The price of imported goods will rise if a currency falls in value, and according to the law of demand, the quantity demanded will fall, BUT whether or not this leads to fall in expenditure on imports depends on the price elasticity of demand for imports.

The Marshall Lerner Condition RULE The Marshall-Lerner condition is a rule that tells us how successful a depreciation or devaluation of currency ‘s exchange rate will be as a means to improve a CAD in the BOP. The condition states that reducing the value of the exchange rate will only be successful if the total value of the price elasticity of demand for exports and price elasticity of demand for imports is greater than one (Elastic)

The Marshall Lerner Condition RULE Expressed as Equation It may be written as an equation, stating that a fall in the exchange rate will reduce a current account deficit if: PEDexports + PEDimports > 1

The Marshall Lerner Condition RULE Demand for Exports is Price Inelastic If the demand for exports was price inelastic and the price fell as a result of a fall in the exchange rate, then the proportionate increase in the quantity of exports demanded would be less than the proportionate decrease in price of exports and export revenue would fall.

The Marshall Lerner Condition RULE Demand for Imports is Price Inelastic In the same way, if the demand for imports was price inelastic and price rose falling a fall in the exchange rate, then the proportionate fall in demand for imports would be less than the proportionate increase in the price of imports and import expenditure would actually increase. The current account deficit would become worse.

Time Periods & Elasticity One of the determinants of elasticity of demand is the time period under consideration Demand becomes more elastic over a longer period of time. This applies to the elasticity of demand for exports and imports. Most developed countries meet the Marshall-Lerner condition in the long run.

Exercises – Marshall-Lerner Condition Part A The country of Isla Bonita has just 3 exports which its sends to one country - the US. The US demand for exports from Isla Bonita is shown below after a range of price changes. Export Good Original Price Original Demand New Price New Demand Beach Chairs $100 10,000 $60 17,000 1.75 Sugar (per kilo) $1.50 50,000 $2.00 46,000 0.24 A1 Resort Rooms (per night) $150 5,000 $175 4,000 1.20 1.06

Exercises – Marshall-Lerner Condition Part B The country of Isla Bonita has just 3 imports which its receives From the US. Isla Bonita’s demand for imports after a range of price changes is shown below: Export Good Original Price Original Demand New Price New Demand Laptop Computers $1000 2,000 $800 2,100 0.25 Televisions $500 1,200 $900 1,000 0.208 Standard Family Sedan-Car $20,000 500 $25,000 480 0.16 0.206

Exercises – Marshall-Lerner Condition Task Using the trade information for Isla Bonita calculate the PED for exports and the PED for imports. If Isla Bonita is suffering from CAD, should it depreciate its currency as one possible solution?? In other words does Isla Bonita satisfy the Marshall-Lerner condition?? Justify your answer.

Research: Origin – Marshall Lerner Why is it called the Marshall-Lerner condition? When was the theory proposed?

Research: The J Curve A very famous graph called the J Curve is associated with the Marshall Lerner Condition. Conduct appropriate internet research to explain the concept of the J Curve or Use an Economics text book. Draw the graph and provide a summary paragraph (8 to 10 sentences) regarding the main ideas.

J CURVE – GRAPH

Explanation of J Curve (8 to 10 sentences)