Question: Is the Marshall-Lerner condition satisfied in practice? 1) Historical examples Italy Poland ) Econometric estimation of elasticities OLS The J-curve 3) Both determinants together: Real exchange rate & income Keynesian model of the TB Estimation for the case of East Asian countries LECTURE 2: THE TRADE BALANCE IN PRACTICE

Professor Jeffrey Frankel, Kennedy School, Harvard University 1992 devaluation Rise in trade balance (i) Italy devalued in Europe’s 1992 ERM crisis. The lira’s Real Effective Exchange Rate value & effect on its trade balance. Historical examples

(ii) Poland’s Exchange Rate Rose 35% when Global Financial Crisis hit in late Source: Cezary Wójcik Zloty/€

Poland’s trade balance improved sharply in 2009 while its European trading partners all went into recession. Source: National Bank of Poland From FocusEconomics 2014 Trade balance in billions of euros => Poland avoided recession. Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7%

A textbook case where depreciation was expansionary: Poland, the only continental EU member with a floating rate, was also the only one to escape negative growth in the global recession of Source: Cezary Wójcik, 2010 (de facto) % change in GDP

Empirical estimation of export & import elasticities Coefficient estimated by OLS regression. – In logs, so parameters are elasticities. log of X demanded log of EP*/P ≡ Price of foreign goods relative to domestic goods

Common econometric finding Estimated trade elasticities with respect to relative prices often ≈ 1, after a few years have been allowed to pass. – => Marshall-Lerner condition holds in the medium run. – e.g., Marquez (2002). Some face a higher elasticity of demand for their exports: – small countries, and – producers of agricultural & mineral commodities or other commodities that are close substitutes for competitors’ exports.

Common empirical observation: After a devaluation, trade balance gets worse before it gets better. Explanation: Even if devaluation is instantly passed through to higher import prices, buyers react with a lag. Also, in practice, it may take time up front before the devaluation is passed through to import prices.

The trade balance is a function of both the real exchange rate and income. Recall the Keynesian model of the trade balance from Lecture (iii) of the pre-semester Macro Review. Micro theory: The demand for the import or export good, as for any good, is a function of both price & income.

Keynesian Model of the Trade Balance Import demand is a function of the exchange rate & income. The same for exports: => X = X(E, Y*) M = M(E, Y).. If the domestic country is small, Y* is exogenous.

Estimated price elasticities (LR) satisfy the Marshall-Lerner Condition. Estimated income elasticities are mostly between

END OF LECTURE 2: THE TRADE BALANCE IN PRACTICE

After big devaluations in Mexico in 1994 and Korea & Southeast Asia in 1997, trade balances “improved” quickly, but because of expenditure-reduction, not expenditure-switching. Appendix 1 -- More historical examples: EM currency crises of the 1990s.

Professor Jeffrey Frankel, Kennedy School, Harvard University Why did trade fall so much more sharply than income in the global recession? Appendix 2– An application of the marginal propensity to import

An application of the marginal propensity to import: Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " Why did trade fall so much more sharply than income in the global recession? 2009

Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of " Why did trade fall so sharply in the global recession? The usual explanations involve trade credit, inventories, and trade in intermediate inputs.

Behavior of real components of GDP in the recession Demand, adjusted for import-intensity GDP Investment Imports & Exports Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of “ Bussière et al (2013) argue that Investment, which declined much more in 2009 than the other components of GDP, has a higher marginal propensity to import than the other components.