Marshall-Lerner & J-Curve (DP IB Economics)

Revision Note

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The Marshall-Lerner Condition

  • When a currency is devalued in a fixed exchange rate system or experiences depreciation in a floating exchange rate system, it makes the country's exports cheaper 

  • Depreciation of the currency causes exports to be cheaper for foreigners to buy and imports to the UK are more expensive

  • The extent to which this depreciation improves the current account balance depends on the Marshall-Lerner condition

    • This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand

    • If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance

The J-Curve Effect

  • It is also important to recognise that there is a time lag between the depreciation of the currency and any subsequent improvement in the current account balance

  • This time lag is explained by the J-Curve effect

    • It takes time for firms and consumers to respond to changes in price

    • Once it becomes evident that price changes will last for a longer period of time, firms and consumers change their patterns

    • E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term they are likely to switch

     

The J Curve explains what happens to a trade balance over time when the country's currency depreciates

The J Curve explains what happens to a trade balance over time when the country's currency depreciates

Diagram Analysis

  • In the short run, the sum of PEDs for exports and imports was less than one / inelastic (or the Marshall-Lerner condition was not fulfilled) so the deficit widens

  • However, in the long run the Marshall-Lerner condition is met so it leads to a surplus

  • With any currency depreciation/devaluation, the trade balance will initially worsen before it improves

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