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