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

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