Marshall-Lerner Condition and J Curve

The Marshall-Lerner condition is at the heart of the elasticities approach to the balance
of payments. It is named after the economists who discovered it independently: Alfred
Marshall (1842-1924), Abba Lerner (1903-82).
The condition seeks to answer the following question: when does a real devaluation (in
fixed exchange rates) or a real depreciation (in floating exchange rates) of the currency
improve the current-account balance of a country?
The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of
the currency will improve the trade balance if the sum of the elasticities (in absolute
values) of the demand for imports and exports with respect to the real exchange rate is
greater than one,

Exportsped+Importsped > 1
J Curve
A country's trade balance experiences the J-curve effect if its currency becomes
devalued. At first, the country's total value of imports (goods purchased from abroad)
exceeds its total value of exports (goods sold abroad), resulting in a trade deficit. But
eventually, the currency devaluation reduces the price of its exports. Consequently, the
country's level of exports gradually recovers, and the country moves back to a trade
surplus.
Rationale behind J-Curve
Immediately following the depreciation or devaluation of the currency, the volume of
imports and exports may remain largely unchanged due in part to pre-existing trade
contracts that have to be honoured. Moreover, in the short run, demand for the more
expensive imports (and demand for exports, which are cheaper to foreign buyers using
foreign currencies) remain price inelastic. This is due to time lags in the consumer's
search for acceptable, cheaper alternatives (which might not exist).
Over the longer term a depreciation in the exchange rate can have the desired effect of
improving the current account balance. Domestic consumers might switch their
expenditure to domestic products and away from expensive imported goods and
services, assuming equivalent domestic alternatives exist. Equally, many foreign
consumers may switch to purchasing the products being exported into their country,
which are now cheaper in the foreign currency, instead of their own domestically
produced goods and services
Economic integration results in trade creation and trade diversion. Trade creation leads
to advantages while trade diversion is not desirable from an economists point of view.

Trade Creation
Trade creation takes place when domestic consumers in member countries import more
goods from other members as import prices fall due to a removal of tariff and quotas;
production will shift to lower cost producer.
In the above diagram, when Thailand and Malaysia form a trading bloc, Thailand will
remove tariffs from Malaysian imports. Trade will go to more efficient Malaysian
producers. The blue shaded regions shows that world efficiency wil be regained as now
more efficient producer is producing the good and there are lower prices which lead to
regaining of consumer surplus.
Increased income resulting from specialisation and benefits of scale, can further this by
creating increased demand for imports from non-member countries.
Initial effects are the increase in consumer welfare resulting from more goods and lower
prices, while the long-run effects include enhance competitive advantage and increasing
specialization.

Trade Diversion
When a customs union is created and tariffs differentials between members and non-
member result in trade flows being diverted toward higher cost producers.

In the upper image, once the UK joined the EU, it had to place tariffs on the Palm Oil
that it used to import from Malaysia at lower prices. The trade now is diverted to EU
nations, in spite of the fact that they are inefficient in producing palm oil.
The blue shaded regions show a loss in efficiency due production by inefficiently
European producers. Moreover, the prices for consumers have increased from Pm to
Peu which results in loss of consumer surplus.
In other words, lower cost imports from outside the union have been replaced by high
cost imports from within the union.
Current Account Deficits and Exchange rate
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest

and dividends.

A deficit in the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.

Implications of a persistent current account

deficit
Exchange rate: As discussed earlier, a persistent current account deficit will lead to
a fall in the value of the domestic currency.

Another way is to draw on reserves, however if the reserves are run down to rapidly, it
may cause a crisis of confidence and foreign investment may withdraw suddenly.
Persistent current account deficits will also lead to depletion of foreign exchange
reserves.

Indebtedness: If the combined balance is a deficit, then it would have to be covered

by borrowings from abroad or attracting deposits from abroad. It might mean paying
more interest.
Increase in Interest rates: With a falling exchange rate, the government might have to
take more serious monetary measures such as increasing the interest rates. This will
attract foreign currency, however, the higher interest rates means compromising the
Aggregate Demand in the economy.

Another alternative is to attract foreign investments. However, it leads to greater

outflows in interest and dividends in the future.

Methods to correct a persistent current

account deficit
Expenditure switching policies
These are policies implemented by the government that attempt to switch the
expenditure of domestic consumers away from imports towards domestically produced
goods & services.

Devaluating currency: Fixing the domestic currency value at a lower price and
thus making exports more attractive. Moreover, imports will become more
expensive, thus diverting consumption to domestic goods.

However, expensive imports will lead to imported inflation

Protectionist measures: Reducing imports by levying tariffs and setting up

quotas. Please refer to problems related with protectionism.

Expenditure reducing policies

These are policies implemented by the government that attempt to reduce overall expenditure in the
economy, so shifting the AD to the left.

deflationary fiscal policies: Increasing taxes and reducing government spending.

deflationary monetary policies: Increasing Interest rates.

However, contractionary fiscal and monetary policies will lead to fall in Aggregate Demand, which is
not desirable. This will result in compromising economic growth and higher unemployment.

Supply Side policies

The main objective of the supply side policies is to improve the quantity and quality of factors of
production. By achieving efficiency in the production of goods and services, the economy can
improve its international competitiveness and increase its exports. This would include

Improvement in technology

Improving the education and skill level of its workforce

Providing better infrastructure

Privatization

deregulation

All of the above measures will also attract foreign investment in the economy, which will lead to inflow
of foreign currency and improve balance of payment.

Supply-side policy can provide a highly effective policy framework for long term improvement in
competitiveness and current account performance. The main problem is that supply-side policy
may take decades to work and is not a quick-fix.

Current Account Surplus

A current account surplus occurs when the countrys exports are more than its imports. This is a
desirable condition, however it has its own problem associated with it.

A surplus in the long run will lead to the appreciation of the countrys currency which will reduce its
export competitiveness.

Lower domestic consumption: Relatively stronger currency will induce people to go in for imported
goods, thus harming the domestic consumption and investment. In the long run, it will harm the
domestic industry and increase unemployment.
Consequences of overvalued and
undervalued currencies
Overvalued Currency
Advantages
Downward pressure on inflation i.e. imported goods will be cheaper

More imports can be bought

High value of currency forces domestic producers to improve their efficiency to be more
competitive in the international market.

Disadvantages
Overvalued currency will make exports uncompetitive in the international market which
will hurt the export industries

Imports are relatively cheaper to buy due to overvalued currency. Consumers will go in for
more imports which will damage to domestic industries

Undervalued currency
Advantages
If currency is undervalued, the exports will be cheaper and they will grow leading to greater
employment in export industries

Undervalued currency will make imports expensive for consumers, they will divert to
domestic goods and thus employment in domestic industries will increase.
Disadvantages
As discussed earlier undervalued currency makes imports expensive which also leads
to Imported inflation i.e. all the products using imported components/raw material will become
expensive thus effecting the general price level.

Government Intervention in the

exchange rate
Fixed Exchange Rate
A fixed exchange rate system refers to the case where the exchange rate is set and maintained at
same level by the government irrespective of the market forces.

Revaluation and Devaluation

It refers to official changes in the price of a currency in a fixed exchange rate system.

Devaluation is when the price of the currency is officially decreased in a fixed exchange rate
system.

Revaluation is the official increase in the price of the currency within a fixed exchange rate
system.

Managed Exchange Rate

A managed exchange rate occurs when there is official intervention by a government or an agency
such as the Central Bank to determination the value of a countrys exchange rate. Through such
official interventions it is possible to manage both fixed and floating exchange rates.

For example,

The Fedral Bank may decide to enter the foreign exchange market as either a buyer or seller to
stabilise any short-term fluctuation in the value US$. To limit a fall in the value of US$ (depreciation)
the Fed will buy US$, and to prevent a rise in the value of US$, the central bank will sell US$ in the
market.
Such intervention by the central bank is known as a dirty float, or more correctly a managed
float.

Other Government actions and their effect

Expansionary monetary policy (MS) causes an increase in GNP and a depreciation of the domestic
currency in a floating exchange rate system in the short run.

Contractionary monetary policy (MS) causes a decrease in GNP and an appreciation of the
domestic currency in a floating exchange rate system in the short run.

Expansionary fiscal policy (G, TR, or T) causes an increase in GNP and an appreciation of the
domestic currency in a floating exchange rate system.

Contractionary fiscal policy (G, TR, or T) causes a decrease in GNP and a depreciation of the
domestic currency in a floating exchange rate system.

In the long run, once inflation effects are included, expansionary monetary policy (MS) in a full
employment economy causes no long-term change in GNP and a depreciation of the domestic
currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-
run target and GNP rises then falls.

A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the AA-
DD model, unless international investors adjust their expected future exchange rate in response.

A central bank can influence the exchange rate with direct Forex interventions (buying or selling
domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic
currency, the central bank must have a stockpile of foreign currency reserves.

A central bank can also influence the exchange rate with indirect open market operations (buying or
selling domestic treasury bonds). These transactions work through money supply changes and their
effect on interest rates.

Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and
cause a secondary indirect effect upon the exchange rate.