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Chapter 16
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Key Terms
Dutch disease Stable/unstable foreign exchange market Elasticity pessimism Marshall Lerner condition J-curve effect Price specie flow mechanism
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1 Introduction
Examines how the nation's current account is affected by exchange rate changes. Examines the effect of exchange rate changes on domestic prices in the country. Deals with the closely related topic of the stability of foreign exchange markets. Presents estimates of trade elasticities and explains why the current account usually responds with a time lag and only partially to a change in the nation's exchange rate. Describes the adjustment mechanism under the gold standard.
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7 Marshall-Lerner Condition
The condition that tells us whether the foreign exchange market is stable or unstable is the MarshallLerner condition. The condition is valid when the supply curves of imports and exports (i.e., SM and Sx) are both infinitely elastic, or horizontal. Then the Marshall-Lerner condition indicates a stable foreign exchange market if the sum of the price elasticities of the demand for imports (DM) and the demand for exports (Dx), in absolute terms, is greater than 1. If the sum of the price elasticities of DM and Dx is less than l, the foreign exchange market is unstable, and if the sum of these two demand elasticities is equal to 1, a change in the exchange rate will leave the balance of payments unchanged.
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8 Elasticity Estimates
The Marshall-Lerner condition postulates a stable foreign exchange market if the sum of the price elasticities of the demand for imports and the demand for exports exceeds 1 in absolute value. However, the sum of these two elasticities will have to be substantially greater than 1 for the nation's demand and supply curves of foreign exchange to be suffciently elastic to make a depreciation or devaluation feasible as a method of correcting a deficit in the nation's balance of payments. Thus, it is very important to determine the real-world value of the price elasticity of the demand for imports and exports.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 11/17
8 Elasticity Estimates
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Thank You!
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