MarshallLerner condition

The MarshallLerner condition (after Alfred Marshall and Abba P. Lerner) has been cited as a technical reason why a reduction in value of a nation's currency need not immediately improve its balance of payments. The condition states that, for a currency devaluation to have a positive impact on trade balance, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1. As a devaluation of the exchange rate means a reduction in the price of exports, quantity demanded for these will increase. At the same time, price of imports will rise and their quantity demanded will diminish. The net effect on the trade balance will depend on price elasticities. If goods exported are elastic to price, their quantity demanded will increase proportionately more than the decrease in price, and total export revenue will increase. Similarly, if goods imported are elastic, total import expenditure will decrease. Both will improve the trade balance. Empirically, it has been found that goods tend to be inelastic in the short term, as it takes time to change consuming patterns.{Bahmani-Oskoee & Ratha 2004 } Thus, the MarshallLerner condition is not met, and a devaluation is likely to worsen the trade balance initially. In the long term, consumers will adjust to the new prices, and trade balance will improve. This effect is called J-Curve effect. For example, assume a country is a net importer of oil and a net producer of ships. Initially, the devaluation immediately increases the price of oil, and as consumption patterns remain the same in the short term, an increased sum is spent on imported oil, worsening the deficit on the import side. Meanwhile, it takes some time for the shipbuilder's sales department to exploit the lower price and secure new contracts. Only the funds acquired from previously agreed contracts, now devalued by the currency devaluation, are immediately available, again worsening the deficit on the export side. In economics, the 'J curve' refers to the trend of a countrys trade balance following a devaluation or depreciation under a certain set of assumptions. A devalued currency means imports are more expensive, and on the assumption that the volume of imports and exports change little immediately, this causes a depreciation of the current account (a bigger deficit or smaller surplus). After some time, though, the volume of exports may start to rise because of their lower more competitive prices to foreign buyers, and domestic consumers may buy fewer of the costlier imports. Eventually, if this happens, the trade balance may improve on what it was before the devaluation. If there is a currency revaluation or appreciation the same reasoning leads to an inverted 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. Empirical investigations of the J-curve have sometimes focused on the effect of exchange rate changes on the trade ratio, i.e. exports divided by imports, rather than the trade balance, exports minus imports. Unlike the trade balance, the trade ratio can be logged regardless of whether a trade deficit or trade surplus exists.