Question

Explain the potential ambiguity in the effect of exchange rate changes on the balance of trade. How does the Marshall-Lerner condition clarify the nature of this ambiguity? [ 25 marks]

Answer 1

According to the PPP (purchasing power parity)-based definition, the real exchange rate is defined in the long-run as the nominal exchange rate after adjustment to the ratio of the foreign price level to the domestic price level. Mathematically, it is given by

The decline in "r" is interpreted as the real appreciation of the domestic currency, since it indicates that few units of the domestic currency are needed to purchase the same one unit of foreign currency.

On the other hand, the tradable/nontradable based definition takes the relative price of the tradables and nontradables in a country as an indicator for the level of competitiveness in international trade. The rationale behind this definition is that the cost differential between countries is interrelated with the relative price structures in these economies.

Under a flexible exchange rate system, balance-of-payments disequilibria are immediately corrected by automatic changes in exchange rates without any international flow of money or reserves. Thus, under a flexible exchange rate system, the nation retains dominant control over its money supply and monetary policy. Adjustment takes place as a result of the change in domestic prices that accompanies the change in the exchange rate.

The actual exchange value of a nation’s currency in terms of the currencies of other nations is determined by the rate of growth of the money supply and real income in the nation relative to the growth of the money supply and real income in the other nations

Standard Trade Theory relates merchandise with the movements of real exchange rate following a simple common sense approach. Setting all other variables fixed, a fluctuation in exchange rate affects both the value and volume of trade. If real exchange rate increases in home country, that is, real depreciation, the households can get less imported goods in exchange for a unit of domestic goods and services. Thereby, a unit of imported goods would give higher number of units of domestic goods. Eventually, domestic households buy fewer imports while foreign households purchase relatively more domestic goods. Ultimately, the higher the real exchange rate for the home country, the more the trade surplus the country obtains

Lerner further extended the typical trade theory by accounting for demand price elasticities of imports and exports as instrumental elements in measuring the effect of real exchange rate variations on trade balance. Thus, a rise in exports and a reduction in imports due to depreciation in real exchange rate do not necessarily mean a correction of trade balance deficit. According to Lerner, trade balance is not concerned with the volume of physical goods but with their actual values

In elasticities approach, trade balance adjustment path is viewed on the basis of elasticities of demand for imports and exports. The elasticity of demand is defined as the quantity responsiveness of demanded goods or services to changes in price

Change in the foreign currency value of the trade balance depends upon the import and export supply and demand elasticities and the initial volume of trade.

Lower prices in the domestic country as a result of currency devaluation will normally increase foreign demand for domestic goods, but only when foreign demand is elastic. On the other hand, if foreign demand elasticity for domestic goods is weak, the quantity of domestic goods will not rise to the extent that it exceeds the decline in the value of exports caused by the cheaper prices. Following the same notions, the case of domestic elasticity of demand can be understood in the same context. If domestic demand for foreign goods is elastic, the change in prices in the domestic market will lead to a change in the domestic consumer’s behavior. The consumers will then compensate by consuming domestic rather than foreign goods forcing the value of imports to decline. In summary, if the decline in value of domestic imports is greater than the decline in value of domestic exports, the trade balance will improve. Marshall-Lerner Condition is a further extension of the elasticities approach.

According to this approach, if monetary policymakers depreciate the currency with the intention of improving trade balance, the demand for the nation’s exports and imports should be adequately elastic. Assuming trade in services, investment-income flows, and unilateral transfers are equal to zero, so that the trade account is equal to the current account, Marshall-Lerner Condition states that the sum of the absolute values of the two elasticities must exceed unity. Conversely, if the sum is less than one, trade balance worsens when a depreciation takes place.

In the short-run, instantly after currency devaluation, domestic importers face inflated import prices as paid in domestic currency; thus, the net exports decline. On the other hand, the domestic exporters in the devaluating country face lower export prices since the demand for exports and imports is fairly inelastic in the short-run. This inelasticity of demand is caused by the sluggishness in the change of consumer’s behavior and the lag of renegotiating deals. In other words, in the short-run when prices are relatively constant the balance of trade faces a decline due to the stickiness of prices and sluggishness to demand change. Prices stickiness is when goods are still traded at the price levels prior to devaluation. The trade balance worsens by the value of total imports in foreign currency multiplied by the magnitude of the rise in the price of foreign currency since contracts made before the depreciation force fixed prices and volumes. The short-run period is commonly known as the “exchange rate pass-through period.”

Afterwards, domestic demand starts to shift from foreign to domestic production of substitution goods as a reaction to the higher prices of imports, causing a trade balance improvement. Furthermore, the markets in home country experience an increase in exports volume due to the decrease in exports prices. The period of these two long-run factors is commonly known as the “volume adjustment period” and they have a favorable impact on trade balance. However, the J-Curve phenomenon predicts the trade balance to improve in the long-run to a higher level compared to its level before depreciation.