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?
                                                                                                                                   
                                                                                                                                    [26 marks]

Answer 1

Answer:
Balance of trade in a simple term can be defined as the difference between total export and total import being made by the country. When country exports more than it imports from outside then its said to be in trade surplus form or in positive balace of trade on the other hand if export is less than the import then country is said to be in trade deficit form. The exchange rate has an effect on balance of trade number as supply and demand can lead to appreciation and depreciation of the currencies. So if a country exports more than it imports so there would be more demand of the local currency outside and hence currency will appreciate and gain more strength. In the same manner if total import is more than it exports it will lead to currency depreciation as there would be more demand for foreign currency in this case.
The potential ambiguity of exchange rate change is that it affects trade balance of the country as well. Countries basically devalue their currency to sell out their more goods in international market.

The Marshall-Lerner condition states that an exchange rate depreciation will only cause balance of trade improvement if the absolute sum of long term export and import demand elasticities are greater than unity. So this condition may not hold in short run but always hold in medium to long term. This is because in short run there will be extra exports sold when prices fall, people overseas do not react immediately and but in medium to long term they react forcing it to reach to the equilibrium again.


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