Question

1. Define the Marshall-Lerner condition. What are the likely effects of devaluation during a recession when supply elasticities are high?

2. Explain the J-curve phenomenon. Consider an economy with a fixed exchange rate with a fixed price level. What is the effect of depreciation on equilibrium income and trade balance in the first six months after depreciation?

3. Define uncovered interest parity. What is the relationship among the forward exchange rate, the spot exchange rate, and the interest rate? Suppose the (1-year) interest rate on bank deposits is 2% in Canada and 1.75% in United States. If the (1-year) forward US$–C$ exchange rate is C$1.25 per US$ and the spot rate is C$1.2 per US$, will the C$ depreciation or appreciation against the US$ over one year, and by how much?

Answer 1

Marshall Lerner conditions are as follows:

1. If the sum of elasticities of demand for exports and imports is greater than unity i.e. (Edx +Edm > 1) devaluation will improve the BOP deficit.
2. if the sum of these elasticities coefficient is equal to unity i.e. (Edx +Edm = 1) devaluation will leave the balance of payment unchanged.
3. if the sum of these elasticities is less than unity i.e. (Edx +Edm < 1) devaluation can cause the worsening of the balance of payment.

The effects of devaluation during a recession when supply elasticities are high are as follows:

1. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase the demand for exports.
2. A devaluation means imports, such as petrol, food, raw materials, and other essential commodities will become more expensive. This will reduce the demand for imports.
3. A devaluation could cause higher economic growth as higher exports and lower imports will increase aggregate demand followed by higher real GDP.
4. Inflation will occur because imports are more expensive causing cost-push inflation, an increase in aggregate demand can cause demand-pull inflation and with exports becoming cheaper, manufacturers may have less incentive to cut costs and become more efficient.
5. With exports more competitive and imports more expensive, we will be able to see higher exports and lower imports, which will reduce the current account deficit.
6. In a period of stagnant wage growth, devaluation can cause a fall in real wages. This is because devaluation causes inflation, but if the inflation rate is higher than wage increases, then real wages will fall.

The J-curve phenomenon is related to the time-series graph in which the curve falls negative and then eventually rises to a higher level than before thus making the curve like the alphabet 'J'.

The following effect of depreciation on equilibrium income and trade balance in the first six months considering a fixed exchange rate with a fixed price level are as follows:

1. Under a fixed exchange rate system when citizens of a country spend some of their income on imports, it reduces the value of multiplier because imports, like savings and taxes, serve as a leakage from the circular flow of income.
2. On the other hand, exports, like investment and Government expenditure, raise the aggregate demand for domestically produced goods and services and thereby cause an expansion in output through a mul­tiplier process. Also, the trade balance will suffer (thus making the 'J' curve) and there can be an increase in the rate of inflation.

Uncovered interest rate parity is defined as the difference in interest rates between two countries. This will equal the relative change in currency foreign exchange rates over the same period.

To describe the relationship, one can say that the forward exchange rate is determined by the relationship among the spot exchange rate and differences in interest rates between two countries and thus reflecting an economic equilibrium in the foreign exchange market.

Following the question, one can say that the C$ depreciates against the US$ over one year.