Question

(c) What is meant by the Marshall-Lerner condition?

(d) Assuming the Marshall-Lerner condition holds, contrast the factors that influence goods market equilibrium in an open economy with those of a closed economy.

Answer 1

C. The Marshall–Lerner condition is a condition that, if satisfied, allows devaluation or depreciation to lead to an improvement in a country’s balance of trade and ultimately its current account.

Country can devalue its currency to improve its export competitiveness and earn more foreign exchange. This is done to correct balance of trade deficit. If a country's imports and exports are inelastic then even devaluation will not help on the contrary it will lead to further deterioration of current account balance.

Hence this condition is Ped(Export) + Ped(Import) > 1.

Ped = Price elasticity of demand

D. Goods market in an economy will be immediately affected as exports becomes more cheaper, demand for domestic goods will increase an as imports become more expensive it will go down. This will help in correction of deficit on current account.

Open economy will show appreciation of its currency too. Open economy may also see change in investments and more consumer goods can be produced as capital imports become expensive.

A closed economy is one that has no trade activity with outside economies. Hence no change in goods market.