Question

Consider an economy where the current account is negatively affected by a depreciation in the real exchange rate in the short run (that is, the Marshall-Lerner condition does not hold). Explain the effects of a monetary expansion in this economy by comparing it to the baseline case where the Marshall-Lerner condition holds. Use a graphical analysis accompanied by an intuitive (verbal) explanation.

Answer 1

Marshall-Lerner condition states that a currency fluctuation will only lead to an improvement in the balance of payments if the sum of elasticities for imports and exports is greater than 1.

When `the currency of a country depreciates, the import falls and export rises. Therefore the balance of trade improves. When a currency appreciates, the import rises, and export declines and thus worsen the balance of trade.

As the economy discussed in the question, the current account is negatively affected by a depreciation in the real exchange rate in the short run. It explains that the Marshall-Lerner conditions do not hold in the short run but does in the long run. In the short run, export demand will take time to change as prices fall. People do not react immediately and the further extra money will have to be paid for imports immediately and so the current account will tend to deteriorate.

As the currency depreciates it can be observed that there are easy monetary policy and high chances of inflation can be seen. Sometimes higher inflation increases the cost of the inputs which makes exports less competitive in global market which widens the trade deficit and causes the currency to further depreciate, and if, currency depreciation orderly and gradually improves a nation's export competitiveness and may improve its trade deficit over time.