Question

Define Marshall-Lerner condition and J-curve .Explain the relation between the two concepts.

Answer 1

Answer to the question:

The Marshall-Lerner condition refers to the impact of a depreciation, or devaluation of a economic currency on the current account of the balance of payments (BOP). The condition states that the current account will improve after a depreciation, if the sum of the price elasticities of demand for imports and exports is greater than one. And the further above 1 the sum of the elasticities is, the greater the improvement in the current account will be.

The depreciation of a currency will increase import prices and decrease export prices. Therefore, the more price elastic the demand for imports and exports, the greater will be the fall in demand for imports and the increase in demand for exports and the greater will be the improvement on the current account.

The J Curve is an economic theory which states that, under certain assumptions, a country's trade deficit will initially worse after the depreciation of its currency, mainly because higher prices on imports will be greater than the reduced volume of imports.

The J Curve effect a depreciation in the exchange rate can cause a deterioation of the current account in the short term (because demand is inelastic). However, in the long-term, demand becomes more price elatic and therefore the current account begins to improve.

The J-Curve is related to the Marshall-Lerner ondition which states that

If (PED x + PED m > 1) then a devaluation will improve the current account.

The J curve is an example of how time lags can affect economic policy. It also shows the link between microeconomic principles (elasticity) and macroeconomic outcomes (current account).

The current account on the balance of payments measures the net vause (X-M) of exports and imports of goods, services and investment incomes.

The relation can be better shown with the help of the following diagram.

In the above diagram we can clearly see how devaluation worsens the current account in the initial stages and after that it improves the current situation, that mean in the long run.

Evidence around the world suggest that the Marshall-Lerner condition does not hold in the short run, but does in the medium to long run. This is because in the short run, there will be few extra exports sold when prices fall- people overseas do not react immediately and so export demand will take time to change. Generally this is due to exports being on contracts and these need renegotiating.

In the medium term, however the lower export prices will lead to an increase in demand for exports and so the cuurent account will start to improve. The price elasticiy of demand for exports is lower in the short-run, but will be higher in the long run.

These all leads to the pattern of J shaped curve as shown in the above diagram. And this curve is called J curve.