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? [ 25 marks]

Answer 1

potential ambiguity refers to a term itself or within a sentence sound ambiguous. sometimes it creates confusion to understand the meaning of the sentence or the joint words. here " the effect of exchange rate changes on the balance of trade" falling under the category of  "Lexical ambiguity" which represent the different meaning of a word "change" it may be "better off" or it may be "worse off" but creat ambiguity.

Marshall -Lerner's condition is clarifying the confusion of exchange rate change as it shows the condition of the exchange rate of a country may be better off or worse off in a country's balance of trade.

the M-L condition states that a country's exchange rate assumes to be improving when the sum of price elasticity of export and import >1. so any condition away from it will not bring improvement. so it shows that depreciation or devaluation improves the currency value in the current account. for example, i) Country A X+countryAM<1 result currency value degraded. ii) Country AX+countryAM=1, the result is no change in the trade balance. iii) CountryAX+Country AM>1, result improvement in trade balance or effective devaluation.

The currency of a country got less value when there is a current account deficit. the reason behind this deficit may be due to the purchasing habit of the domestic consumers more depends on the imported good. so this will leads to PEDX<1 and current account deficit. In this situation, export is cheaper and import is dearer.

this shows initially in short-run consumers are more inclined towards imported goods but with the course of time, they realize the high cost of imported goods and they try to replace it by domestic cheap products. so slowly the current account deficit will be corrected and it will come to the positive segment. as the nature of the graph shows the first negative or declining reaching a minimum then it started recovering in longrrun it will be in positive segment.