Question

Exchange rate adjustments can be important in eliminating current account deficits, however, one should not expect a devaluation to work in the same manner for all countries. Briefly discuss and define the Marshall-Lerner condition.

Please provide a full answer.

Answer 1

Answer-:

The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments.

The condition states that, provided that the sum of the price elasticity of demand coefficients for exports and imports is greater than one then a fall in the exchange rate will reduce a deficit and a rise will reduce a surplus.

A current account deficit implies the value of imports of (goods/services/investment incomes) is greater than the value of exports.

Movements in the exchange rate will have an impact on the current account. For example, a depreciation in the value of a currency is likely to improve the current account (reduce deficit).

How current account may be affected?

• If there is a depreciation in the exchange rate. Then that particular country will experience a fall in the foreign price of its exports. It will appear more competitive and therefore there will be a rise in the quantity of exports.
• Assuming demand for exports is relatively elastic then a depreciation will lead to an increase in the value of exports and therefore improve the current account deficit.
• Similarly, a depreciation of the exchange rate will also lead to an increase in the cost of buying imports. This will lead to a fall in demand for imports and also help to reduce the current account deficit.
• Therefore, in theory, a depreciation in the exchange rate should improve the current account
• An appreciation should worsen the current account.

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