N06 [Paper 2]: Explain the link between the Marshall-Lerner condition and the J-curve effect.
19 Jan 2011 Leave a Comment
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Definition:
Marshall-Lerner condition: looks at the overall impact of a depreciation on the current account of the balance of payments
J-curve: 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. However, extra money will have to be paid for imports immediately and so the current account will tend to deteriorate. In the medium term however, the lower export prices will start to lead to an increase in demand for them and so the current account will start to improve. The export elasticity of demand is therefore low in the short run, but will be higher in the long run.
Balance of Payments: The balance of payments accounts measure the international trade performance of an economy and show how well it is managing to match imports and exports of goods and services and the flows of investment in and out of the country. The accounts are usually split into two parts – the current account and the capital account. The current account shows trade in goods and services while the capital account shows flows of investment into and out of the country.
- Current account
- Capital account
Triple A:
Marshall-Lerner condition
A depreciation 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 Marshall-Lerner condition looks at the overall impact of a depreciation on the current account of the balance of payments. This will be the sum of the effects we identified above on imports and exports. 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 1. The further above 1 the sum of the elasticities is, the greater the improvement in the current account will be. Follow the link below for a more detailed explanation of this with associated diagrams.
J-curve
Evidence around the world suggests 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. However, extra money will have to be paid for imports immediately and so the current account will tend to deteriorate. In the medium term however, the lower export prices will start to lead to an increase in demand for them and so the current account will start to improve. The export elasticity of demand is therefore low in the short run, but will be higher in the long run.
Relevant Powerpoint Slides
Diagrams
