Elasticity Approach of Balance of Payment

The Marshall-Lerner condition states that a devaluation or depreciation of a currency will help reduce a current account deficit, if the sum of the price elasticity of demand (PED) for exports and imports is greater than 1 (price elastic). 

• This makes sense, because if your goods are price inelastic, then a price difference does not really change demand. Hence, neither will a devaluation.

The J-Curve Effect:

Empirical evidence shows that the Marshall- Lerner condition is satisfied in the majority of advanced countries. But there is a general consensus among economists that both demand-supply elasticities will be greater in the long run than in the short run. The effects of devaluation on domestic prices and demand for exports and imports will take time for consumers and producers to adjust themselves to the new situation.

The short-run price elasticities of demand for exports and imports are lower and they do not satisfy the Marshall-Lerner condition. Therefore, to begin with, devaluation makes the BOP worse in the short- run and then improves it in the long-run. This traces a J-shaped curve through time. This is known as the J-curve effect of devaluation. This is illustrated in where time is taken on the horizontal axis and deficit- O surplus on the vertical axis. Suppose devaluation takes place at time T.

In the beginning, the curve / has a big loop which shows increase in BOP deficit beyond D. It is only after time T₁ that it starts sloping upwards and the deficit begins to reduce. At time T₂ there is equilibrium in BOP and then the surplus arises from T₂ to J. If the Marshall-Lerner condition is not satisfied, in the long run the J-curve will flatten out to F from T₂.

However, in case the country is on a flexible exchange rate, BOP will get worse when there is devaluation of its currency. Due to devaluation, there is excess supply of currency in the foreign exchange market which may go on depreciating the currency. Thus the foreign exchange market becomes unstable and the exchange rate may overshoot its long-run value.

Its Criticisms:

The elasticity approach based on the Marshall-Lerner condition has the following defects:

1. Misleading:

The elasticity approach which applies the Marshallian concept of elasticity to solve BOP deficit is misleading. This is because it has relevance only to incremental change along a demand or supply curve and to problems dealing with shifts in these curves. Moreover, it assumes constant purchasing power of money which is not relevant to devaluation of the country’s currency.

2. Partial Elasticities:

The elasticity approach has been criticised by Alexander because it uses partial elasticities which exclude all factors except relative prices and quantities of exports and imports. This is applicable only to single-commodity trade rather than to a multi-commodity trade. It makes this approach unrealistic.

3. Supplies not Perfectly Elastic:

The Marshall-Lerner condition assumes perfectly elastic supplies of exports and imports. But this assumption is unrealistic because the country may not be in a position to increase the supply of its exports when they become cheap with devaluation of its currency.

4. Partial Equilibrium Analysis:

The elasticity approach assumes domestic price and income levels to be stable within the devaluing country. It, further, assumes that there are no restrictions in using additional resources into production for exports. These assumptions show that this analysis is based on the partial equilibrium analysis.

It, therefore, ignores the feedback effects of a price change in one product on incomes, and consequently on the demand for goods. This is a serious defect of the elasticity approach because the effects of devaluation always spread to the entire economy.

5. Inflationary:

Devaluation can lead to inflation in the economy. Even if it succeeds in improving the balance of payments, it is likely to increase domestic incomes in export and import-competing industries. But these increased incomes will affect the BOP directly by increasing the demand for imports, and indirectly by increasing the overall demand and thus raising the prices within the country.

6. Ignores Income Distribution:

The elasticity approach ignores the effects of devaluation on income distribution. Devaluation leads to the reallocation of resources. It takes away resources from the sector producing non-traded goods to export and import-competing industries sector. This will tend to increase the incomes of the factors of production employed in the latter sector and reduce that of the former sector.

7. Applicable in the Long Run:

As discussed above in the J-curve effect of devaluation, the Marshall-Lerner condition is applicable in the long-run and not in the short. This is because it takes time for consumers and producers to adjust themselves when there is devaluation of the domestic currency.

8. Ignores Capital Flows:

This approach is applicable to BOP on current account or balance of trade. But BOP deficit of a country is mainly the result of the outflow of capital. It thus ignores BOP on capital account. Devaluation as a remedy is meant to cut imports and the outflow of capital and increase exports and the inflow of capital.

Conclusion:

There has been much controversy over the Marshall-Lerner condition for improvements in the balance of payments. Economists tried to measure demand elasticities in international trade. Some economists found low demand elasticities and others high demand elasticities.

Accordingly, the former suggested that devaluation was not an effective method while the latter suggested that it was a potent mechanism of balance of payments adjustment. But it is difficult to generalize due to these diverse findings on account of differences in the volume and structure of foreign trade.

This study note for A-Level and IB Economics covers the Marshall-Lerner condition.

The Marshall-Lerner Condition is a crucial concept in international economics that describes the conditions under which a change in the exchange rate will improve a country's trade balance. It states that a depreciation (or devaluation) of a country's currency will improve its trade balance if the sum of the price elasticities of exports and imports is greater than one.

Key Components of the Marshall-Lerner Condition

1. Price Elasticity of Demand
   • Elasticity of Exports (εx): Measures how the quantity demanded of exports responds to changes in the exchange rate.
   • Elasticity of Imports (εm): Measures how the quantity demanded of imports responds to changes in the exchange rate.
   • The condition can be expressed as: |?x|+|?m|>1|?x?|+|?m?|>1
   • If the sum of these elasticities is greater than one, a depreciation of the domestic currency will improve the trade balance.
2. Impact of Currency Depreciation
   • Depreciation: A fall in the value of a country's currency relative to another currency.
   • Improved Trade Balance: When the sum of the elasticities is greater than one, the increase in export volumes and the decrease in import volumes (due to higher prices in domestic currency) will more than offset any price changes, leading to an improved trade balance.

Application of the Marshall-Lerner Condition

• Real-World Example: The United Kingdom
  • During the 1992 Sterling Crisis, the UK left the European Exchange Rate Mechanism (ERM), leading to a significant depreciation of the pound. Following this depreciation, the UK's trade balance improved, consistent with the Marshall-Lerner Condition.
• Developing Economies
  • Many developing countries have used currency devaluation as a tool to improve trade balances. For instance, Egypt’s devaluation in 2016 was aimed at improving its trade deficit.

Timeline of Key Economic Events and Policy Responses

• 1923: Alfred Marshall's work on elasticity is published in "Money, Credit and Commerce".
• 1944: Abba Lerner publishes "The Economics of Control", where he elaborates on the elasticity approach to the balance of payments.
• 1971: End of the Bretton Woods system, leading to more frequent currency adjustments and applications of the Marshall-Lerner Condition.
• 1992: UK's Sterling Crisis exemplifies the real-world application of the condition.
• 2016: Egypt devalues its currency to address trade imbalances.

Critique of the Model

• Short-Term vs Long-Term Effects: The condition assumes that elasticities are stable and can be applied in both the short and long term. However, in the short term, contracts and consumer habits may not adjust quickly.
• J-Curve Effect: Following a depreciation, the trade balance may initially worsen before improving, as prices adjust faster than quantities.
• Assumption of Perfect Competition: The condition assumes markets are perfectly competitive, which may not hold in reality due to monopolistic practices, trade barriers, and other distortions.

Glossary

• Depreciation: A decrease in the value of a country's currency relative to another currency.
• Elasticity of Exports: The responsiveness of the quantity demanded of exports to a change in price.
• Elasticity of Imports: The responsiveness of the quantity demanded of imports to a change in price.
• Exchange Rate: The price of one currency in terms of another.
• J-Curve Effect: A situation where a country's trade deficit initially worsens following a depreciation before it improves.
• Price Elasticity of Demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good.
• Trade Balance: The difference between a country's exports and imports of goods and services.

This study has attempted to estimate the J-curve phenomenon for Azerbaijan through an analysis of the country’s non-oil exports and total imports. The Johansen co-integration approach has been employed to measure the long-run responses of the balance of trade to currency depreciation, and an Impulse Response Function was built to analyze the short-run trade dynamics. The empirical results have indicated one long-run co-integrating equation, according to which a real devaluation causes a decrease in the trade balance in the short-run and an increase in the long-run. An additional set of models with the export and import prices was constructed to reveal the underlying reasons for the long-run improvement in the balance. The test has shown that the terms of trade ratio drops following the devaluation in parallel with the balance of trade worsening. The ratio does not return to its pre-depreciation level in the long-run, however, while the balance of trade continues to improve, suggesting an underlying presence of the volume effect. Overall, the results of this study suggest a fulfillment of the Marshall-Lerner condition criteria, indicate the existence of the J-curve pattern, as well as the price and volume effects. However, it’s necessary to augment this study with considerations for the oil-sector exports and the contemporaneous currency effects. 

THE MARSHALL-LERNER CONDITION DERIVED

As indicated in the last chapter the elasticity approach to the analysis of balance-of-payments adjustment based on the Marshall-Lerner condition rests on several restrictive assumptions. First , the analysis is founded upon partial equilibrium in the sense that it considers only the effect of exchange -rate variations in the market for exports and imports, and everything else is held constant, so that the position of the demand curves for exports and imports themselves are held constant. In practice everything else will not remain constant. Exchangerate changes will have price effects elsewhere in the system which will shift th e demand curves for exports and imports. Income will also change, affecting the demand curves for exports and imports . A second restrictive assumption is that all relevant elasticities of supply of output are assumed to be infinite so that the price of exports in the home currency does not rise as demand increases , the price of foreign goods that compete with exports does not fall as demand for them falls, the price of imports in foreign currency does not fall as the demand for imports falls, and the price of domestic goods competing with imports does not rise as the demand for import substitutes increases.

There are four elasticities of supply to consider: the elasticity of supply of exports; the elasticity of supply of foreign goods that compete with exports; the foreign elasticity of supply of imports; and the elasticity o f supply of home goods that compete with imports. The basic Marshall-Lerner condition for a successful currency depreciation assumes all four supply elasticities to be infinite. The simple formula can be modified to incorporate the elasti city of supply of imports and exports, but the elasticity of supply of goods that compete with imports and exports is still assumed to be infinitely elastic . Third , the elasticity approach ignores the monetary effects of exchange-rate changes. FinalIy , it is assumed that trade is initially balanced and that the change in the exchange rate is a small one. The Marshall-Lerner condition is easily mod ified to cover the case where trade is initially unbalanced, but the smalI-change assumption is necessary so that second-order interaction terms arising from changes in multiplicative variables can be ignored. 

The Marshall-Lerner condition can be derived in a number of ways, and with respect to measurement in foreign or domestic currency. Since the essence of a balance-of-payments problem is a shortage of foreign currency, it is more appropriate to conduct the analysis measuring exports and imports in units of foreign currency. If the focus of attention were on the impact of exchange-rate changes on domestic income and employment , it might be more appropriate to work with units of domestic currency.

The elasticity approach to the analysis of balance-of-payments adjustment based on the Marshall-Lerner condition rests on several restrictive assumptions. First, the analysis is founded upon partial equilibrium in the sense that it considers only the effect of exchange-rate variations in the market for exports and imports, and everything else is held constant, so that the position of the demand curves for exports and imports themselves are held constant. In practice everything else will not remain constant. Exchange-rate changes will have price effects elsewhere in the system which will shift the demand curves for exports and imports. Income will also change, affecting the demand curves for exports and imports. A second restrictive assumption is that all relevant elasticities of supply of output are assumed to be infinite so that the price of exports in the home currency does not rise as demand increases, the price of foreign goods that compete with exports does not fall as demand for them falls, the price of imports in foreign currency does not fall as the demand for imports falls, and the price of domestic goods competing with imports does not rise as the demand for import substitutes increases.