Depreciation - What assumptions are required for the Marshall-Lerner condition to hold?

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Depreciation

  1. What assumptions are required for the Marshall-Lerner condition to hold? (short answer)

The Marshall-Lerner condition states that the balance of payments will improve with a fall in the exchange rate, i.e. a depreciation, if the sum of the price elasticities of demand for imports and exports exceeds unity. For this condition to hold four restrictive assumptions are made:

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. This is a very restrictive assumption because in practice prices and income will not remain constant and therefore change the position of the demand curves for imports and exports. But this assumption helps us crucially to identify the effects of a depreciation.

Second, all relevant elasticities of supply 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. As can be seen, 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 elasticity of supply of imports, and the elasticity of supply of home goods that compete with imports.

Third, the elasticity approach ignores the monetary effects of depreciations, i.e. effects on the price level which then influence real balances. Particularly if the exchange rates, prices and wages were fully flexible, a depreciation would not work and the economy were always in equilibrium.

And finally, 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 however easily modified to cover the case where trade is initially unbalanced.

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  1. Does depreciation ‘work’? Discuss with reference to the UK. (longer answer)

To discuss the impact of nominal exchange rate changes it is crucial to discuss two main questions as stated by Dornbusch (1996). First, are trade flows responsive to relative prices, and second, can nominal exchange rate changes change relative prices?

 

  1. real exchange rate changes (or relative price changes) and effects on trade flows

To evaluate whether real exchange rate changes influence trade flows, it is necessary to take a look at the initial Marshall-Lerner condition of whether the demand elasticities of imports ...

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