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MarshallLerner condition Overview

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Title: MarshallLerner condition Overview


1
Marshall-Lerner conditionOverview
  • We want to know how a devaluation affects the
    current account, holding constant the dollar
    prices of foreign goods and the baht prices of
    home goods.
  • This makes the proportionate change in the
    nominal exchange rate equal to the proportionate
    change in the real exchange rate. In effect, we
    are analyzing an exogenous change in the real
    exchange rate.

2
Notation
  • If we ignore current transfers and the
    difference net factor payments from abroad, (or
    if we include them in exports and imports), the
    current account is
  • CA (P/S).X PM
  • where P domestic price of exports in baht,
  • P foreign of imports in dollars,
  • X quantity of exports in tons of home good
  • M quantity of imports in tons of foreign good
  • S the exchange rate in baht/dollar.
  • P/S the price of exports in dollars

3
  • It is assumed that when the exchange rate is
    devalued (that is, when S is increased), P and P
    do not adjust in the short run.
  • Devaluation of the baht therefore makes Thai
    goods cheaper and more competitive relative to
    foreign goods.
  • People in Thailand see no change in the price of
    Thai goods, measured in baht, but the prices in
    baht of foreign goods have risen from 1 to 1.01
    baht/ton

4
  • For simplicity, it is assumed that we start in
    a situation of current account balance with
  • P P S 1
  • and X M 100
  • CA 0.
  • This makes the new value of the CA equal to the
    change in the CA from the initial situation.

5
  • People in the rest of the world, see no changes
    in the dollar prices of their own goods, but see
    a 1 fall in the dollar price of Thai goods from
    1 per ton 1/1.01 0.99 per ton
    (approximately)
  • Suppose that the absolute value of the world
    elasticity of demand for Thai exports, with
    respect to their relative price, is b.
  • Suppose that the absolute value of the Thai
    demand for imports with respect to their relative
    price is d. That is, a 1 devaluation reduces
    imports by d.

6
  • The 1 fall in the relative price of Thai goods
    therefore increases exports to 100b tons and
    reduces imports to 100-d tons.
  • CA 0.99 x (100 b) 1.(100 d)
  • In practice, b and d are small numbers compared
    to 100, so we can ignore the difference between b
    and 0.99 b

7
  • Suppose that b 3. Multiplied by 0.99 this
    gives 2.97. The difference between 2.97 and 3 is
    far less than the margin for error in measuring
    b, so we can set 0.99b b. This gives
  • CA 99 100 b d
  • b d - 1

8
  • The current account balance improves, provided
    that bdgt1.
  • This is the Marshall-Lerner condition.
  • What you need to remember is the intuition where
    does the 1 come from?
  • Dont worry about the approximation. In very
    small changes there is no approximation.

9
The J-curve
  • There is quite a lot of evidence that the
    relevant export and import elasticities are low
    in the short run, but much higher in the long
    run.
  • In this case, devaluation may initially worsen
    the CA, before gradually improving it. The time
    path of the CA effects therefore looks a bit like
    the letter J. Really, the long vertical stroke
    in the letter J should have a bit of a forward
    lean / to capture the effect of the gradual
    improvement in the medium and long run.

10
  • The next slide shows the movements in Thailands
    imports and exports following the large
    devaluation of the baht in 1997.
  • Do you think the Thai experience supports the
    view that the absolute elasticities of imports
    and exports are less than unity in the short-run
    and higher than unity in the long-run?

11
Thailands merchandise trade (goods) (US
billion)
12
  • Note that exports in dollars actually fell in
    1998, despite the huge devaluation.
  • Even in 1999, exports in dollars were only just
    back at the level of 1997.
  • However, by 2000, exports in dollars were 20
    above the level of 1997.

13
  • The big effect in 1998, relative to 1997, was the
    huge fall in imports. This was partly due to the
    devaluation, but also partly due to the fall
    income. For the time being, we are ignoring the
    effect on imports of a change in income. That
    will be dealt with in the second half of the
    course.
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