4.6.8 The Marshall-Lerner condition and the J-curve effect (HL only) Notes

Marshall-Lerner Condition

For this condition, there are two key notations:

1. $ PED_m = PED_{imports} = \text{PED of country's imports for depreciating country}$
2. $ PED_x = PED_{exports} = \text{PED of country's exports for foreigners}$

The summary for the condition is:

1. If the sum of $PED_x$ and $PED_m$ is greater than one ($PED_x + PED_m > 1$) then the depreciation of the currency will reduce the current account deficit.
2. If the sum of $PED_x$ and $PED_m$ is less than one ($PED_x + PED_m < 1$) then the depreciation of the currency will increase the current account deficit.
3. If the sum of $PED_x$ and $PED_m$ is equal to one ($PED_x + PED_m = 1$) then the depreciation of the currency will not affect the current account deficit.

Alongside this, the greater the $PED_m$, the better the improvements possible in the trade balance (current account deficit).

J-Curve

1. The J-curve effect is when there might be an even further deficit in the current account or larger trade imbalance immediately after the depreciation of the currency.
2. Then, the current account deficit will start to minimise, and the trade balance will improve, provided the depreciating country is meeting the Marshall-Lerner condition (Sum of PEDS > 1).

1. Observing the figure below, the axis labelling is different from other diagrams with the x-axis representing the time and y-axis representing the balance of trade.
2. Trade balance at zero refers to when imports is equal to exports.
3. Below zero indicates to trade deficit and above zero indicates trade surplus.
4. The J-curve effect can be observed as the curve dips right after the depreciation of the currency.
5. Then over time (as time increases), the trade balance shifts from trade deficit to a trade surplus.

Initial Worsening

Initially, the trade balance often worsens after a depreciation because there is a time delay between the depreciation and the effects on exports and imported demanded. In specifics:

1. Initial PEDs for imports and exports are very low when depreciation occurs, the Marshall-Lerner condition is not satisfied as $PED_x + PED_m < 1$.
2. This leads to the trade deficit to increase.
3. The reason for these low PEDs are:
   1. Existing trade contracts are fixed in the short term.
   2. Consumers and firms take time to adjust to new prices.

Long-Term Improvement

Over time, if the Marshall-Lerner condition holds, the trade balance improves because:

1. The Marshall-Lerner condition is satisfied as $PED_x + PED_m > 1$.
2. This is because:
   1. Consumers adjust, buying more exports and fewer imports.
   2. Trade agreements reflect the new, more favourable exchange rates.