Ordinarily, when our real exchange rate depreciates, we would expect our trade balance to
rise since the depreciation has enhanced our competitiveness, lowering domestic product
prices relative to foreign prices. However, the trade balance doesn't always rise,
especially not right away. The paradox of a deteriorating current account in the face of
enhanced competitiveness is resolved by the Marshall-Lerner stability condition.
The possibility of a
J-curve arises because each one percent depreciation of a currency makes a country's
initial volume of imports one percent more expensive. The country's net exports can rise only if changes in trade volumes can offset
this price effect.
Formally, a depreciation raises net exports if and only if: |
the % increase in
quantity exported |
+ |
the % decrease in
quantity imported |
> |
the %
depreciation |
|
| Divide both sides by the % depreciation: |
the % increase in
quantity exported
the % depreciation |
+ |
the % decrease in
quantity imported
the % depreciation |
> |
1. |
|
| The numerators are percentage changes
in quantities and the denominator is the percentage change in foreign exchange prices, so
the two lefthand terms are elasticities: the first term is the foreign elasticity of
demand for domestic exports and the second is the domestic elasticity of demand for
imports. The Marshall-Lerner condition states that the two elasticities must add up to a
value greater than one: |
| (*) |
foreign elasticity
of demand for
domestic exports (eX*) |
+ |
domestic elasticity
of demand for
imports (eM) |
> |
1. |
|
In other words, the combined quantity
effects must offset the price effect of the depreciation.
Consider the intuition behind (*): The
righthand side of (*) says that each 1% depreciation raises the dollar cost of current
import volume by 1%. The lefthand side of (*) says that the larger quantity of exports and
smaller quantity of imports must add up to more than a 1% improvement to overcome the
adverse price effect. |
 |