31 Jul Testing Marshall Lerner Condition
Readers Question: When my class and I try to test the Marshall-Lerner condition it doesn’t always work. i.e. we assumed a country with just one export and one import and assumed their price elasticities added up to less than one. We gave each a price and quantity that led to a current account balance =0 for simplicity then assumed a devaluation of the exchange rate – on calculating the new quantities and then new current account balance IT IMPROVED. Why ? I can give the figures we worked with if that helps…or does the Marshall-Lerner condition have additional conditions?
To be honest, I have never tested the Marshall Lerner condition with figures. I have always just taught it as given that what is in the textbooks must be correct. There is probably some mathematical proof that the Marshall Lerner condition must hold. But, to be honest, I don’t know it. (it isn’t required for what I teach) I think the most likely thing is an error in your calculation.
Definition of The Marshall Lerner condition
This states that, for a currency devaluation to lead to an improvement (e.g reduction in deficit) in the current account, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1.
- E.g. if PED of exports is -0.2
- And if PED of Imports is -0.5
In this case, a devaluation of the currency should worsen the current account.
Empirical evidence suggests the elasticity of demand for exports and imports tends to be inelastic in the short run, but more elastic in the long run. Therefore a devaluation often worsens the current account in the short term but improves it in the long-term
(in absolute value means modulate numbers.) i.e. -0.3 + -0.6 = 0.9