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Sem 5 Prep
← Open Economy MacroPrice adjustment, Marshall-Lerner and the J-curve

Formulas for this chapter

Marshall-Lerner condition

|eta(x)| + |eta(m)| > 1 devaluation improves the balance = 1 balance unchanged < 1 devaluation worsens it

Before any devaluation arithmetic, to know the direction of the answer. Above one is also the condition for a stable foreign exchange market; below one, a deficit nation needs revaluation instead.

eta(x)
Absolute price elasticity of foreign demand for the home country's exports
eta(m)
Absolute price elasticity of home demand for imports

New trade balance after a depreciation

New exports = X x (1 - e) x (1 + eta(x) e) New imports = M x (1 - eta(m) e) Balance = new exports - new imports

Every numerical in this chapter. Exports are priced in domestic currency so their foreign-currency price falls by the full depreciation; imports are dollar-priced so their dollar price is unchanged.

e
The depreciation, as a decimal: 10 % is 0.10
X, M
Initial export and import values, in foreign currency
Sanity check
If the elasticity sum is below one the answer must be worse than the base balance

Generalised condition for a deficit country

(X / M) x eta(x) + eta(m) > X / M

When trade is not initially balanced. With X below M the export elasticity is discounted, so the adjustment must come mainly from compressing imports.

X / M
The ratio of exports to imports, below one for a deficit country
Practical advice
The source recommends recomputing the trade values directly in an exam rather than using this form

Critical import elasticity

Solve M x (1 - e x eta(m)) - new exports = original deficit for eta(m)

When asked what elasticity would leave the balance unchanged. Compute the new export value first and hold it fixed, then solve the import equation.

New exports
X x (1 - e) x (1 + eta(x) e), computed with the given export elasticity
Original deficit
M minus X before the depreciation

Exchange rate pass-through

ERPT = % change in domestic-currency price / % change in the exchange rate Effective volume response = elasticity x pass-through

Any question giving a price change and a currency change, or asking how much an exporter absorbed. Indian stages: border 0.5 to 0.9, WPI 0.2 to 0.3, CPI 0.05 or below.

ERPT = 1
Complete pass-through: the whole move reaches the buyer
ERPT = 0
The foreign exporter absorbed the entire move in its margin
RBI rule of thumb
A 5 % depreciation adds around 20 basis points to CPI inflation
Step 2 of 40
The real wordsTheory

The assumptions, and the name of the approach

Salvatore's two, from slide 2:

  • International private capital flows take place only as passive responses to cover temporary trade imbalances.
  • The nation wants to correct a deficit in its current account by exchange rate changes.

The student's note adds the third and the label: assume no international capital or financial flows, only trade flows. Because everything then turns on how responsive trade is to price, the method is called the trade approach or the elasticity approach.

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