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