Marshall-Lerner criterion

The Marshall-Lerner criterion states that a currency devaluation will improve a country’s trade balance if the sum of the price elasticities of exports and imports is greater than one.
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Updated on Jun 25, 2024
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3 key takeaways

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  • The criterion determines the conditions under which a depreciation of a country’s currency will improve its trade balance.
  • It emphasizes the importance of price elasticity of demand for exports and imports in response to exchange rate changes.
  • Understanding the Marshall-Lerner criterion helps in formulating effective currency and trade policies.

What is the Marshall-Lerner criterion?

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The Marshall-Lerner criterion is an economic condition that predicts the impact of a change in the exchange rate on a country’s trade balance. Specifically, it states that a depreciation (or devaluation) of a currency will lead to an improvement in the trade balance if the combined price elasticities of demand for exports and imports exceed one. This means that the percentage change in the quantity demanded of exports and imports must be large enough to offset the price change resulting from the currency depreciation.

The criterion is named after economists Alfred Marshall and Abba Lerner, who developed the concept independently. It is a fundamental principle in international economics, particularly in the context of exchange rate adjustments and their effects on trade balances.

Importance of the Marshall-Lerner criterion

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The Marshall-Lerner criterion is important for several reasons:

  1. Trade Policy: It helps policymakers understand how exchange rate adjustments can be used to address trade imbalances.
  2. Currency Strategy: It informs decisions on currency devaluation or depreciation as a tool to improve the trade balance.
  3. Economic Analysis: It provides insights into the responsiveness of trade flows to changes in exchange rates, aiding in macroeconomic analysis and forecasting.

How to calculate the Marshall-Lerner criterion

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The Marshall-Lerner criterion is satisfied when the sum of the absolute values of the price elasticities of demand for exports ((E_x)) and imports ((E_m)) is greater than one:

[
|E_x| + |E_m| > 1
]

Where:

  • (E_x) is the price elasticity of demand for exports
  • (E_m) is the price elasticity of demand for imports

Price elasticity of demand measures how the quantity demanded of a good responds to a change in its price. For exports, it reflects how foreign demand for a country’s goods changes with exchange rate fluctuations. For imports, it indicates how domestic demand for foreign goods changes with exchange rate movements.

Example of the Marshall-Lerner criterion

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Consider a hypothetical country with the following price elasticities:

  • Price elasticity of demand for exports ((E_x)): -0.7
  • Price elasticity of demand for imports ((E_m)): -0.5

Applying the Marshall-Lerner criterion:
[
|E_x| + |E_m| = |-0.7| + |-0.5| = 0.7 + 0.5 = 1.2
]

Since the sum (1.2) is greater than one, the criterion is satisfied. Therefore, a depreciation of the country’s currency is expected to improve its trade balance.

Implications of the Marshall-Lerner criterion

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The Marshall-Lerner criterion has significant implications for economic policy and analysis:

  • Exchange Rate Policy: If a country’s trade balance is worsening, policymakers might consider devaluing the currency. However, the Marshall-Lerner criterion indicates that this strategy will only be effective if the price elasticities of exports and imports are sufficiently responsive.
  • Trade Balance Adjustment: Understanding the criterion helps in anticipating the impact of exchange rate changes on the trade balance, aiding in the design of effective trade policies.
  • Elasticity Estimates: Accurate estimates of price elasticities for exports and imports are crucial for applying the Marshall-Lerner criterion effectively. This requires detailed economic analysis and data.

Challenges and limitations

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While the Marshall-Lerner criterion provides valuable insights, it also has limitations and challenges:

  • Short-term vs. Long-term Effects: The criterion primarily applies to long-term adjustments. In the short term, factors such as existing contracts, inventory adjustments, and slow response to price changes may delay the expected effects.
  • Data Accuracy: Estimating price elasticities accurately can be challenging due to data limitations and variability in economic conditions.
  • Other Influences: Exchange rates are influenced by various factors, including capital flows, speculative activities, and monetary policies, which can complicate the straightforward application of the criterion.
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To further understand the Marshall-Lerner criterion, explore related concepts such as price elasticity of demand, which examines how the quantity demanded responds to price changes. Exchange rates look at the value of one currency relative to another and their economic implications. Balance of payments provides a broader context for understanding trade balances and international financial flows. J-curve effect examines the short-term worsening and long-term improvement of the trade balance following a currency depreciation. Additionally, studying macroeconomic policy offers insights into how governments manage economic performance through fiscal and monetary measures.

For a comprehensive exploration into price elasticity of demand, exchange rates, balance of payments, J-curve effect, and macroeconomic policy, delve into these topics to enhance your understanding of the Marshall-Lerner criterion and its significance in international economics and trade policy.


Sources & references

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