Exchange Rate and the Marshall-Lerner Condition

The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments. Under a floating exchange rate regime balance of payments disequilibrium should automatically be restored to equilibrium without the need for government policy. In the case of a fixed exchange rate, devaluation or a revaluation may be used to restore disequilibrium. However, this is based on certain key assumptions which, some economists argue, do not apply to certain LDCs. The assumptions concern the extent to which a change in import and export prices affects the quantity of imports and exports demanded.

The inflows and outflows of foreign currency recorded in a country's balance of payments account are dependent on these price changes. Crucially the price elasticity of demand will determine the impact of the price change on the quantity of exports demanded and the quantity of foreign exchange earned. If the exchange rate of a country decreases then the price of its exports will fall and the price of imports rises. Initially one might expect little to happen to the amount of exports and imports demanded as consumers take time to change their preference from imported goods to domestically produced goods. In addition, foreign consumers will take time to adjust from domestic goods to foreign exports. If this was the case the balance of payments might be expected to worsen as the value of exports would decrease and the value of imports would increase.

After a while the situation improves as the deficit gets smaller and then moves to surplus. In the longer time period once consumers' preferences have adjusted to the changes in imports and export prices then the amount of exports and imports will change. The amount by which they change will determine the effect on the balance of payments on current account. The extent of the change will depend upon the price elasticity of demand for imports and exports. If demand for exports is first assumed to be relatively price elastic then the fall in the price of exports caused by the fall in the exchange rate will lead to a proportionately greater increase in the quantity of exports demanded. This would improve the balance of payments. If demand for imports is also assumed to be relatively price elastic then the rise in the price of imports caused by the fall in the exchange rate will lead to a proportionately greater decrease in the quantity demanded of imports. This would also improve the balance of payments on current account.

If the Marshall Lerner Condition is not met and the sum of the price elasticity of demand for exports and imports is less than one, then a fall in the exchange rate will bring about a worsening of the balance of payments. The fall in the price of exports will lead to a proportionately smaller increase in the number of exports demanded and the rise in the price of imports will lead to a proportionately smaller reduction in the amount demanded. Both of these factors will contribute to a deterioration of the balance of payments. In assessing the likely impact of a policy that will lead to a fall in the value of the currency consideration must be given to the price elasticity of demand for both the exports and imports.