Chapter 17 · Further topics on exchange rates and the balance of payments (HL only)
Marshall–Lerner condition and adjustment
Explore how export and import demand elasticities affect the current account after depreciation. Explain the Marshall–Lerner condition and time lags.
The economic idea
The balance of payments records economic transactions between residents of a country and the rest of the world. Its current account contains trade in goods and services, primary income and secondary income transfers. A current-account deficit means current-account outflows exceed inflows during the period.
Currency depreciation is a market-driven fall in value under a floating system; devaluation is an official reduction under a fixed system. Either lowers the foreign-currency price of exports and raises the domestic-currency price of imports if firms pass the exchange-rate change through.
The Marshall–Lerner condition states that depreciation improves the trade balance in the long run when the sum of the absolute price elasticities of demand for exports and imports exceeds one. It is a condition about quantity responsiveness, not a guarantee that all current-account components improve.
The J-curve describes timing: the trade balance may deteriorate immediately after depreciation because contract quantities change little while import prices rise, then improve as export and import volumes become more responsive.
When net exports rise, aggregate demand increases because AD equals consumption plus investment plus government expenditure plus net exports. The real-GDP and price-level effects depend on the shape of short-run aggregate supply and the economy’s spare capacity.
Reading the adjustment from t₀ through t₁ to t₂
“Time” is measured horizontally; it shows adjustment time rather than a quantity of output.
“Trade balance (X − M)” measures the trade or current-account balance. Values below “(X = M)” show a trade deficit and values above it a trade surplus; deterioration or improvement is read as movement down or up from the pre-change balance.
“Trade-balance response” is a time path, not a demand curve. Its slope at a point does not measure an elasticity.
t₀: prices change before quantities
At “Depreciation / devaluation”, the path begins on “(X = M)”. Import contracts and trade volumes initially change little while the domestic-currency cost of imports rises immediately, so the balance falls from its pre-change level.
t₁: the trough
“Short-run low” marks the point of maximum deterioration in the stylised path. Substitution and supply responses have begun but have not yet offset the initial value effect.
t₂: the long-run result
After the exchange-rate change at “t₀”, “Trade-balance response” falls from its pre-change balance and reaches “Short-run low” at “t₁” before recovering above its starting position by “t₂”. The current path displays the characteristic J-shaped adjustment.
The sum of the absolute export- and import-demand elasticities is greater than one. The long-run quantity response is therefore strong enough for depreciation to improve the trade balance, ceteris paribus.
Use the elasticity test without overclaiming
Use the magnitudes of the two demand elasticities and add them. They do not both have to exceed one: a sufficiently responsive export market can offset less responsive import demand, or the reverse.
The familiar sum-greater-than-one test assumes an initially balanced trade position, price changes passed through to buyers and suppliers able to meet the quantity response. It is a useful simplified condition, not a forecast that depreciation will remove every current-account deficit.
How to build a connected IB explanation
At “t₀”, explain the immediate price and contract effect rather than assuming trade volumes adjust instantly.
Follow “Trade-balance response” toward “Short-run low” as the initial value effect dominates.
Explain how substitution, export supply and contract renewal gradually make trade volumes more responsive.
Use the elasticity condition to explain whether “Trade-balance response” improves on its starting balance by “t₂”. Crossing “(X = M)” is a separate question about whether a deficit has become a surplus.
Common mistakes to avoid
- Depreciation does not automatically improve the current account; apply the elasticity condition and allow for time.
- The J-curve is a time path of the external balance, not the shape of a demand curve.
- Use absolute elasticity magnitudes in the Marshall–Lerner sum.
- A current-account deficit is not identical to a trade-in-goods deficit and is not automatically harmful.
- A rightward AD shift requires an actual increase in net exports, not merely a lower nominal exchange rate.
How to draw this diagram
- Title the diagram “Marshall–Lerner condition and adjustment”. Label the horizontal axis “Time” and the vertical axis “Trade balance (X − M)”.
- Draw (X = M) first and label it clearly.
- Draw Trade-balance response next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The elasticity condition is partial equilibrium and holds other influences on exports, imports and income constant.
- The simple elasticity-sum threshold assumes initially balanced trade, full exchange-rate pass-through and sufficiently responsive supply; an initial imbalance or different pricing assumptions changes the more general test.
- Export supply may be capacity constrained even when foreign demand is price elastic.
- Imported intermediate inputs can raise exporters’ costs after depreciation and weaken the competitiveness gain.
- Foreign-currency debt service, inflation expectations and capital flows can dominate the trade channel.
- The current account includes income and transfers as well as trade, while the diagram focuses mainly on exports and imports.