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The Marshall-Lerner Condition - YouTube

Channel: Jason Welker

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[Music]

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in this video lesson we'll be talking

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about a topic from The Ivy year to

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economics syllabus the topic today it

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comes from the International Economics

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component of the syllabus specifically

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the section on a nation's balance of

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payments and extend its exchange rates

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we'll be exploring the relationship

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between the exchange rate for nation's

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currency and the balance on that

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nation's current account which measures

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the trade in goods and services between

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one nation and all the other nations of

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the world the topic we're talking about

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today is called the Marshall Lerner

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condition before we actually identify

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what the Marshall Lerner condition is

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we're going to review some assumptions

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that we have from previous sections of

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the syllabus about the relationship

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between the nation's exchange rate and

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its balance of payments the first

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assumption is that a nation's current

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account measures the balance of trade in

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goods and services therefore the current

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account measures the income a nation

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receives from the sale of its exports to

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the rest of the world - the expenditures

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of that nation's households on imports

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from the rest of the for this reason we

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can actually simplify the relationship

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between the nation's expenditures on

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imports and revenues from the sale of

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its exports by discussing the total

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revenue from net exports a country's

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total revenue from net exports which we

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refer to as TR xn increases if the

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country's exports grow faster than its

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imports or another way of saying that is

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if revenues from the sale of exports

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grows faster than expenditures on

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imports then a nation's total revenue

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from net exports will increase the third

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assumption we'll make about a nation's

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current account balance is that if a

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nation's country depreciates its current

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account balance generally improves as

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the country's currency gets weaker

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foreigners tend to buy more of that

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country's exports and domestic consumers

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tend to buy fewer imports therefore a

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depreciation of the currency tends to

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improve or move a current account

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balance towards surplus however this may

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not always be the case which brings us

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to the Marshall Lerner condition

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let's define the Marshall Lerner

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condition now and talk about what must

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actually be true in order for

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depreciation of a nation's country to

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lead to an improvement in its current

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account balance here we see the Marshall

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Lerner condition if the price elasticity

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of demand for net exports is greater

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than 1 than a depreciation or a

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devaluation of a country's currency will

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lead to an improvement in the country's

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current account balance so what we've

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seen is that the assumption that a

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weakening of a country's currency will

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improve its current account balance is

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actually dependent upon the

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responsiveness of consumers of imported

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goods within the nation and consumers of

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that country's exports abroad in other

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words the price elasticity of demand for

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net exports so our Marshall Lerner

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condition here has a has a similar

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implication that relates to what happens

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if the PE d for net exports is less than

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1 so if the price elasticity of demand

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for net exports is greater than 1 and

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the currency depreciates a nation's

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current account will move towards

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surplus on the other hand if the PE D is

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less than 1 then a depreciation or a

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devaluation of the currency will lead to

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a worsening in the current account

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balance and the nation's current account

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will move towards deficit so if the

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Marshall Lerner condition is meant is

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met then a depreciation of a nation's

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currency will move its current account

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towards surplus in other words its

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current account balance will improve

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however if the Marshall Lerner condition

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is not met then a depreciation of the

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currency will move a current account

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balance towards deficit so the Marshall

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M condition or the MLC takes into

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account the responsiveness of domestic

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consumers for imported goods and the

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responsiveness of foreign consumers for

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our country's exports based on the price

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elasticity of demand for net exports a

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depreciation of the currency may either

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improve or worsen a nation's current

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account balance if demand is elastic a

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weaker currency improves the current

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account balance however if demand for

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net exports is inelastic a weaker

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currency will worsen a current account

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balance now we're going to explain why

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the Marshall Lerner condition holds true

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let's look for example that trade

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between Switzerland and its

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European neighbors both who use

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different currencies of course

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Switzerland uses the Swiss franc which

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we call the CHF and Europe uses the euro

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so we're going to look at the market for

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Swiss francs in Europe and examine what

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happens to Switzerland's net export

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revenues following a depreciation of the

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Swiss franc depending on whether demand

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for Swift's exports is inelastic or

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elastic first let's talk about a factor

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that can lead to a depreciation of the

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Swiss franc assume for instance that

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Switzerland has been running persistent

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current account deficits with its

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European neighbors this means that over

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the years Swiss household has been

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consuming more European goods than

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European households have been consuming

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Swiss goods if this were to occur then

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over time the supply of Swiss francs in

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Europe would increase to supply CHF one

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indicating that the Swiss consumers have

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been buying more European goods than

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Europeans have Swiss goods this of

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course should cause the Swiss franc to

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depreciate or get weaker against the

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euro and the quantity demanded of Swiss

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francs in Europe will increase as

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cheaper francs mean cheaper Swiss goods

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and therefore Europeans will demand more

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Swiss exports let's look at the market

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for Swiss exports on the right here here

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we have the demand for Swiss exports

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abroad

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of course demand is downward sloping

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indicating the inverse relationship

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between the price of Swiss exports which

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is at least somewhat determined by the

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exchange rate of the Swiss franc and the

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quantity of Swiss exports demanded so

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here we have the demand for Swiss net

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exports abroad and what happens when the

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value of the Swiss franc Falls let's

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assume that demand for Swiss exports is

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relatively elastic and we can therefore

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conclude that we're in a range of the

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demand curve in the upper left hand

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corner which indicates the demand is

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probably relatively elastic as the Swiss

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franc gets weaker from er1 to er-2 let's

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assume that the price of Swiss exports

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abroad Falls from P 1 to P 2 and

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therefore the quantity demanded of Swiss

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exports abroad increases from Q 1 to Q 2

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of course the weaker franc has led to an

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increase

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in swiss exports at least in as far as

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the number of exports sold is concerned

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however one thing we must consider is

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that a nation's current account balance

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measures not only the difference between

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exports minus imports rather it measures

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the revenues earned from exports minus

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the expenditures made on imports from a

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nation's household so what we must

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consider therefore is the total revenue

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for net exports not only the physical

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change in exports and imports that

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results from a depreciation of the

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currency how is total revenue for

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Switzerland's export sector affected by

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the depreciation of the Swiss franc of

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course this depends on the relative

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elasticity of demand for Swiss net

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exports so here we're looking at the

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demand curve for Swiss net exports on

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the right this demand curve represents

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foreign consumers of Swiss goods and

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Swiss consumers of foreign goods

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therefore this demand curve actually

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represents demand for net exports not

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only demand for exports it takes into

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account the responsiveness of Swiss

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households to a change in the price of

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foreign goods and the responsiveness of

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foreign households to a change in the

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price of Swiss goods so what's happening

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to that price as the currency gets

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weaker we can see that demand for Swiss

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goods abroad increases as the price

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decreases however since the price of

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Swiss exports abroad is relatively high

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to begin with that p1 demand is

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relatively elastic as the price falls

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from p1 to p2

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therefore we would expect that a

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particular percentage decrease in price

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results in a larger percentage increase

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in quantity as we see here if the

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percentage change in quantity is greater

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than than the percentage change in price

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then PE d for exports net exports is

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greater than 1 in this case as the price

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of Swiss exports Falls foreign consumers

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will be highly responsive to the lower

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price therefore the quantity of exports

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sold will increase relatively by quite a

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lot on the other hand Swiss importers

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are relatively respond

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sensitive to the higher price of Swiss

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imports therefore the quantity demanded

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will fall by quite a lot if this is the

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case then we can say that the Marshall

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Lerner condition is met and therefore

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the total net export revenues in

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Switzerland will increase as the price

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of Swiss exports decreases and we would

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see the total revenue sloped upwards in

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this case so Swiss exports got cheaper

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but Swiss net export revenues increase

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because of the highly responsive nature

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of foreign consumers and domestic

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consumers to the changing prices of

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exports and imports in this example the

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Marshall Lerner condition appears to

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have been met but what would happen if

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foreign consumers were relatively

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unresponsive to the cheaper exports

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coming from Switzerland following the

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depreciation of the Swiss franc and if

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domestic consumers of imports were

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relatively unresponsive to the more

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expensive imports coming from the rest

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of Europe following the depreciation of

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the Swiss franc in other words if a

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depreciation of the franc occurs and net

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export demand is inelastic then it's

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highly likely that the decrease in the

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price of exports abroad let's go now

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from P 3 to P 4 will actually lead to a

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decrease in the total revenues of Swiss

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exporters and therefore the Marshall

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Lerner condition is not met and a

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depreciation of the Swiss franc may

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actually lead to a worsening of

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Switzerland's current account balance of

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course this all relates to what we

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called the total revenue test which we

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learned in an earlier unit in Ivy

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economics the total revenue test said

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that if demand for a good is elastic and

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the price decreases the total revenues

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of sellers of that good will increase

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however if demand is inelastic and price

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decreases then the total revenues from

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the sellers of that good will decrease

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here we see in our graph on the bottom a

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total revenue curve for your net exports

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in Switzerland as demand is elastic

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which occurs in the upper ranges of the

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demand curve for Swiss exports consumers

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abroad are highly responsive to cheaper

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Swiss exports

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therefore decreases in the price caused

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by weaker currency will lead to an

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increase in total revenues and an

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improved

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the nation's current account balance

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however is the price of net exports

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Falls foreigners become less and less

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responsive and therefore demand becomes

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inelastic and that net export revenues

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would actually decline as the currency

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gets weaker the implication of the total

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revenue test is that at some point along

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the demand for country's exports there

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is a point at which PE d equals 1 and a

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change in the exchange rate at this

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point along the demand curve should lead

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to no change in net export revenues and

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therefore no change in the nation's

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current account balance however we can

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see from this graph that if demand for

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net exports in Switzerland which takes

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into account both domestic consumers of

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foreign goods but also foreign consumers

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of Swiss Goods if demand is elastic then

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a depreciation of the currency as we see

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here will lead to an improvement in the

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nation's current account balance in

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other words total export revenues will

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increase and total expenditures on

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imports will increase as well however

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the increase in export revenues will

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exceed the increase in import

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expenditures therefore the nation's

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current account will move towards

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surplus on the other hand if a

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depreciation of the currency leads to an

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increase in the quantity demanded as we

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see here from P 3 to P 4 and from q3 -

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q1 foreign consumers are not very

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responsive to the weaker Swiss franc and

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domestic consumers are not very

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responsive to the now more expensive

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imported goods then the expenditures on

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imports will increase by more than the

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net export revenues increase and a

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nation's current account balance will

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worsen to conclude the Marshall Lerner

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condition is basically an application of

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the total revenue test applied to

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international trade if a nation's

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currency gets weaker the value if a

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nation's currency gets weaker the price

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of its exports of raw abroad Falls

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however if foreign consumers are

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unresponsive to the lower price of our

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nation's goods then we would not expect

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net export revenues to rise by very much

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in the same token if a currency

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depreciates and imports become more

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expensive it may actually be the case

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that domestic households end up spending

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