PKT
mailing list archive
[ Other Periods  | Other mailing lists  | Search  ]
Date:  [ Previous  | Next  ]      Thread:  [ Previous  | Next  ]      Index:  [ Author  | Date  | Thread  ]

Re: Fixed vs. flexible exchange rates

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 a balance of payments
disequilibrium should automatically be restored to equilibrium without
the need for government policy. In the case of a fixed exchange rate, a
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 affect 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.
J-curve - effects of a depreciation

The diagram above shows the effect of a depreciation of the currency on
the balance of payments on current account. In the short term the
balance of payments worsens as the deficit grows. This is the so-called
J curve effect.

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. This is illustrated in the diagram above. The
importance of the price elasticity of demand for imports and exports is
thus crucial.

If a balance of payments disequilibrium is to be restored then it is
important that the PED coefficient for exports is greater than 1 and
that the PED coefficient for imports is greater than 1. This is embodied
in a condition called the Marshall Lerner Condition and this states that:
"Provided that the sum of the price elasticity of demand coefficients
for exports and imports is greater than one then a fall in the exchange
rate will reduce a deficit and a rise will reduce a surplus."

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.

http://www.bized.ac.uk/virtual/dc/trade/theory/th12.htm

Warren Mosler wrote: 

I think those with those who think that a fixed
exchange rate is the
problem and a flexible exchange rate is the solution
-- suffer from a
failure to understand the lack of Marshall -Lerner
conditions in modern day
international trade so that devaluation exacerbates
the problem -- as those
who speak about the J-curve are implying for in the
short-run the downward
slope in the J is almost inevitable and -- you will
note as I demonstrate
in my book,it is assumed thatthe  upward slope of
the J kicks in --in the
longer run, the Marshall-Lerner condition kicks in.



But again, here you imply imports are a 'problem?'
And that a weaker exchange rate won't reduce imports.
But imports are a benefit, not a cost.  And exports
are the cost of imports.

Of course it is the basis an excellent substitute
for everything else --
price elasticities are very large if not infinite.

This assumption -- often implicit and therefore not
specified --of high
elasticities assures that a flexible price system
will clear all markets at
full employment --



I agree that is an incorrect assumption.  What I have
said is that a country with a flexible exchange rate
can maintain full employment regardless at all times,
via elr, for example, or even more mainstream demand
management.

at least in the long run -- when

we are all dead. In the
short-run interim in which we all live, there can be
many painful, and
perhaps even deadly,  income effects of flexible
exchange rates.



Yes, that domestic full employment policy can turn to
the advantage of the domestic standard of living.
These 'deadly' income effects are generally due to
imports 'costing jobs' and income.  But with a
floating exchange rate the domestic govt. can simply
hire the unemployed to make sure their income is
continued or manage additional net spending to make
sure there is sufficient agg demand to keep domestic
income high enough.

Warren



For a further discussion see my article "Are Fixed
Exchange Rates the
Problem and Flexible Exchange Rates the Solution?"
in the Spring 2003 issue
of the EASTERN ECONOMIC JOURNAL.

Paul

Paul





=====
Warren Mosler, www.mosler.org
c/o James River Capital Corp
5007 Chandler's Wharf, Suite 201/202
Christiansted, USVI  00820
340-719-8813 office phone
340-719-8804 Fax
Primary email contact:  mosler@xxxxxxxxxxxxxx

__________________________________
Do you Yahoo!?
The New Yahoo! Search - Faster. Easier. Bingo.
http://search.yahoo.com




[ Other Periods  | Other mailing lists  | Search  ]