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Overview

Expectation

It is often expected that a lower exchange rate will reduce a current account deficit.

Reality

The outcome will depend, in part, on the price elasticities of demand for both exports and imports.

Marshall Lerner condition

The Marshall-Lerner condition provides a simple rule to assess whether a change in the exchange rate can improve the current account.

The condition states that when the sum of the export and import price elasticities is greater than unity (ignoring the minus sign), a fall in the exchange rate can reduce a deficit and a rise in the exchange rate can reduce a surplus.

When, however, the export and import price elasticities of demand are both highly inelastic, summing to less than unity, a fall in the exchange rate can have the reverse effect of worsening a deficit (while a revaluation might increase a surplus).


The J-curve effect

In some cases, a fall in the exchange rate will actually worsen the current account position before it starts to improve it.

Short term

In the short term, demand for imports and exports may be relatively inelastic. It takes time to recognise that prices have changed and then to search for alternative products.

Long term

In the longer term, demand becomes more elastic and current account position may move from deficit into a surplus.

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The J curve effect

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