Marshall-Lerner Condition

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This condition says that, for a currency devaluation to have a positive impact in trade balance, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1. The principle is named for economists Alfred Marshall and Abba Lerner.

As a devaluation of the exchange rate means a reduction on price of exports, demand for these will increase. At the same time, price of imports will rise and their demand diminish.

The net effect on the trade balance will depend on price elasticities. If goods exported are elastic to price, their demand will increase proportionately more than the decrease in price, and total export revenue will increase. Similarly, if goods imported are elastic, total import expenditure will decrease. Both will improve the trade balance.

Empirically, it has been found that goods tend to be inelastic in the short term, as it takes time to change consuming patterns. Thus, the Marshall-Lerner condition is not met, and a devaluation is likely to worsen the trade balance initially. In the long term, consumers will adjust to the new prices, and trade balance will improve.

[edit] Mathematical Derivation

Let the trade balance be defined as:

Where B is the trade balance, X physical exports M import expenditure, and p the international prices.

A devaluation will improve the trade balance if

Given the export elasticity Ex, and import elasticity Em, the inequality above can be written as follows:

If the trade balance starts even, M = pX, then