Hope might be in sight for the UK: The Marshall-Lerner Condition and the J-Curve

This article discusses how trade data underlines fears that the pound is increasing import costs rather than significantly boosting exports. As imports shot up 5 times fast than exports in March, Britain’s trade gap widened more than expected. Officials say that this casts fresh doubts over “the prospects of an export-driven economic recovery.” Thanks to the weak pound, contrasting surveys show fast growing oversea demand causing the UK’s deficit on trade in goods to widen.”While many businesses say overseas orders have been improving, the official data underlined worries among economists that, for now at least, a weak pound is raising costs for importers but not yet providing a significant boost to exports.” Although the weakness of the pound improves competitiveness, it will have no effect until it if accompanied by an increase in international demand.

The Marshall-Lerner condition states that a depreciation of devaluation, of a currency will only lead to an improvement in the current account balance if the elasticity of demand for exports plus the elasticity of demand for imports is greater than 1.

The J-curve theory suggests that in the short term, even if the marshall-Lerner condition is fulfilled. a fall in the bale of the currency will lead to a worsening of the current account deficit, before things improve int he long term.

The article states how expectations in exports are not being achieved. This relates to the above concepts because there is an initial deterioration of the trade balance, but it will be followed by an improvement, as some economists have predicted. Evidence around the world suggests that the Marshall-Lerner condition does not hold in the short run, but does in the medium to long run. This is seen in this article because in the short run, it has shown few extra exports sold when prices fell – people overseas have not reacted immediately and so export demand is taking longer to change. However, extra money will have to be paid for imports immediately and so the current account will tend to deteriorate. Eventually, the lower export prices will increase demand and the current account will improve. The export elasticity of demand is therefore low in the short run, but will be higher in the long run. Since the UK is in a deficit, they have to depreciate their currency, which will in turn increase import prices and decrease export prices. As a result, the more elastic the good is, the greater the fall in demand for imports and increase in demand for exports will be.

Figure:  The J-Curve

The diagram on the left is known as the J-curve. The UK has a current account deficit at point X on the diagram. The exchange rate of the currency is lowered to rectify this. In the short term, because of existing contracts and imperfect knowledge, the deficit worsens to Y. However, in the long term, if the Marshall-Lerner condition is fulfilled, export revenue will begin to increase and import expenditure will start to fall. The current account deficit will get smaller, moving in the direction of Z on the diagram, just as economists predicted would happen in the article.