» » Marshall-Lerner condition: Importance of the Marshall-Lerner Condition

Published: 2-12-2012, 07:31

Marshall-Lerner condition: Importance of the Marshall-Lerner Condition

Marshall-Lerner condition

Marshall-Lerner condition: Empirical Studies

The Marshall-Lerner condition is important because it enables policymakers to predict the effects of changes in the exchange rate on the balance of payments (equivalent to the current account if capital flows are ignored). This is especially relevant to developing countries that find it difficult to sell their goods abroad because their currencies are ‘‘overvalued,’’ or overpriced, or that wish to devalue their currencies in an attempt to reduce their current account deficits. In 1994, for example, a number of countries belonging to the African Financial Community franc zone, an arrangement under which several former French colonies fix their currencies to the French franc, devalued simultaneously by 50 percent to improve their balance of payments. But the condition is also of interest to developed countries, including the debate over the sustainability of the large U.S. current account deficit and the extent to which this can be reduced by a depreciation of the U.S. dollar.

The Marshall-Lerner condition also has important implications for the stability of the foreign exchangemarket. A foreign exchangemarket is stable if a disturbance that upsets the balance between the supply and demand for foreign exchange is corrected automatically through adjustment of the exchange rate. If, however,market movements in the exchange rate result in amovement further away froma supply and demand equilibrium, then the foreign exchange market is unstable. Although it is possible to establish conditions for the stability of the foreign exchange market based on the supply and demand curves for foreign exchange, these cannot be measured empirically. It turns out, however, that if the Marshall- Lerner condition is fulfilled, the foreign exchange market will also be stable, so all one has to do is to measure the price elasticities of demand for exports and imports.

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