The Effects of Exchange Rate Changes on Trade and the Macroeconomy
A change in the exchange rate alters the foreign-currency price of a country's exports and the domestic-currency price of its imports, which affects the trade balance, aggregate demand, and inflation.
Before you start
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Method
- Identify whether the exchange rate has appreciated or depreciated in the question.
- Trace the direct price effect: a depreciation makes exports cheaper in foreign currency terms and imports dearer in domestic currency terms (and vice versa for an appreciation).
- Apply the Marshall-Lerner condition: state that a depreciation improves the trade balance only if the sum of the price elasticities of demand for exports and imports (PEDx + PEDm) is greater than 1.
- Explain the J-curve: in the short run, demand is often price inelastic because of existing contracts, consumer habit, or the time needed to find and switch to new suppliers, so import spending can initially rise before quantities fully adjust, meaning the trade balance can worsen before it improves.
- Assuming the Marshall-Lerner condition holds, link the resulting rise in net exports (X minus M) to a rightward shift of aggregate demand, raising real output and, other things being equal, the price level.
- Evaluate using: the actual size of the relevant price elasticities (which vary by market and take time to adjust, hence the time lag implied by the J-curve), whether other AD components offset the change, the state of the economy (extra demand causes inflation rather than growth if the economy is near full capacity), and unintended consequences such as higher costs for firms reliant on imported inputs, squeezing their profit margins even as exporters gain.
Worked example
The price elasticity of demand for a country's exports is 0.7, and the price elasticity of demand for its imports is 0.9. The government wants to know whether a depreciation of the exchange rate would be expected to improve the trade balance. Apply the Marshall-Lerner condition to reach a conclusion.
- State the Marshall-Lerner condition: a depreciation improves the trade balance if PEDx + PEDm > 1.
- Sum the two elasticities: 0.7 + 0.9 = 1.6.
- Compare this to 1: 1.6 is greater than 1, so the condition is satisfied.
- Conclude: the depreciation would be expected to improve the trade balance in the long run, once quantities have had time to adjust to the new relative prices.
- Add the evaluative caveat: in the short run, the J-curve effect means the trade balance may still worsen initially, even though these elasticity values suggest the balance will improve once demand fully adjusts.
Practice questions
Try each question, then tap to reveal the answer.
Q1State the Marshall-Lerner condition.Show answer
Answer: A depreciation (or devaluation) will improve the trade balance only if the sum of the price elasticities of demand for exports and imports is greater than 1.
Q2What does the J-curve show?Show answer
Answer: That following a depreciation, a country's trade balance can worsen in the short run before improving in the long run, because demand is initially price inelastic.
Q3PEDx = 0.4 and PEDm = 0.3. Using the Marshall-Lerner condition, state whether a depreciation would improve or worsen the trade balance.Show answer
Answer: 0.4 + 0.3 = 0.7, which is less than 1, so the Marshall-Lerner condition is not satisfied and the depreciation would be expected to worsen the trade balance.
Q4Explain in one sentence why demand for imports might be price inelastic in the short run.Show answer
Answer: Buyers may be locked into existing supply contracts, or it may take time to find and switch to alternative domestic suppliers.
Q5Give one reason why an appreciation could reduce cost-push inflation.Show answer
Answer: An appreciation lowers the domestic-currency price of imported goods and raw materials, reducing firms' costs of production.
Q6Name the effect where a depreciation causes consumers to switch spending from imports to domestically produced goods.Show answer
Answer: The expenditure switching effect.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain, using the Marshall-Lerner condition, how a depreciation of a country's exchange rate could affect its trade balance and rate of economic growth.
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Evaluate the likely impact of a significant, sustained depreciation of the pound on the UK economy.
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