Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Delving into the Marshall–Lerner condition

The Marshall–Lerner condition says that a depreciation of an economy’s currency leads to an increase in net exports (NX) so long as:

PED_X is the price elasticity of demand for exports (that is, how responsive the quantity of exports are to a change in their price [in other words, the exchange rate]) and PED_M is the

price elasticity of demand for imports; |.| is the absolute value function, which keeps any positive number unchanged and turns any negative number into its positive equivalent (for example, |3| = 3, and |–5| = 5).

The price elasticity of demand tells you how responsive demand for something is to a change in its price. Formally

In words, the price elasticity of demand is equal to the percentage change in the quantity

demanded divided by the percentage change in its price. Basically, when the price of something rises, the quantity demanded falls. The PED tells you by how much the quantity demanded falls in response to an increase in price.

Price and quantity demanded are inversely related (when price goes up, demand goes down and vice versa), so PED is a negative number. This is why the Marshall–Lerner condition uses the absolute value function – to turn it into a positive number.

The larger is |PED|, the more responsive is demand to price. The Marshall–Lerner condition says that in order for a depreciation to lead to an increase in net exports, the demand for exports and imports needs to be sufficiently responsive to a change in its price. One way of thinking about it is that a depreciation is equivalent to an increase in the price of imports and a fall in the price of exports. Because NX is the value of net exports (in the domestic currency), the quantities need to respond sufficiently in order to ensure that the depreciation leads to an increase in NX overall.