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LEARN IT WELL! THE MARSHALL-LERNER CONDITION

and other factors affecting success of devaluation

• Weakening of S$ raises export revenue

A devaluation of the SGD leads to SG’s exports becoming relatively cheaper in foreign currency, improving the export competitiveness hence raising their demand in the foreign markets. Demand curve for exports shifts to the right increasing the value of export revenue in SGD. This happens as long as the price elasticity of demand for exports is more than zero (i.e. PEDx>0 or when the demand curve is downward sloping). Hence, a devaluation necessarily increases the value of export revenue in SGD ceteris paribus. Diagram 1(b) illustrates.

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As long as the PEDx>0 (the demand curve is downward sloping) , the fall in the foreign price of the export due to a devaluation � a greater amount of export demanded (an increase of Q1Q2) as seen in diagram 1.

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A devaluation of SGD � rise in demand of export � righttward shifts in the demand curve � rise in the value of export revenue ( � X) measured in SGD from area (A) to area (A+B) as seen in diagram 1(b) �� )�

Diagram 1(b) : Impact of devaluation of SGD on exports

A DEVALUATION OF SGD WILL REDUCE SG’S BALANCE OF PAYMENTS DEFICIT.

ANALYSING HOW A DEVALUATION OF SGD WILL REDUCE SG’S BALANCE OF PAYMENTS DEFICIT.

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• Weakening of S$ lowers import expenditure

With a rise in price of imports in SGD, quantity demanded of imports decreases. If PEDm>1, a rise in the price of imports brings about a more than proportionate fall in quantity demanded and leads to a fall in import expenditure (M or Cm) in SGD. Diagram 1(c) illustrates.

(Domestic consumers switch their consumption towards domestically produced goods, increasing domestic consumption (Cd).)

• Combined impact on exports and imports In this case, when Marshall-Lerner condition holds, a devaluation raises the export revenue in SGD and reduces the import expenditure in SGD. This reduces the trade deficit, improves the current account hence reduces the balance of payments deficit.

The higher the PEDx+PEDm the more successful would a devaluation be in reducing current account deficit

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As long as the PEDm>1 , the rise l in the price of the import (in domestic currency) due to a devaluation � a more than proportionate decrease in the amount of import demanded as seen in diagram1 (c)

Diagram 1(c): Impact of devaluation on imports

Comment : Students to learn to isolate effects into impact on X and impact on M and then combined the two as part of their acquisition of analytical skills

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A devaluation of the currency may not improve the balance of payments position to the extent described above for a number of reasons: The effectiveness of a devaluation policy depends on the price elasticity of demand for exports and imports. Devaluation will not improve trade balance and hence the BoP if the Marshall-Lerner condition (PEDx+PEDm>1) does not hold. The higher both elasticities are, the more successful devaluation will be in terms of reducing the current account deficit. Devaluation is only effective in improving the current account if the Marshall-Lerner condition holds, i.e. when the sum of the price elasticities of demand for SG’s imports and exports is greater than one (PEDx + PEDM > 1). The condition for exports and imports separately can be summarised as follows:

PEDx > 0 for a devaluation to increase export revenues in domestic currency.

PEDm> 1 for a devaluation to reduce import expenditures.

By adding the zero and the one, we get the following overall condition:

PEDx + PEDm> 1 for a devaluation to be successful in terms of reducing a current account deficit, hence a balance of payments deficit.

Overall, as long as the two elasticities add up to more than one the devaluation will reduce the deficit even if the two individual conditions above are not satisfied. For example, if PEDx = 0.6 and PEDm = 0.6, import revenue will rise following a devaluation, but this will be more than compensated for by a larger rise in export revenue. The elasticities add up to 1.2, which is more than one, so overall the situation improves. The higher both elasticities are, the more successful devaluation will be in terms of reducing the current account deficit.

(i) Marshall-Lerner condition may not hold/J curve effect However, in the short run, the price elasticity of demand for a country’s imports and exports tends to be highly inelastic, thus the Marshall-Lerner condition may not hold, i.e. (PEDx + PEDM < 1).

Let us assume that the SG economy is at point A (time, t1), experiencing a current account deficit. The government decides to devalue the SGD to help eliminate this deficit. The J-curve shows that, in the short term, the deficit may get bigger before, eventually, it starts to reduce. In other words, the Marshall Lerner condition is not satisfied in the short run, even though it will be in the medium to long term.

The main reason for this is time lags. It takes time for producers and consumers to adjust their purchases to the changed prices brought about by the devalued exchange rate. Firms will have orders planned in advance, and will not react to the price changes for a number of months.

EVALUATING HOW A DEVALUATION OF SGD MAY NOT NECESSARILY REDUCE SG’S BALANCE OF PAYMENTS DEFICIT.

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Exports revenues measured in SGD may not rise immediately since export prices in SGD and demand is unchanged in the short term. But import expenditure may rise, as increased import prices in SGD are combined with static quantity demanded. The current account deficit will get worse. After a period of time (t2), foreigners will react to the lower export prices and SG firms and consumers will react to the higher import prices. The Marshall Lerner condition should be satisfied as demand for both exports and imports become more price elastic and the deficit should start to fall.

This could be due to both domestic and foreign consumers requiring some time to respond to the price changes. For example, it may take time to change import and export contracts signed before the devaluation. Hence, a devaluation may in the short run causes the current account to worsen, but will lead to an improvement in the current account in the long run when the sum of demand for imports and exports become more price elastic.

This initial deterioration and subsequent improvement in the current account is usually referred to as the ‘J-curve’ effect. Diagram 2 shows the J-curve. When devaluation is pursued at time, t1, the current account of the country would worsen initially since the sum of price elasticities of demand for exports and imports tends to be less than one (i.e. Marshall-Lerner condition does not hold) in the short run. However, in the long run, beyond time t2, the current account starts to improve as the sum of demand for exports and imports become more price elastic and the Marshall-Lerner condition is met.

Diagram 2: J-Curve Effect (ii) Retaliation by trading partners A devaluation could be ineffective if trading partners retaliate erecting protectionistic measures such as tariffs, quotas or by devaluing their currencies in response. A tariff is a tax on imports. Tariffs have the impact of reducing the supply and raising the equilibrium price of the import. This makes domestic products relatively cheaper, resulting in a fall in imports of the foreign country which is the export of SG. Illustrate with a tariff diagram. The SG’s exports ( US’s import) to US falls from Q1Q4 to Q2Q3 because of the tariff. Thus the tariffs negate some of the increase in exports due to the devaluation of the SGD. It leads to a lower increase in real output (Y3) than otherwise (Y2).

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Diagram 2b : Effects of a tariff on price and output

Diagram 2c : Effects of Retaliation

(iii) Imported inflation offsets part of price advantage of export gained For countries, such as Singapore which import a large proportion of raw materials, a devaluation can raise inflation rate by increasing imported inflation. A fall in the external value of SGD will make imports dearer in SGD. A rise in the price of imported raw materials puts upward pressure on the price level by raising the costs of production, increasing the price of finished imports. Thus, imported inflation may offset part of the price advantage of exports gained through devaluation. An illustration will make this clear. Assume the depreciation of 10% leads to a 10% rise in import prices, hence a 10% rise in the price of raw materials used to produce exports. If raw materials make up 50% of the production costs and all other costs remain constant there will, ceteris paribus, be a 5% rise in the price of the exports. Export prices have, however, fallen by 10% because of the devaluation – the combined effect of these two changes is therefore a fall in the price of exports of 5%. Hence, imported inflation may offset part of the price

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advantage of exports gained through devaluation. The combined effect of these two changes is therefore the fall in the price of exports is less than that caused directly by the depreciation leading to the increase in value of export due to the depreciation being smaller. (iv)Lack of spare capacity in the economy and the resulting demand-pull inflation eliminates the price advantage of devaluation.

Devaluation will result in foreigners demanding more exports(�X) and Singapore residents demanding more domestically produced goods (�Cd) as the quantity demanded for imports falls. There must be spare capacity in the economy to meet the increased demand for the country’s goods. If the country is already at full employment, a devaluation by bringing about an increase in AD since export (X) and domestic demand (Cd) are direct components of aggregate demand (AD) could bring about demand-pull inflation. Diagram 3 illustrates.

Diagram 3: Demand-Pull Inflation

Demand–pull inflation is defined as a situation where AD is persistently greater than AS, close to or at full employment of all resources. The excess demand cannot be met because existing resources are fully or almost fully employed. This will bid up prices of real output, causing demand–pull inflation. As shown in diagram 3, a rise in AD from AD1 to AD2 will simply lead to an increase in general price level without any increase in real output. Hence, a persistent rise in AD (AD1 increases to AD2 to AD3 etc) will generate a sustained rise in the general price level. Hence, demand-pull inflation may offset part of the price advantage of exports gained through devaluation. The combined effect of these two changes is therefore the fall in the price of exports is less than that caused directly by the depreciation leading to the increase in value of export due to the depreciation being smaller.

Thus, inflation may eventually eliminate the price advantage gained through devaluation. The subsequent rise in inflation (the government's number one macroeconomic objective nowadays) and its implications for competitiveness mean that devaluation is never a good long-term solution.

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