Exchange Rates & Trade Balance: The Elasticities Approach

In the bustling global economy, two rival nations, Econland and Tradeora, found themselves locked in a strategic economic battle. Their central banks and businesses closely monitored exchange rates and their impact on the trade balance—the difference between a country's exports and imports.

One day, both nations faced a crisis. Econland’s currency depreciated, while Tradeora’s currency appreciated. Their finance ministers, Rajiv from Econland and William from Tradeora, had different views on how this shift would impact trade.

Econland’s Currency Depreciation: The Export Boost?

Econland’s currency, the EcoDollar (E$), fell in value against Tradeora’s TradeCoin (T$):

1 E\$ = 2 T\$ \quad \text{(Previous rate)}

1 E\$ = 2.5 T\$ \quad \text{(New rate)}

Rajiv was optimistic. He believed depreciation would make Econland’s goods cheaper for Tradeora’s consumers, boosting exports. A laptop that previously cost 1,000 E$ (2,000 T$) now cost only 1,000 E$ (1,600 T$).

More demand for exports meant Econland’s trade deficit would shrink—but only if demand for exports was elastic, meaning consumers would buy significantly more when prices drop.

Tradeora’s Currency Appreciation: A Stronger Currency, But at What Cost?

Meanwhile, Tradeora’s currency appreciated, making its exports more expensive:

1 T\$ = 0.5 E\$ \quad \text{(Previous rate)}

1 T\$ = 0.4 E\$ \quad \text{(New rate)}

William worried that Tradeora’s products, now pricier for Econland, would lose international buyers, reducing export revenue. However, if Tradeora’s imports were inelastic (necessary goods like oil or medical equipment), Econland would still buy them despite higher prices—worsening Tradeora’s trade balance.

The Elasticities Approach: Marshall-Lerner Condition

Marshall-Lerner Condition (MLC) Explained: When Does Currency Depreciation Improve Trade Balance?

The Marshall-Lerner Condition (MLC) is a fundamental principle in international trade that determines whether a currency depreciation will improve a country's trade balance. It focuses on how sensitive exports and imports are to price changes—measured by their elasticities.

The Core Idea

When a currency depreciates:
✅ Exports become cheaper for foreign buyers → More exports
✅ Imports become more expensive for domestic buyers → Fewer imports

This should, in theory, improve the trade balance (Net Exports = Exports - Imports). But in reality, it depends on how much demand for exports and imports changes in response to price shifts.

The Formula: Marshall-Lerner Condition

|\varepsilon_X| + |\varepsilon_M| > 1

Where:

$\varepsilon_X$ = Price Elasticity of Exports (How much demand for exports changes when prices drop)
$\varepsilon_M$ = Price Elasticity of Imports (How much demand for imports changes when prices rise)
Absolute values are used because we only care about magnitudes, not direction.

What It Means:

🔹 If the sum is greater than 1 ( $>1$ ), depreciation improves the trade balance.
🔹 If the sum is less than 1 ( $<1$ ), depreciation worsens the trade balance.
🔹 If the sum is exactly 1 ( $=1$ ), depreciation has no effect on the trade balance.

Breaking It Down with a Real-World Example

Let’s say India’s Rupee depreciates against the U.S. Dollar.

🔹 Before: 1 USD = 80 INR
🔹 After depreciation: 1 USD = 90 INR

Step 1: Effect on Exports

✅ Indian goods become cheaper for U.S. buyers → More demand for Indian exports.
✅ Suppose the elasticity of demand for Indian exports ( $\varepsilon_X$ ) is -0.6 (i.e., a 1% price drop increases demand by 0.6%).

Step 2: Effect on Imports

❌ U.S. goods become more expensive for Indian buyers → Fewer imports.
❌ Suppose the elasticity of demand for Indian imports ( $\varepsilon_M$ ) is -0.4 (i.e., a 1% price increase reduces demand by 0.4%).

Step 3: Applying the MLC Formula

|\varepsilon_X| + |\varepsilon_M| = 0.6 + 0.4 = 1

Here, the sum is exactly 1, meaning depreciation has no effect on the trade balance!

When Does Depreciation Actually Work?

Depreciation only improves the trade balance if the sum is greater than 1. This happens when:

Exports are highly elastic → Foreign buyers respond strongly to price changes.
Imports are highly elastic → Domestic buyers quickly switch to local alternatives.

Examples where MLC is likely to hold:
✅ Countries exporting luxury goods, electronics, or competitive manufacturing products.
✅ Nations that can easily replace imports with domestic alternatives (e.g., local food production).

Examples where MLC is likely to fail:
❌ Countries that import essential goods (oil, medicine, machinery) that have inelastic demand.
❌ Nations whose exports have low elasticity because they sell niche products with few substitutes.

Both leaders turned to their economists, who introduced them to the Elasticities Approach, guided by the Marshall-Lerner Condition:

|\varepsilon_X| + |\varepsilon_M| > 1

Where:

$\varepsilon_X$ = Price Elasticity of Exports (How much demand for exports changes when prices fluctuate)
$\varepsilon_M$ = Price Elasticity of Imports (How much demand for imports changes when prices fluctuate)

🔹 If the sum is greater than 1, currency depreciation improves the trade balance.
🔹 If less than 1, depreciation worsens the trade balance.

Rajiv and William realized that whether their trade balances improved depended on elasticity:
✅ If Econland’s exports were elastic, depreciation boosted exports, reducing the deficit.
❌ If Tradeora’s imports were inelastic, appreciation didn’t reduce import demand, worsening the trade balance.

Conclusion: Exchange Rates Are Only Part of the Story

By the end of their meeting, both ministers agreed:

Exchange rate movements affect trade, but only if demand is elastic.
Industries with high substitution (luxury goods, electronics) see stronger effects from exchange rate changes.
Essential imports (oil, medicine) remain inelastic, limiting the impact of currency shifts.

Armed with this knowledge, Econland focused on exporting more elastic goods, while Tradeora diversified its economy to reduce dependence on currency fluctuations.

[Finance]

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