The Elasticities Approach

% change in expenditure

= %?R = %?P + %?Q = (1-ε)?P

ε > 1, elastic, an increase in price decreases expenditure.

ε< 1, inelastic, an increase in price  increases expenditure.

The Marshall–Lerner condition: Demand for imports and exports must be sufficiently price-sensitive so that increasing the relative price of imports increases the difference between export receipts and import expenditures.

ω_Xε_X + ω_M(ε_M– 1) > 0

where ω_X and ω_M are the shares of exports and imports, respectively. ω_X + ω_M = 1

ε_X and ε_M are the price elasticities of foreign demand for domestic country exports and domestic country demand for imports, respectively.

More elastic demand—for either imports or exports—makes it more likely that the trade balance will improve.

The elasticity of demand for any good or service depends on:

1)       the existence or absence of close substitutes

2)       the structure of the market for that product

3)       its share in people’s budgets

4)       the nature of the product and its role in the economy.

Price changes have two effects on demand.

The substitution effect

The income effect

Exchange rate changes will be a more-effective mechanism for trade balance adjustment if a country imports and exports the following:

Goods for which there are good substitutes

Goods that trade in competitive markets

Luxury goods, rather than necessities

Goods that represent a large portion of consumer expenditures or a large portion of input costs for final producers

The J-curve effect: Devaluation (in a fixed parity regime) or depreciation (in a floating regime) of the currency will initially make the trade balance worse before making it better.