Named after English political economist Alfred Marshall (1842-1924) and Romanian-born economist Abba Lerner (1905-1982), Marshall-Lerner principle states the conditions under which a change in a country’s exchange rate will improve its balance of payments.
In its simplest form, Marshall-Lerner principle states that the price elasticity of demand for imports and exports must be greater than unity for improvements to be effected in the balance of payments.
Also see: fundamental disequilibrium, internal and external balance
A P Lerner, Economics of Control: Principle of Welfare Economics (New York, 1944)
The Marshall–Lerner condition (after Alfred Marshall and Abba P. Lerner) is satisfied if the absolute sum of a country’s export and import demand elasticities (demand responsiveness to price) is greater than one. If it is satisfied, then if a country begins with a zero trade deficit then when the country’s currency depreciates (e.g., it takes fewer yen to buy a dollar), its balance of trade will improve (e.g., the U.S. will develop a trade surplus with Japan). The country’s imports become more expensive and exports become cheaper due to the change in relative prices, and the Marshall-Lerner condition implies that the indirect effect on the quantity of trade will exceed the direct effect of the country having to pay a higher price for its imports and receive a lower price for its exports.
Suppose the U.S. exports 100 million tons of goods to Japan at a price of $1/ton and imports 100 million tons at a price of 100 yen/ton and an exchange rate of $.01/yen, so the trade balance is zero, $100 million of goods going each way. Then the dollar depreciates by 10%, so the exchange rate is $.011/yen. The immediate effect is to hurt the U.S. trade balance because if the quantities of imports and exports stay the same the value of exports is still $100 million but imports will now cost $110 million, a trade deficit of $10 million. It takes time for consumers around the world to adapt and change their quantities demanded; the shorter the time frame, the less elastic is demand. In the long run, consumers react more to changed prices: demand is more elastic the longer the time frame. Japanese consumers will react to the cheaper dollar by buying more American goods– say, a 6% increase to 106 million tons for $105 million– and American consumers will react to the more expensive yen by buying less Japanese goods– say, a 10% decline to 90 million tons for $99 million, creating a trade surplus of $14 million.
This example has an elasticity of Japanese demand for American exports of .6 (= 6%/10%) and elasticity of demand for American imports of -1 (= -10%/10%), so it satisfies the Marshall-Lerner condition that the sum of the magnitudes of the elasticities (|-.6| + |1|) exceeds 1. The direct negative price effect of the depreciation on the balance of trade is outweighed by the indirect positive quantity effect. This pattern of a short run worsening of the trade balance after depreciation or devaluation of the currency (because the short-run elasticities add up to less than one) and long run improvement (because the long-run elasticities add up to more than one) is known as the J-curve effect.
Essentially, the Marshall–Lerner condition is an extension of Marshall’s theory of the price elasticity of demand to foreign trade, the analog to the idea that if demand facing seller is elastic he can increase his revenue by reducing his price.