Devaluation and Balance of Payment Improvement

Devaluation is the deliberate downward adjustment of a country's currency value relative to other currencies. Its impact on the balance of payments (BOP) deficit depends on the price elasticities of demand for its exports and imports.

Marshall-Lerner Condition

The widely accepted condition for devaluation to successfully reduce a BOP deficit is the Marshall-Lerner condition. This condition states that the sum of the price elasticities of demand for a country's exports and imports must be greater than one.

Let:

• $E_x$ = Price elasticity of demand for exports
• $E_m$ = Price elasticity of demand for imports

According to the Marshall-Lerner condition, for a devaluation to improve the balance of payments (i.e., reduce the deficit or increase the surplus), the following must hold:

$ E_x + E_m > 1 $

Explanation

• If $E_x + E_m > 1$, a depreciation leads to a proportionally larger increase in the volume of exports demanded than the volume of imports demanded (when measured in foreign currency). This results in an improvement in the trade balance and thus the BOP.
• If $E_x + E_m < 1$, the depreciation will worsen the BOP deficit.
• If $E_x + E_m = 1$, the BOP deficit remains unchanged.
• If $E_x + E_m < 0$ (negative), it implies that demand for exports and imports is positively sloped, which is highly unusual. In this scenario, devaluation would likely worsen the deficit significantly.

Therefore, for devaluation to improve the balance of payment deficit, the sum of the elasticity of exports and imports must be greater than unity.