Effects of exchange rate changes: Marshall-Lerner and the J-curve

The Marshall-Lerner condition

A depreciation (or devaluation) improves the current account only if the sum of the price elasticities of demand for exports and imports is greater than 1 (in absolute values): |PEDx| + |PEDm| > 1.

If demand is inelastic, export volumes rise only a little and import volumes fall only a little, while each import costs more in domestic currency, so the deficit can widen.

The J-curve

In the short run, demand for exports and imports is price inelastic: contracts are already signed, buyers take time to find new suppliers, and habits are slow to change. So straight after a depreciation the current account worsens. Over time, elasticities rise, the Marshall-Lerner condition is met and the current account improves.

Diagram in words: time on the horizontal axis, current account balance on the vertical. The balance dips below its starting level after the depreciation, then rises above it, tracing the letter J.

Wider effects of a depreciation

• Growth and employment: higher net exports raise AD, output and jobs (if there is spare capacity).
• Inflation: dearer imported goods, raw materials and energy (cost-push), plus demand-pull from higher AD; less pressure on exporters to cut costs.
• Capital and financial accounts: foreign assets become cheaper to buy, which can attract FDI; but expectations of further falls can cause outflows.
• Debt: debts denominated in foreign currency become more expensive to repay.

An appreciation has the opposite effects: lower inflation, cheaper imports, but less competitive exports.

Competitive devaluations

If several countries try to depreciate at the same time to gain export share (a currency war), the gains cancel out. Consequences: inflation, uncertainty that reduces trade and investment, retaliation with tariffs, and strained international cooperation. Each country tries to export its unemployment to others ('beggar-thy-neighbour').

Worked example

PED for exports is -0.6 and PED for imports is -0.3. Will a depreciation improve the current account in the long run?

1. |PEDx| + |PEDm| = 0.6 + 0.3 = 0.9
2. 0.9 < 1, so the Marshall-Lerner condition is not met

Answer: No: the current account would worsen.

Check yourself

1. PED for exports is -0.8 and PED for imports is -0.7. Calculate the sum of their absolute values.
   Show answer

   1.5. 0.8 + 0.7 = 1.5, greater than 1, so the condition is met.

2. PED for exports is -0.4 and for imports is -0.5. A depreciation will, according to Marshall-Lerner,
   • improve the current account
   • leave the current account unchanged
   • worsen the current account
   • cause an appreciation
   Show answer

   worsen the current account. 0.4 + 0.5 = 0.9, which is less than 1.

3. Why does the current account often worsen immediately after a depreciation?
   • Demand for exports and imports is price inelastic in the short run
   • Exports become more expensive
   • Imports become cheaper
   • Interest rates always rise
   Show answer

   Demand for exports and imports is price inelastic in the short run. Volumes take time to respond while import prices rise at once.

4. A firm imports a component priced at $50. The exchange rate falls from £1 = $1.25 to £1 = $1.00. Calculate the rise in the sterling cost of the component.
   Show answer

   £10. Before: 50 / 1.25 = £40. After: 50 / 1.00 = £50. Rise = £10.

5. A UK good sells for £400. Calculate the percentage fall in its US dollar price when the pound falls from $1.30 to $1.17.
   Show answer

   10 %. $520 to $468: a fall of 10%.

6. Explain how a depreciation can cause inflation.
   Show answer

   Imported goods, raw materials and energy become more expensive, raising firms' costs (cost-push inflation), and higher net exports increase aggregate demand (demand-pull inflation).. Two routes: cost-push and demand-pull.

7. Why might a depreciation increase inward FDI?
   • It raises domestic wages in foreign currency
   • Domestic assets and costs become cheaper for foreign investors
   • It makes imports cheaper
   • It increases interest rates automatically
   Show answer

   Domestic assets and costs become cheaper for foreign investors. Foreign firms get more domestic currency for each unit of their own currency.

8. Explain why competitive devaluations may leave all countries worse off.
   Show answer

   Each country's devaluation cancels out the others, so no country gains competitiveness, but they suffer higher import prices and inflation, uncertainty that reduces trade and investment, and possible retaliation.. Beggar-thy-neighbour policies are self-defeating if all play.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.