If the sum of price elasticities of imports and exports of a country exceeds unity, then a depreciation of domestic currency will ultimately result in
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1 mark, −0.333International EconomicsBalance of payments and exchange ratesDevaluation, the Marshall-Lerner condition and the J-curveModerateabout 2 min
GATE 2021 Question 4: Balance of payments and exchange rates
Answer and worked solution
Answer: (A)
This directly tests the Marshall-Lerner condition: a depreciation of the domestic currency improves (contracts a deficit in) the trade balance if and only if the sum of the price elasticities of demand for imports and exports exceeds 1 (in absolute value).
When this condition holds, the volume effects of depreciation (cheaper exports selling more abroad, pricier imports being bought less domestically) outweigh the negative price effects (each unit of export now earns less foreign currency, each unit of import costs more domestic currency), so the trade balance improves — i.e., the trade deficit contracts.
Therefore the answer is (A).
The trap: (B) widening of trade deficit of the country
Students sometimes reason naively that depreciation 'makes imports more expensive,' which sounds inflationary/bad for the trade balance at first glance, without recalling the specific elasticity threshold (the Marshall-Lerner condition) that determines whether the volume response is strong enough to actually IMPROVE the trade balance despite the adverse price effect.
Balance of payments and exchange rates has come up 120 times in 7 exams since 2007.
What this question tests
This question is on Devaluation, the Marshall-Lerner condition and the J-curve, part of Balance of payments and exchange rates in International Economics.
When a fall in the currency improves the trade balance and why it may first worsen it.
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Question from the GATE 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.