Exchange Rate and Trade Balance

The management of the Exchange Rate has been a critical issue for the economic policy,

especially in developing countries. In defining an exchange rate policy, one of the most

important considerations is the responsiveness of Trade Balance (TB) to changes in terms

of trade or, more generally, in Real Exchange Rate (RER). The effects of currency

depreciation on a country's trade balance have centred an important and on-going debate

in the international economic literature. Precisely, this issue has been traditionally studied

in the Marshall-Lerner condition (ML) and the so called J-curve framework. According

to the ML condition, currency devaluation improves the trade balance in the long run

only if the sum of the absolute values of imports and exports demand price elasticities

exceeds unit. However, due to the lag dynamics structure, TB can worsen in the short-run

because of the inelastic demand for imports and exports in the immediate aftermath of an

exchange rate change. In this case, TB is said to follow the J-curve pattern.

A wide number of papers have tested the ML condition and J-curve. Bahamani-

Oskooee and Ratha (2004) is a good survey on ML and J-curve showing non conclusive

results on this issue. In Bahamani-Oskooee and Niroomand (1998) the ML condition is

addressed for almost thirty developed and developing countries over the period 1960-92.

Gomes and Paz (2005) and Tsen (2006) demonstrate the existence of a long run

relationship among TB, real exchange rate, foreign and domestic income for Brazil in the

nineties and for Malaysia during 1965-2002 respectively. Mahmud et al. (2004) suggest

that, though during fixed exchange rates periods ML condition is supported, it is less

probable in flexible exchange periods. Almost all these papers find support for the

existence of the J-curve pattern except Narayan (2004) who does not confirm the ML

condition in New Zealand.

As far as we know, there is only one paper that deals with ML condition