• Question: Is the Marshall-Lerner condition satisfied in practice?

1) Historical examples• Italy 1992-93• Poland 2009

2) Econometric estimation of elasticities• OLS• The J-curve

3) Both determinants together: Real exchange rate & income• Keynesian model of the TB• Estimation for the case of East Asian countries

LECTURE 2: THE TRADE BALANCE IN PRACTICE

Professor Jeffrey Frankel, Kennedy School, Harvard University

1992 devaluation

Rise in trade balance

(i) Italy devalued in Europe’s 1992 ERM crisis. The lira’s Real Effective Exchange Rate value & effect on its trade balance.

Historical examples

I III V VII IX XI I III V VII IX XI I III V VII IX

2008 2009 2010

3.2

3.5

3.7

4.0

4.2

4.5

4.7

(ii) Poland’s Exchange Rate Rose 35% when Global Financial Crisis hit in late 2008.

Source: Cezary Wójcik

Zlot

y/€

Poland’s trade balance improved sharply in 2009while its European trading partners all went into recession.

Source: National Bank of Poland From FocusEconomics 2014

Trade balance in billions of euros

=> Poland avoided recession.

Contribution of Net X in 2009: 3.1% of GDP > Total GDP growth: 1.7%

A textbook case where depreciation was expansionary: Poland, the only continental EU member with a floating rate,

was also the only one to escape negative growthin the global recession of 2009.

2006 2007 2008 2009 2010 Exchange Rate

Poland6.2  6.8  5.1  1.7  3.5f 

Floating

Lithuania7.8  9.8  2.9  -14.7  -0.6f 

Fixed

Latvia12.2  10.0  -4.2  -18.0  -3.5f 

Fixed

Estonia10.6  6.9  -5.1  -13.9  0.9f 

Fixed

Slovakia8.5  10.6  6.2  -4.7  2.7f 

Euro

Czech Republic6.8  6.1  2.5  -4.1  1.6f 

Flexible

Hungary3.6  0.8  0.8  -6.7  0.0f 

Flexible

Source: Cezary Wójcik, 2010

(de facto)

% change in GDP

Empirical estimation of export & import elasticities

• Coefficient estimated by OLS regression.– In logs, so parameters are elasticities.

log of Xdemanded

log of EP*/P ≡ Price of foreign goods relative to domestic goods

Common econometric finding

• Estimated trade elasticities with respect to relative prices often ≈ 1, after a few years have been allowed to pass.– => Marshall-Lerner condition holds in the medium run.– e.g., Marquez (2002).

• Some face a higher elasticity of demand for their exports:– small countries, and– producers of agricultural & mineral commodities or other

commodities that are close substitutes for competitors’ exports.

Common empirical observation:After a devaluation, trade balance gets worse before it gets better.

Explanation:Even if devaluation is instantly passed throughto higher import prices,buyers react with a lag.

Also, in practice, it may take time up frontbefore the devaluation is passed through to import prices.

The trade balance is a function of both the real exchange rate and income.

• Recall the Keynesian model of the trade balance from Lecture (iii) of the pre-semester Macro Review.

• Micro theory: The demand for the import or export good, as for any good, is a function of both price & income.

Keynesian Model of the Trade Balance

Import demand is a function of the exchange rate & income. The same for exports: => X = X(E, Y*) M = M(E, Y).

.

If the domestic country is small, Y* is exogenous.

0dE

dX

0**

mdY

dX0m

dY

dM

0dE

dM

Estimated price elasticities (LR)

satisfy the Marshall-Lerner

Condition.Estimated income elasticities are mostly

between 1.0 - 2.0.

END OF LECTURE 2: THE TRADE BALANCE IN PRACTICE

After big devaluations

in Mexico in 1994

and Korea

& Southeast Asia in 1997,

trade balances “improved” quickly, but because of expenditure-reduction, not expenditure-switching.

Appendix 1 -- Morehistorical examples: EM currency crises of the 1990s.

Professor Jeffrey Frankel, Kennedy School, Harvard University

• Why did trade fall so much more sharply than income in the 2008-09 global recession?

Appendix 2–

An application of the marginal propensity to import

An application of the marginal propensity to import:

Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, 2013,"Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-2009."

Why did trade fall so much more sharply than income in the 2008-09 global recession?

2009

Bussière, Callegari, Ghironi, Sestieri, & Yamano, 2013, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-09."

Why did trade fall so sharply in the 2008-09 global recession?

The usual explanations involve trade credit, inventories, and trade in intermediate inputs.

Behavior of real components of GDP in the 2008-09 recession

Demand, adjusted for import-intensity

GDP

Investment

Imports & Exports

Bussière, Callegari, Ghironi, Sestieri, & N.Yamano, "Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008-2009.“

Bussière et al (2013) argue that Investment, which declined much more in 2009 than the other components of GDP, has

a higher marginal propensity to import than the other components.