The Elasticity Approach is a classical framework used to analyze how changes in the exchange rate affect a country’s balance of payments, especially the trade balance (exports minus imports). It focuses on the price responsiveness — or elasticity — of exports and imports to changes in the exchange rate.
This approach is particularly useful for countries facing a current account deficit and considering currency devaluation as a corrective measure.
Core Idea: Exchange Rate and Trade Balance
The central idea of the elasticity approach is:
A depreciation (or devaluation) of the domestic currency improves the trade balance if the combined price elasticity of exports and imports is sufficiently high.
When a currency depreciates:
- Exports become cheaper for foreigners → demand for exports rises.
- Imports become more expensive for domestic consumers → demand for imports falls.
But whether this actually improves the trade balance depends on how elastic the demand is — that is, how much quantity demanded changes in response to price changes.
The Marshall-Lerner Condition
The effectiveness of currency depreciation in improving the trade balance depends on the Marshall-Lerner condition. This condition states:
If Ex + Em > 1, then devaluation will improve the trade balance
Where:
- Ex = Price elasticity of demand for exports
- Em = Absolute value of price elasticity of demand for imports
In simple terms: The sum of the export and import elasticities must be greater than one for devaluation to work in improving the trade balance.
Illustration
Currency Depreciation:
- Suppose the domestic currency depreciates by 10%.
- If export demand is elastic → export volume rises → more foreign exchange earned.
- If import demand is elastic → import volume falls → less foreign currency spent.
- Result: Trade balance improves.
If demand is inelastic:
- Export volume barely increases.
- Import volume remains high despite costlier prices.
- Result: Trade balance may worsen in the short run.
J-Curve Effect
Even if the Marshall-Lerner condition holds, the trade balance may initially worsen after devaluation. This is known as the J-curve effect:
- Short run: Contracts and habits delay quantity adjustment → trade deficit may widen.
- Medium to long run: As export volumes rise and imports fall, the trade balance improves → forming a J-shaped path.
Assumptions of the Elasticity Approach
- Exports and imports respond to price changes (are elastic).
- Income levels and other macro variables remain constant.
- Only the current account is considered (not capital flows).
- High exchange rate pass-through is assumed (prices reflect exchange rate changes).
Criticisms and Limitations
- Focuses only on the current account, ignoring capital flows and financial integration.
- Assumes elastic demand, which may not hold, especially in the short run.
- Ignores income effects: higher import prices may reduce real income and consumption.
- Modern trade includes many intermediate goods, making price elasticity analysis complex.
Relevance for Nepal
For Nepal:
- The exchange rate is pegged to the Indian rupee, so Nepal has limited scope to use devaluation as a policy tool.
- The elasticity approach has limited applicability under a fixed exchange rate system.
- However, it is useful for understanding trade with third countries like China, the USA, and the EU.
- Price competitiveness is important, but Nepal must also improve non-price factors such as product quality, reliability, and trade infrastructure.
Conclusion
The elasticity approach provides a simple and intuitive explanation of how exchange rate adjustments can influence the trade balance. Its key message is clear: depreciation only helps if exports and imports respond strongly to price changes.
While this approach has limitations in today’s globally integrated economy, it remains a valuable tool — especially when combined with other perspectives like the absorption approach and the monetary approach — for diagnosing and addressing balance of payments issues.
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