Trade and Marshall-Lerner Problems - Assignment Example

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The central bank can purchase the local currency against the foreign currency so that a shortage is created in local currency and may lead to the local currency being expensive in the long run over the foreign currency.
Secondly, the central bank can appreciate the value of the…
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Trade and Marshall-Lerner Problems
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Trade and Marshall-Lerner Problems Assume a fixed exchange regime a. Show graphically how with an increase in the demand for UK assets will cause excess demand for foreign exchange (£) at the fixed exchange rate.
Foreign exchange
C Fixed exchange

A B UK assets
A graph showing the relationship between the UK assets and foreign exchange
When the demand for the UK assets increase (from point A to B), the foreign exchange moves in excess from point C to E.
b. Discuss the three options that the UK central bank has in the particular case
The central bank can purchase the local currency against the foreign currency so that a shortage is created in local currency and may lead to the local currency being expensive in the long run over the foreign currency.
Secondly, the central bank can appreciate the value of the local currency against the foreign one, so that it becomes the local becomes expensive against the foreign currency and stem the excess demand.
Third, the central bank can sell the foreign currency reserves so that it floods the market with foreign currency, and hence the demand for the foreign currency will fall.
2. Show how an increase in the foreign exchange rate (E=£/$) from 1.0 to 1.5 will affect the trade balance using the data below.
(US Computer) (UK Jaguar Auto)
$3000=3000£ E: £/$ = 1.0, thus 1.0£ = $1.00 30, 0000£ = $30, 000
$3000 = 4500£ E: £/$ 1.5, thus 1.5£ = $1.00 30, 000£ = $20, 000
UK imports up UK Trade balance better UK Exports up
US imports down US Trade balance worse US Exports down
a. Define the Marshall-Lerner condition.
The Marshall-Lerner condition explains the situations where the transformation of the local exchange rate corresponds to an improvement or worsening of a the country’s balance of payments.
b. Show why UK import and export elasticities, determine whether a devaluation of the pound will improve the trade balance in terms of foreign exchange holdings. Use your prices from problem 4 above in conjunction with supply and demand graphs for UK imports and exports.
Devaluation is actually good for the UK economy as it improves the balance of payments, as improves the exports and reduces imports. In short, export becomes cheaper and imports become expensive. Assume that the exchange rate has been devalued such as the £ 2.0 exchanges for 1.0$, then the
The Import from the US will be £ 6000 from £4500, and the export will be $15000 from $ 20, 000, for US computer and UK Jaguar Auto respectively.
Exchange rate Import

B ------------------------------------
C D E F Price
A graph showing the relationship between exchange rate and Exports/Imports demanded
The exchange rate is devaluated from point A to B, and the price imports increases from C to D. similarly, the price of exports fall from point E to F. Read More
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