Question

Consider an economy where the current account is negatively affected by a depreciation in the real exchange rate in the short run (that is, the Marshall-Lerner condition does not hold). Explain the effects of a monetary expansion in this economy by comparing it to the baseline case where the Marshall-Lerner condition holds. Use a graphical analysis accompanied by an intuitive (verbal) explanation. (Assume that the DD curve under the revised assumption will be steeper than the AA curve.) (You have to show the changes in AA and DD curves to derive the answer)

Answer 1

When there is devaluation or depreciation of real exchanges rate in short run, the monetary expansion will lead to lower interest rates which shall cause firther depreciation of real exchange rate and subsequently the current account will be more negatively impacted in absence of Marshall lerner conditions. Here monetary supplys expansion will cause AA curve and DD curve to shift rightwards as supply increases the credit availability of funds rises, consumption rises and thus aggregate demand rises causing real GDP to rise and hence inflation rises.

If Marshall lerner conditions hold true, the depreciation of rral exchange rate will lead to positive terms or balance of trade and thus exports will be higher.

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