Essential definitions

Expenditure switching

Policies that redirect spending from foreign to domestic output.

Expenditure reducing

Policies that lower total domestic spending, including spending on imports.

Price elasticity of demand

The percentage change in quantity demanded divided by the percentage change in its price; absolute values measure responsiveness here.

Marshall–Lerner condition

In the standard model starting from balanced trade, depreciation improves the trade balance if the absolute export- and import-demand elasticities sum to more than one.

Distinguish three policy routes

Expenditure switching redirects spending from foreign towards domestic output. Depreciation or devaluation changes relative prices; tariffs can deter imports but raise input costs and risk retaliation. Switching works poorly when imports are essential or domestic firms cannot expand.

Expenditure reducing lowers overall domestic demand through higher taxes or rates or lower public spending. Imports may fall, but so can output and employment. Higher rates may also attract funds and appreciation, weakening exports. Supply-side measures improve skills, infrastructure, quality or costs over time. They need funding and delivery, so cannot be assumed to fix an immediate financing gap.

Explain the elasticity test

The trade balance is export revenue minus import expenditure in a stated currency. Price elasticity of demand measures percentage quantity change divided by percentage price change. Here use absolute values to measure responsiveness: an elasticity of 0.7 means a 1% price change produces about a 0.7% opposite quantity change locally.

Under the standard Marshall–Lerner model, starting from balanced trade with suitable supply and pricing responses, depreciation improves the trade balance if absolute export-demand plus import-demand elasticities exceed one. A sum of 0.7 + 0.6 = 1.3 passes the test; 0.2 + 0.3 = 0.5 does not. The condition is not a prediction for every initial balance or the income and transfer parts of the current account.

Choose a sequence, not a guarantee

Immediate import-price increases can precede quantity adjustment. Contracts, available substitutes and domestic capacity influence how long the response takes. The next J-curve lesson separates that timing from the eventual elasticity condition.

A useful recommendation identifies the deficit's cause, the urgency of financing and the costs of each policy. Temporary demand restraint may reduce import spending while harming employment; supply investment may address competitiveness later. Explain those trade-offs and supporting measures instead of promising that a weaker currency alone removes the deficit.

Apply and evaluate

• A policy mix may limit reliance on contraction, but measures can work against each other.
• Evaluate the underlying deficit cause before recommending a policy.