When will the Marshall-Lerner condition kick in?

The CAD appreciation hit a milestone in October, averaging above 1 USD for the first time in over thirty years. And the trade surplus went up. What's going on?

Here's how the StatsCan release put it:

In constant dollar terms, which isolates volume changes, volumes for imports rose 2.7% as prices declined 4.6%. Meanwhile, export volumes were up 1.9% and prices fell 2.4%.

On a current dollar basis, lower prices contributed to overall reductions in the value of Canadian imports and exports. Imports declined 2.0% to $34.0 billion, while exports edged down 0.5% to $37.4 billion, the third consecutive monthly decrease.

Nevertheless, for the first 10 months of 2007, both imports and exports were higher than for the same period in 2006: the movements in quantities were not enough to counter the changes in prices, especially for imports.

This is not a one-month phenomenon, of course - it's been going on for more than five years. Here's a graph of 12-month moving sums of the trade balance against a 12-month moving average of the CAD-USD exchange rate:

In order for an exchange rate appreciation to reduce the nominal trade surplus, the Marshall-Lerner conditions have to hold: the sum of the demand elasticities for imports and exports has to be greater than one. It's reasonable to expect that the short-run elasticities will be not be large enough to satisfy these conditions, but they are generally believed to apply in the long run. So an exchange rate appreciation could have the effect of temporarily increasing a trade surplus before it came down  - the J-curve.

That's not happening - or at least, not yet. A partial explanation no doubt involves the shift towards exports of energy, whose demand appears to be pretty inelastic. But for how long?

Comments

[Bill Conerly]

Many years ago I had to model the U.S./Canadian exchange rate. I found that changes in the rate followed along fairly closely with changes in relative inflation, but I got a really great fit when I added a measure of commodity prices. High commodity prices (a broth of oil and metals)are very positive for the Loony. I have not run the numbers lately, but that old model feels good at the gut level.