If domestic income falls, what must happen to keep the trade balance the same?
A) The real exchange rate must fall.
B) Foreign income must rise.
C) The domestic price level must fall.
D) Domestic income must fall.

Question

Quizplus · Accepted Answer

According to the Marshall-Lerner condition, if domestic income falls, the trade balance can only be maintained if the elasticity sum of exports and imports is greater than 1. In other words, if the sum of these elasticities is greater than 1, a depreciation of the currency will lead to an improvement in the trade balance. Alternatively, a fall in domestic income could lead to a fall in demand for imports, which would improve the trade balance, but this would not necessarily keep the balance the same. Therefore, the real exchange rate must fall to maintain the trade balance.

If Domestic Income Falls, What Must Happen to Keep the Trade