e in Shenzhen and other mainland cities are desired to spend in HK as the prices are now lower than previously (hktdc.com) [2] .
Above examples demonstrated that there is a strong correlation between real exchange rate and the trade balance (Figure 1), holding home and foreign prices fixed and the trade balance increases as real exchange rate increases: 'a€| trade balance of the home country to be an increasing function of the home country's real exchange rate' (P715 Feenstra and Taylor 2008). This linearly relationship is illustrated in Figure 1 as the upward sloping line. In summary, currency depreciation (an increase in the real exchange rate) increases trade balance by raising exports and lowering imports: when exchange rate increase from E0 to E1, trade balance also increase from TB0 to TB1.
Another important theory in consistent of the expenditure theory that explains the relation between exchange rates and TB is the Marshall-Lerner (ML) elasticity's approach (an extension view of the expenditure switch theory), this theory also suggests that the TB will improve provided that the demand elasticity of imports (PED-imports) and exports (PED-exports) are high enough, in specific, to be greater than one. (p760 Feenstra and Taylor).
PED (exports) + PED (imports) > 1
Essentially, the greater the volume effects, the greater will be the improvement of the trade balance. 'a€|.the responsiveness of trade volumes to real exchange rate is sufficiently elastic to ensure that the volume effects exceed the price effects' (p760 Feenstra and Taylor). It has to be greater than one because of the following (example adapting the theory): suppose home country is Ireland, set PED (imports) = 1, then 1% Euro devaluation means 1% increase in price of imports and this resulting 1% reduction in quantity demanded in the domestic country(Ireland). The overall effects cancel out and the value of imports stay unchanged. Furthermore, any increase in export demand following 1% decrease in $ price of Irish goods will move the current account towards balance, i.e. must have PED (exports) > 0 (recall that price is fixed). Similarly, if PED (imports) = 0, import values rise by 1% due to the price effect and export revenues must rise by more than 1% to improve current account, i.e. require PED(exports) > 1. (Christopher, 2007)
Empirical evidence claim that the ML condition might not hold in the short run because, in the short run exports and imports tend to be less fluctuated in its volume 'a€|demand is more inelastic in the short run, thus the elasticity's approach represents a long-run relationship only' (Ryan, 1993). This implies that the price effect exceeds volume effect, depreciation will in fact, worsening the TB rather than improving it. As Christopher (2007) quoted that supply is inelastic especially in the short-run (Figure 2) and it is in the short-run that demand curves are most inelastic e.g. due to sluggish adjustment linked to consumer switching costs, consumption habits and the like.
This leads us to the J-curve analysis where it tends to explain the short run effects better. The essential idea is that devaluation is expected to worsen the TB in the short term. This process also reflects the shortcomings of ML where demand and supply of goods/services are inelastic in the short run and firms may not be able to immediately increase supply following a change in exchange rates, thus, allow the TB to worsen before improving. Same concept applies in the J-curve argument.
Recall the assumption in expenditure switching earlier that real depreciation improves a country's TB by in
