Changes of the price level and the nominal exchange rate can have quite different impacts on the trade balance

Most of the literature on the real exchange rate and the trade balance assumes that the trade balance reacts in the same way irrespective of whether the nominal exchange rate or the price level change. Both are seen as equivalent and the sign of the reaction of the trade balance dependent only on the fulfillment of the Marshall-Lerner (ML) condition. However, as will be shown analytically in this paper, the trade balance can react quite differently to changes of the nominal exchange rate on the one hand and of the price level on the other hand. More specifically, with a sufficiently large initial trade surplus, a country's increase of the price level (an appreciation) can lead to a further - and perverse - increase in the surplus. On the other hand, with a sufficiently high initial deficit, a country's depreciation of the nominal exchange rate can lead to a - perverse - further widening of the deficit. Formal conditions are derived under which the reaction of the trade balance is normal or perverse. As will be shown, those conditions are quite different from the traditional ML condition which is shown to hold only under very restrictive assumptions. It is further shown that the trade balance only reacts in the same way to changes in the price level and the nominal exchange rate when the ML condition is met. The focus on the ML condition might thus be seriously misleading.