OCR A Level Economics: Purchasing power parity and the Marshall-Lerner condition (H460) – Revision Notes

These notes condense the second half of the topic Exchange rates in the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It sits in the area of study The global context, within Macroeconomics. The specification does not mark any of this content as AS or Extension. All figures are invented and illustrative.

Read the study guide first for full explanations, then test yourself with the practice set. See also the OCR Economics hub, the checklist and the free diagnostics.

Key definitions

• Purchasing power parity (PPP) theory: exchange rates move so that a given sum of money buys the same basket of goods in every country.
• Absolute PPP: the exchange rate equals the ratio of the two price levels.
• Relative PPP: the exchange rate changes by the gap between the two inflation rates.
• Managed exchange rate: the central bank or government acts to influence the value of its currency instead of leaving it wholly to the market.
• Marshall-Lerner condition: a depreciation improves the trade balance only if PEDx + PEDm > 1, using positive values.
• J-curve: the trade balance worsens after a depreciation, then improves.
• International competitiveness: the ability of a country’s firms to sell against foreign rivals, through price and non-price factors.

Formulas and conversions

Item	Rule
PPP rate	Basket price in country A divided by basket price in country B (A-currency per B-currency)
Over- or undervaluation	(market rate − PPP rate) / PPP rate × 100
Relative PPP	New rate = old rate × (1 + inflation A) / (1 + inflation B)
Overseas price of an export	Its home price times the rate quoted as foreign units per home unit
Home-currency cost of an import	Its price abroad divided by the rate quoted as foreign units per home unit
PED	% change in quantity demanded / % change in price
Marshall-Lerner	PEDx + PEDm > 1
Multiplier	1 / marginal propensity to withdraw (save + tax + import)

PPP in steps

1. Find the PPP rate: basket cost at home divided by basket cost abroad.
2. Compare it with the market rate. If the market rate shows the foreign currency buying more home currency than PPP implies, the foreign currency is overvalued.
3. Express the gap as a percentage of the PPP rate.
4. For a forecast, apply relative PPP using the inflation gap.

Worked reminder. The rate is 1.60 arcs per bel. A basket costs 192 arcs in Country A and 150 bels in Country B. The PPP rate is 192 / 150 = 1.28, so the bel is overvalued by (1.60 − 1.28) / 1.28 = 25%.

Evaluating PPP. Say what limits it, then judge.

• Non-tradable goods cannot be arbitraged.
• Transport costs and trade barriers keep prices apart.
• Products are differentiated, and baskets differ.
• Capital flows and speculation dominate the short run.
• Judgement: weak short-run predictor, better long-run guide and a useful benchmark.

Why countries manage their exchange rate

• Keep the currency low to hold export prices down abroad and protect home producers from import competition.
• Give firms a stable rate to plan against.
• Help correct a persistent current account deficit.

Costs: inflation from the extra money created when buying foreign currency, reserves that are finite and have an opportunity cost, interest rate conflict, retaliation by trading partners, and dearer imports.

Marshall-Lerner in steps

1. Work out the percentage change in prices from the depreciation.
2. Use PEDx to find the change in export volume, and PEDm to find the change in import volume.
3. Revalue exports at the new foreign or home price, and imports at their new home price.
4. Compare the balance before and after, or simply add PEDx and PEDm and compare with 1.

Reminder example. Trade is balanced at 5,000 on both sides: 500 exports at 10, and 250 imports at 20. A 5% depreciation, with PEDx = 0.8 and PEDm = 0.5 (sum 1.3):

• Export volume up 4% to 520; revenue 520 × 10 = 5,200.
• Import price up 5% to 21; volume down 2.5% to 243.75; cost 243.75 × 21 = 5,118.75.
• Balance = 5,200 − 5,118.75 = about +81. The sum exceeds 1, so the balance improves.

Competitiveness reminder. In a separate illustration, a firm makes a unit in 3 hours at 20 arcs an hour, so unit labour cost is 60 arcs. If 1 arc buys 0.50 bels, that is 30 bels. After the arc falls to 0.40 bels, the same cost is 24 bels, 20% lower in Country B’s currency. Imported components, pass-through and rivals’ responses can reduce this gain.

J-curve points. Short-run elasticities are low because of existing contracts, slow buyer responses and supply lags. The balance falls to a trough, passes its starting level, then rises. A J-curve needs the condition to hold in the long run.

Competitiveness and macro objectives: chain of reasoning

Link	Effect
Depreciation	Foreign price of exports falls, home price of imports rises
If elasticities are high	Volumes respond, net exports rise
Aggregate demand	Rises, then the multiplier amplifies it
Growth and jobs	Improve, if there is spare capacity
Inflation	Rises through imported costs, and from demand-pull if capacity is tight
Balance of payments	Improves after the J-curve, if the condition holds

Evaluate with: the size of the elasticities, time lags, spare capacity, pass-through, imported inputs, competitor responses and the weight of imports in spending. Supply-side improvements in productivity and quality give lasting non-price competitiveness.

Must-know distinctions

Pair	Difference
Absolute and relative PPP	Level of the rate against change in the rate
Marshall-Lerner and J-curve	Whether the balance improves at all, against the timing of the improvement
Price and non-price competitiveness	Cost and price factors against quality, design and reliability
Fall in a currency and rise in import prices	They differ: a 20% fall in what one arc buys (0.50 to 0.40 bels) raises import prices in arcs by 25%

Quick self-test

1. State what absolute PPP predicts about the same basket in two countries.
2. Basket cost: 160 arcs in Country A, 80 bels in Country B. The market rate is 2.30 arcs per bel. Find the PPP rate and say how far the bel is overvalued.
3. The rate is 2.00 arcs per bel. Country A inflation is 4% and Country B is 1%. Use relative PPP to forecast the new rate.
4. An export is priced at 60 arcs. The rate falls from 0.50 to 0.40 bels per arc. Find the old and new bel price and the percentage change.
5. An import costs 30 bels. Using the same rates as question 4, find the arc price before and after and the percentage change.
6. A 5% fall in the foreign price of exports raises volume by 9%. A 5% rise in the home price of imports cuts volume by 2%. Find PEDx and PEDm and say if the condition is met.
7. Trade is balanced at 5,000 on each side (500 exports at 10, 250 imports at 20). A 5% depreciation occurs with PEDx = 0.8 and PEDm = 0.5. Find the new balance.
8. Give two reasons for the J-curve.
9. Give two reasons why PPP predicts poorly in the short run.
10. Net exports rise by 3 billion arcs. Saving takes 0.1 of extra income, tax 0.2 and imports 0.2. Find the multiplier and the rise in income.
11. Imports are 20% of the price basket and import prices rise 10%. By how much does the price level rise?
12. Give two costs to a country of keeping its currency low.

Answers

1. The rate settles where one basket costs the same once converted, so it equals the price ratio of the two countries.
2. PPP rate = 160 / 80 = 2.00. Overvalued by (2.30 − 2.00) / 2.00 = 15%.
3. 2.00 × 1.04 / 1.01 = 2.059 arcs per bel, a rise of about 3.0%. The arc depreciates.
4. 60 × 0.50 = 30 bels; 60 × 0.40 = 24 bels; a fall of 20%.
5. 30 / 0.50 = 60 arcs; 30 / 0.40 = 75 arcs; a rise of 25%.
6. PEDx = 9 / 5 = 1.8; PEDm = 2 / 5 = 0.4; sum 2.2, above 1. Met.
7. About +81 (5,200 − 5,118.75).
8. Contracts fixed in advance, and slow buyer and supplier adjustment. Import costs rise before volumes change.
9. Non-tradable goods, trade costs and differentiated products; also capital flows and speculation.
10. Multiplier = 1 / 0.5 = 2; income rises by 6 billion arcs.
11. 0.20 × 10 = 2%.
12. Any two of: inflation from money creation, reserve costs, interest rate conflict, retaliation, dearer imports and lower living standards.

Where marks are usually lost

• Computing PEDx + PEDm but not comparing the sum with 1.
• Reversing the quoting convention, so the depreciation seems to raise foreign prices.
• Calling the Marshall-Lerner condition a rule for the short run. The J-curve is the short-run story.
• Describing what PPP says but offering no evaluation.
• Evaluation that lists “it depends” without naming on what: the elasticities, spare capacity or time.
• Leaving out imported inflation when judging depreciation.
• Missing the final step in a chain, from exports to aggregate demand to output and jobs.
• Writing every currency fact as general when the question gives a context.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), first assessment 2021. Component 2, Macroeconomics: area of study The global context, topic Exchange rates (purchasing power parity, managing the exchange rate, the Marshall-Lerner condition and J-curve, competitiveness, and effectiveness of changing the value of a currency).