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

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers the second half of the topic Exchange rates, in the area of study The global context, within Macroeconomics. The specification does not mark any of this content as AS or Extension. Every figure below is invented and illustrative: the countries, currencies and firms do not exist.

Use it with the revision notes, the practice set, the OCR Economics hub, the checklist and the free diagnostics. Related pages: Macroeconomics, elasticity and inflation and index numbers.

What this unit covers

Outcome	You must be able to
PPP theory	Explain it, then evaluate it
Managing the exchange rate	Explain why a country might do so to achieve international competitiveness
Marshall-Lerner and J-curve	Explain both
Competitiveness	Evaluate the impact of exchange rate changes
Macro objectives	Evaluate how effective changing a currency’s value is

Component 3 has no content of its own. It is synoptic and draws on the microeconomics and macroeconomics content, so these ideas can be applied there to an unseen theme.

1. Purchasing power parity (PPP) theory

PPP theory says that exchange rates adjust so that a given amount of money buys the same goods and services in every country. If it did not, buyers could make a gain by buying in the cheap country and selling in the dear one, and that trade would push the rate back.

Absolute PPP. The exchange rate equals the ratio of price levels. Suppose a basket of goods costs 240 arcs in Country A and 180 bels in Country B.

• PPP rate = 240 / 180 = 1.33 arcs per bel.
• The market rate is 1.50 arcs per bel.
• A bel buys more arcs than PPP suggests, so the bel is overvalued by (1.50 − 1.333) / 1.333 = 12.5% against the arc, and the arc is undervalued.

Check it as a buyer would. 180 bels swapped at 1.50 give 270 arcs, enough for the basket in Country A with 30 arcs to spare. The theory predicts pressure on the bel to fall towards 1.33.

Relative PPP. This is the weaker version. It says the exchange rate changes by the difference between inflation rates, not that the level equals the price ratio. Country A has inflation of 6% and Country B 2%. Starting at 1.50 arcs per bel:

• New rate = 1.50 × 1.06 / 1.02 = 1.559 arcs per bel.
• The bel appreciates by about 3.9% against the arc, and the arc depreciates.

As a rule of thumb, the higher-inflation country’s currency depreciates by about the inflation gap (here 4 points, close to the exact 3.9%).

Why it matters. PPP gives a long-run anchor and a yardstick for calling a currency over- or undervalued.

Evaluating PPP theory

Weakness	Why it breaks the link
Non-tradable goods	Haircuts, rents and local services cannot be shipped, so their price differences are never arbitraged away
Transport costs, tariffs and quotas	These give a gap between prices that traders cannot close
Differentiated products	A branded good in A is not the same as a different brand in B, so the baskets are not like for like
Imperfect competition	Firms charge different prices in different markets
Capital flows	Interest rate gaps, speculation and confidence move rates far more than goods prices in the short run
Different baskets	Consumers in different countries buy different things, and weights differ

Judgement. PPP predicts poorly over months and years, because financial flows dominate, but is a better guide over long periods, especially where inflation gaps are large. It treats the exchange rate as set only by goods prices.

2. Why countries manage their exchange rate for competitiveness

A government or central bank can manage its currency rather than leave it entirely to the market. The specification’s reason is international competitiveness: a lower exchange rate makes exports cheaper for overseas buyers and imports dearer at home, which helps home producers.

Quoting convention. State which currency is “one”. Take a fresh pair of rates: 1 arc = 0.50 bels. An exporter prices a machine at 100 arcs. Country B buyers pay 100 × 0.50 = 50 bels. If the arc falls to 0.45 bels, the same machine costs 45 bels, a fall of 10%. An import priced at 30 bels cost 30 / 0.50 = 60 arcs before the change and costs 30 / 0.45 = 66.7 arcs after, a rise of 11.1%. A 10% fall in the arc raises import prices in arcs by 11.1%, because the division runs the other way.

Reasons to manage the rate

• To hold the rate low (or avoid a rise) so that exports stay price competitive.
• To give firms a stable rate so that they can plan and price in advance.
• To correct a persistent current account deficit.

Methods. The central bank can sell its own currency and buy foreign currency (adding to reserves) to hold the value down, lower interest rates to deter hot-money inflows, or use capital controls. Exchange rate systems themselves are covered in another unit.

Costs and limits

• Buying foreign currency creates extra money in the economy and can feed inflation unless offset.
• Reserves are finite when defending a rate against selling pressure, and holding them has an opportunity cost.
• Lower interest rates to hold the currency down may conflict with inflation aims.
• Trading partners may retaliate, cancelling the gains.
• A low rate makes imports dearer and keeps living standards lower.

3. The Marshall-Lerner condition

A depreciation changes both prices and quantities. Export volume should rise and import volume should fall, but each import unit now costs more in home currency. Whether the trade balance improves depends on how strongly volumes respond.

Marshall-Lerner condition. A depreciation improves the trade balance (exports minus imports) only if the sum of the price elasticity of demand for exports and for imports, taken as positive numbers, is greater than 1: PEDx + PEDm > 1.

Worked example (10% depreciation, trade starting in balance). Country A exports 1,000 units at 20 arcs, earning 20,000 arcs. It imports 800 units at 25 arcs, costing 20,000 arcs. The depreciation raises the home price of imports by 10% to 27.50 arcs. Exporters keep their arc price, so the foreign price falls.

Case 1: PEDx = 0.6, PEDm = 0.3. Sum = 0.9, below 1.

• Exports: volume up 6% to 1,060; revenue = 1,060 × 20 = 21,200 arcs.
• Imports: volume down 3% to 776; cost = 776 × 27.50 = 21,340 arcs.
• Balance = 21,200 − 21,340 = −140 arcs. The balance worsens.

Case 2: PEDx = 0.9, PEDm = 0.6. Sum = 1.5, above 1.

• Exports: volume up 9% to 1,090; revenue = 21,800 arcs.
• Imports: volume down 6% to 752; cost = 752 × 27.50 = 20,680 arcs.
• Balance = +1,120 arcs. The balance improves.

Calculating the elasticities. If a fall of 8% in the foreign price of exports raises export volume by 12%, PEDx = 12 / 8 = 1.5. If import prices in home currency rise 10% and import volume falls 4%, PEDm = 4 / 10 = 0.4. The sum is 1.9, so the condition is met.

Assumptions to state. The condition suits small changes from balanced trade, and assumes full pass-through to prices, nothing else changing and no supply constraints on exporters.

4. The J-curve

Short-run elasticities tend to be smaller than long-run ones. Contracts are fixed in advance, buyers need time to notice price changes, and firms need time to find new suppliers or expand capacity. So straight after a depreciation, import bills rise while volumes barely move, and the trade balance worsens first, then improves as volumes adjust. Plotted over time, the balance traces a shape like the letter J.

Illustrative balance (billion arcs, invented) before and after a depreciation at quarter 0:

Quarter	0	1	2	3	4	5	6	7
Balance	−2.0	−3.1	−3.8	−3.0	−1.8	−0.6	+0.5	+1.1

The balance is −2.0 at the start and falls to a trough of −3.8 in quarter 2, 1.8 below where it began. It passes the starting point in quarter 4 (−1.8) and ends 3.1 above it by quarter 7. For a J-curve to occur, the Marshall-Lerner condition must hold in the long run. If it does not, the balance never recovers.

5. Impact of exchange rate changes on international competitiveness

Price competitiveness. A depreciation makes exports cheaper for foreign buyers and imports dearer at home (section 2). The exchange rate also changes costs measured abroad: if wages are paid in arcs, a worker earning 2,400 arcs and producing 40 units gives a unit labour cost of 60 arcs. At 0.50 bels per arc, that is 30 bels. After depreciation to 0.45 it is 27 bels, 10% lower in foreign-currency terms.

What determines the size of the gain

• Pass-through. Exporters may keep the foreign price and take a bigger margin, so volumes do not move.
• Imported inputs. If the firm buys components abroad, its costs rise as the currency falls and the gain is reduced.
• Non-price competitiveness. Where demand depends on quality, design and reliability, price falls matter less (low PEDx).
• Competitor responses. Rivals may cut prices or depreciate too.
• Domestic inflation. If the depreciation feeds higher home costs, the advantage fades.

An appreciation reverses these effects: export prices abroad rise and imports get cheaper, though firms using imported inputs benefit.

6. Is changing the value of a currency effective for macro objectives?

Depreciation and growth or employment. If the Marshall-Lerner condition holds, net exports rise, aggregate demand rises, and output and employment rise through the multiplier. Suppose net exports rise by 6 billion arcs and withdrawals are 0.5 of extra income (marginal propensity to save 0.2, marginal rate of tax 0.2, marginal propensity to import 0.1). The multiplier is 1 / 0.5 = 2 and national income rises by 12 billion arcs. With GDP at 400 billion arcs this is a 3.0% rise.

Inflation. Dearer imports raise costs directly. If imports make up 25% of the consumer price basket and import prices rise 11.1%, the price level rises by about 0.25 × 11.1 = 2.8%. Demand-pull pressure adds to this if the economy is near full capacity. Appreciation can lower inflation but hurts exporters.

Balance of payments. The current account improves only after the J-curve and only if the Marshall-Lerner condition holds. Debts in foreign currency become heavier.

Evaluation chain

1. The condition: are the elasticities high enough?
2. Time: how long is the J-curve, and is the government able to wait?
3. Spare capacity: if the economy is at full capacity, extra demand raises prices not output.
4. Pass-through and competitors: do they erode the advantage?
5. Imported inflation: does the price rise cancel the gain in competitiveness?
6. Conflict: growth and employment against inflation, and against living standards.
7. Alternatives: supply-side policies can raise non-price competitiveness.

Judgement. Changing a currency’s value is a quick tool, but effectiveness depends on elasticities, spare capacity and the share of imports in spending. In the long run, productivity and quality matter more than the rate.

Common errors

• Writing PEDx + PEDm > 1 as a condition on each elasticity separately. It is the sum.
• Saying depreciation always improves the balance. It needs the condition to hold, and the J-curve means it may worsen first.
• Mixing up the quoting convention, so a depreciation seems to raise export prices abroad.
• Listing effects without a chain: lower foreign price, higher volume, higher net exports, higher aggregate demand.

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).