In the relevant literature, there are three competing theories that attempt to explain the relation between exchange rates and trade balance.  The first theory relies on the Marshall-Lerner (ML) condition which argues that depreciation will improve the trade balance in the long-run, if the sum of the absolute values of demand elasticities of exports and imports is greater than one.  The second theory argues that intertemporal shocks and exogenous supply shocks explain trade balance imbalances.  Accordingly, these shocks affect the behavior of both the real exchange rate (RE) and the trade balance (TB), so that the RE and the TB influence one another.  Finally, the third theory supports that there is a causal relationship between RE and TB, the direction of which must be determined.
The intention of this paper is to explore the ML condition and does so by using data from Ireland.  The case of Ireland is very interesting from the empirical perspective, because of the Irish economy’s high level of competitiveness in the last years, which makes Ireland a good example of other developing countries.  The scope and nature of the relation between real exchange rates and the balance of payments have very important theoretical policy and implications.  At the same time, the results of empirical literature are as controversial as are the theoretical models.  For the acceptability of the ML condition, Himarios (1989), Han and Suh (1996), Marwah and Klein (1996), Tang and Nair (2002), and Freund (2005), have found evidence in line with the condition.  On the contrary, Rose and Yellen (1989), Backus et al. (1994), Wilson (2001), and Mahmud et al. (2004), have provided results which refute the ML condition.
This empirical study examines the relationship between devaluation and trade balance in the case of the Irish economy, using modern time series techniques.  There are only a few empirical studies that provide results on the ML condition for Ireland.  For instance, Miles (1979), who tested the J-cure effect for the period 1956-1972, using seemingly unrelated regressions, found that there is no evidence of significant positive effect of devaluation causes the trade balance to deteriorate initially due to price consequences, but to improve later as demand for the nation’s commodities rises.  The graph of the trade balance against time is similar to letter J, for this reason economists name this phenomenon the J-curve effect.  Bahmani-Oskooee and Alse (1994), using data covering the 1971-1990 period, found that, in the case of Ireland, depreciation does not have a long-run favorable impact on the trade balance.
This paper adds to the empirical literature on three basic points.  First, the paper explores the long-run impact of devaluation on the Irish trade balance.  Second, it tests the relation between trade balance and devaluations, while standardizing for other important variables which reflect overall activity and affect the balance of payments.  Finally, to check the robustness of the results, the paper adopts a simulation procedure employing impulse response functions.