Question

Explain the J-curve phenomenon. Consider an economy with a fixed exchange rate with a fixed price level. What is the effect of depreciation on equilibrium income and trade balance after the first six months of depreciation?

Answer 1

J-Curve phenomenon- This explains initially when a country's currency depreciates its trade balance worsens and after that it recovers higher than where it started.

Due to currency depreciation an economy's imports becomes costlier and its exports value deceases and this leads to imbalance in current account and further leads to smaller surplus or higher/huge deficit.

initially in the short run there will be a lag in increase in exports and decrease in imports since importers will honor their import contracts with foreign supplier/producers and exports will remain unchanged and imports will get increased.

But due to long run effects of depreciation, export will get increased and imports will get decreased and local consumer will also substitute expensive imports for local cheaply available products and this will improve the trade balance situation and trade balance will be higher than initial level where it started.

So after six months trade balance will improve and equilibrium income will get increased and trade balance will be at higher level than initial level where it started.

This J-Curve phenomenon can be shown through diagram as per below.