Question

Use a J-curve to illustrate the effect on the current account of an exchange rate depreciation. Explain why the curve has the shape that it does. What condition must be fulfilled to have a positive effect of the depreciation of the currency on the current account?

Answer 1

The J Curve is states that, under certain assumptions, a country's trade deficit will initially worsen after the depreciation of its currency before improving after some time.

Initially, when currency depreciates, the imports become expensive and as a result the net balance of trade worsens (because demand is inelastic). The higher prices on imports will be greater than the reduced volume of imports. But as time progresses, export levels begin to dramatically increase, due to their more attractive prices to foreign buyers. Simultaneously, domestic consumers purchase less imported products, due to their higher costs. These parallel actions shift the trade balance to a smaller deficit, then to a value of zero and ultimately to an increased surplus.

The Marshall-Lerner condition must be fulfilled to have a positive effect of the depreciation of the currency on the current account. It states that a currency devaluation will only lead to a net improvement in the balance of payments if the sum of demand elasticity for imports and exports is greater than one.