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

The J-curve effect is a type of diagram where the curve falls at the outset and eventually rises to a point higher than the starting point, suggesting the letter J.

An example of the J-curve effect is seen in economics when a country's trade balance initially worsens following a devaluation or depreciation of its currency. The higher exchange rate first corresponds to more costly imports and less valuable exports, leading to a bigger initial deficit or a smaller surplus. Due to the competitive, relatively low priced exports, the affected country's exports of the goods in question start to increase as outside demand for the lower- priced option increases. Local consumers also purchase less of the more expensive imports and focus on local goods as the exchange rate makes certain locally produced items more affordable than the imported counterpart. The trade balance eventually improves to better levels compared to before devaluation.