Question

Real exchange rate and its relationship with trade balance, volume vs. value effects, J-curve.

Answer 1

Real Exchange rate relationship with trade balance:

There is positive correlation between real exchange rate and trade balance. When real exchange rates rise then domestic currency become weaker which helps in boosting exports and reduction in imports which translates to positive effect on trade balance.

Volume Vs Value effect:

Volume effect explains the effects of "consumer spending shifts" on exports and imports. Value effect explains the change in domestic output on account of change in import quantity. These effects helps in determining what will happen to trade balance when real exchange rate changes. Usually it is assumed that Volume effect is predominant in appearance.

J- Curve;

This effect happens when there is depreciation of domestic currency happening due to worsening of trade balance which may further exacerbates by its devaluation and then there is a quick appreciation happens in the currency value due to drop in its imports and rise in its exports on account of weaker currency. This situation helps in boosting trade balance later and helps in quick increase in exchange rate thereby making a pattern of J curve.