Question

Trade Balances and the J-Curve (chapter 18 – section 1)

a). Provide the TB function from the perspective of Korea, labeling each item appropriately, assuming its counterpart is the rest of the world (ROW).

b) Now graph Korea’s trade balance versus Korea’s real exchange rate.

c) Suppose Korea’s government decides to reduce its taxes on workers in Korea show how its trade balance curve will shift.

d) If Rest of the World Taxes income were to rise (an increase in Y*) would the trade balance curve shift in the same direction as the one described in c)

e) Finally, suppose new optimism about trade opportunities cause Korea’s currency, the won, to appreciate. Using a graph depicting J-curve effects, demonstrate how Korea’s exports (EX), imports (IM) and trade balance (TB) will evolve over time. For reference, you graph should also illustrate the change in Korea’s exchange rate (EKOR|other ) over the same time interval.

Answer 1

a).

Consider the given problem here let’s assume “Korea” is a “home country” and “ROW” is a foreign country. So, here “PH” be the home price and “PF” be the foreign price and “e(H/F)” be the exchange rate measure how much home currency needed to purchase 1 unit of foreign currency. Now, the trade balance is the difference between “export value” and “import value”. So, the export function is given by.

=> TB = PH*X(e, YF) - e*PF*M(e, Y), where “X()” is the amount of export depends on “e” and foreign income “YF”. Similarly, “M()” is the amount of import depends on “e” and home come “YH”.

b).

Now, under the fixed exchange rate regime the relationship between “TB” and “e” is like “J curve” provided “Marshall Lerner condition” hold. Consider the following fig.

So, here we can see that initially the trade balance will decline as a result of devaluation. But after a point of time it starts improving.

c).

Suppose “Korea’s” government decides to reduce its taxes on workers in Korea, => the home income (YH) will increase given everything remains same, => “M(e, YH)” will increases, => “TB” will decrease, => “TB” will shift downside parallelly.

d).

Now, income of the “ROW” increases implied “YF” increases, => “X()” will increases implied given everything remains same, => “TB” will improve given the level of exchange rate, => “TB” will shift upward side this time not downward like part “c”.

e).

So, here as the “Korea’s” currency appreciate, => “e decreases”, => “X()” decreases and “M()” increases implied the “TB” will decreases. Consider the following fig.

So, here at “point 1” the exchange rate and the trade balance are given by, “e1” and “TB1”. Now, as a result of the appreciation “e” decreases implied “TB” also decreases alone the “TB” curve.