The J-curve suggests a typical pattern for a country's trade balance after an abrupt depreciation or...

The J-curve suggests a typical pattern for a country's trade balance after an abrupt depreciation or devaluation of the country's currency. What are the key factors behind this relationship? Explain.

Expert Solution

J-curve is a phenomenon where a country's balance of trade initially worsens due to devaluation/depreciation of the country's currency and then recovers to a level higher than where it started.

Several factors contribute to the J-curve effect:

(i) At the time of devaluation, commodities in transit are priced at the old exchange rate. If the country had been witnessing deterioration of trade balance before devaluation, it willl continue to face so after devaluation. With the passage of some time when new prices begin to prevail at the new exchange rate, the trade balance will improve.

(ii) As a result of devaluation, the country will experience increase in economic activity leading to economic growth. As a result, consumption - both domestic as well as imports - will increase. This increase in imports may offset the positive effect of devaluation, leading to a short term deterioration of trade balance.

(iii) Adjustment of exports and imports to devaluation occurs only with the passage of time (called adjustment lags). Hence the J-shape.

Rahul Sunny answered 1 year ago

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