The J-Curve – Impact of Exchange Rate Changes on National Economies
The domestic activity in an economy is related to its exchange rate movements. In the traditional theory to explain this, there are two components: long-run and short-run.
In the long-run an economy's competitiveness increases with a decline in the country's currency value.
In the short-run, the country's trade balance widens, and inflation increases if the country's currency depreciates. This happens because the cost of imports increases.
This combination of short-term decline, and long-term increase is called the J-curve.
Nominal Exchange Rate Movements: Reflect only inflation differences and do not have a macroeconomic affect.
Real Exchange Rate Movements: Shift the terms of trade between countries, altering macroeconomic behavior.
J-Curve Plot:
Y-axis = Balance of Trade
X-axis = Years since currency devaluation .
- The domestic currency weakens even more.
- More inflation kicks in and the situation facilitates itself.
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