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.
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Nominal Exchange Rate Movements: Reflect only inflation differences and do not have a macroeconomic affect.
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Real Exchange Rate Movements: Shift the terms of trade between countries, altering macroeconomic behavior.
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J-Curve Plot:
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Y-axis = Balance of Trade
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X-axis = Years since currency devaluation 
Traditional J-Curve Sequence
- Real currency depreciation produces to opposite effects.
- Price Effect: Domestic prices rise, reducing consumer demand for domestic produced goods, increases the trade deficit and causes the domestic economy to contract.
- Income Effect: Depreciating currency makes export goods cheaper in foreign markets; the economy becomes more globally competitive and real GDP improves.
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The price effect takes place first and the balance of trade dips initially, but then the income effect kicks in and balance of trade improves.
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This produces the J shaped curve on the plot described above.
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The implication of the J-curve theory is bad short term impacts followed by a positive long term trend.
J-Curve as Downward Spiral - Counter Traditional
The traditional view of the J-Curve may not hold as:
- Depreciating currency produces domestic inflation.
- Inflation reduces demand and GDP contracts.
- Inelastic demand for foreign products cuts the percent of consumption by less than the percent of the price increase.
- The trade balance continues to worsen (income effect does not kick in).
- The domestic currency weakens even more.
- More inflation kicks in and the situation facilitates itself.