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 ![](

Traditional J-Curve Sequence

• Real currency depreciation produces to opposite effects.

1. Price Effect: Domestic prices rise, reducing consumer demand for domestic produced goods, increases the trade deficit and causes the domestic economy to contract.
2. Income Effect: Depreciating currency makes export goods cheaper in foreign markets; the economy becomes more globally competitive and real GDP improves.

• 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.

• This produces the J shaped curve on the plot described above.

• 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.