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.
- 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.
- 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.