The J-Curve
ECON3236 International Finance
Girish Bahal
Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 515-516
(Output and the Exchange Rate in the Short Run)
Learning Objectives
Understand ...
(cid:73)
Why the home current account may initially worsen after the domestic
currency depreciates in real terms
(cid:73)
The time lag with which a real currency depreciation improves the CA
(cid:73)
How the J-curve effect may amplify the volatility of exchange rates?
Understanding so far ...
As domestic currency depreciates against the foreign currency in real terms, CA
improves
CA improves as domestic goods become cheaper relative to foreign goods
EX ↑; IM ↓;→CA=(EX −IM)↑
Note: q =EP∗/P
q can change due to relative shifts in supply or demand (lecture 7.2) or as E
changes keeping prices fixed (short-run)
The J-Curve
CA can initially worsen after a domestic
currency depreciation against the
foreign currency
Because most import and export orders
are placed several months in advance
EX and IM volumes may not change
immediately after the currency
depreciation
As current export and import volumes
reflect trade decisions made in the past
The J-Curve
The value of the pre-contracted level of
imports ↑ in terms of domestic output
units (because of real depreciation)
While the value of exports (which are
already measured in domestic output
units) do not change
As a result CA=EX −IM (measured
in domestic output units) deteriorates
immediately in the short-run (point 2)
The J-Curve
Over time, as export volumes ↑ while
import volumes ↓
The total value of exports ↑ while the
total value of imports ↓
→ CA starts to improve over time
(point 2 to 3 and beyond)
The J-curve describes the time lag with
which a real currency depreciation
improves the CA
The J-Curve: Empirical Evidence
A J-curve lasts more than six months
but less than a year
Point 3 is typically reached within a
year of the real depreciation
Eventually, the ↑ in CA tapers off as
adjustment to the real depreciation is
completed
The J-Curve: Reasons for time lag
It takes time for new shipments to adjust fully to the relative price change
Producers of exports may have to install additional plant, equipment, etc.
Import adjustment is a slow process
To ↑ foreign consumption of domestic exports, it may be necessary to build new
retail outlets abroad
The J-Curve and exchange rate volatility
In week 9 lectures: monetary expansion → E ↑ → NX ↑ → Y ↑
Existence of J-curve → monetary expansion can initially ↓NX → Y ↓
This may decrease the demand for money → R decreases even further
$
Domestic currency depreciates even more sharply in the short-run
The J-Curve and exchange rate volatility (recall: lecture
5.2)
