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Understanding the J-Curve in Exchange Rate Dynamics and Trade Balance Adjustment

The J-Curve effect highlights that in the short term, a depreciation of an exchange rate may not improve a country's current account deficit due to the inelastic demand for imports and exports. Initially, after the exchange rate change, the trade balance may worsen. However, if the demand elasticity for imports and exports is greater than one in the long term, the trade balance will eventually improve, in line with the Marshall-Lerner condition. Conversely, an appreciation can temporarily enhance the trade balance by making imports cheaper and exports costlier.

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Understanding the J-Curve in Exchange Rate Dynamics and Trade Balance Adjustment

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  1. J-Curve http://alphaeconomics.wordpress.com/category/exchange-rates/

  2. Summary: • In the short term a depreciation of an exchange rate may not improve the current account deficit of the balance of payments • This is due to the low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change. (Inelastic, at least in the short run)

  3. When will the balance of trade improve? • Providing that the elasticities of demand for imports and exports are greater than 1 (elastic) in the long term the trade balance will improve over. • This is known as the Marshall-Lerner condition.

  4. The Inverse J Curve Effect • An appreciation in the exchange rate can lead to a short term improvement in the balance of trade. • Imports become cheaper and exports more expensive in overseas markets. • But initially the elasticity of demand for both imports and exports is fairly low - leading to an overall improvement in the trade balance.

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