the j curve effect

In the short term a devaluation or depreciation of the 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. The diagram below shows this possibility.

Assuming that the economy begins at position A with a substantial current account deficit there is then a fall in the value of the exchange rate. Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed. 

However, the depreciation raises the sterling price of imports causing total spending on imports to rise. Export demand will also be inelastic in response to the exchange rate change in the short term, therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The current account deficit may worsen for some months. This is shown by the movement from A to B on the diagram.

Expenditure Switching causes a change in trade volumes

Providing that the elasticities of demand for imports and exports are greater than one in the longer term then the trade balance will improve over time. This is known as the Marshall-Lerner condition. 

In the diagram above showing the J curve effect, as demand for exports picks up and domestic consumers switch their spending away from imported goods and services, the overall balance of payments starts to improve. This is shown by the movement A to C on the diagram.

There is some evidence for the J Curve effect shown in the diagram above which shows the quarterly balance of trade in goods and the average value for the sterling exchange rate index between 1990-2000.

In late 1992 the pound was devalued by nearly 15% following the United Kin gdom's exit from the European Exchange Rate Mechanism. The sharp fall in the exchange rate provided a welcome boost to the competitiveness of UK producers - but in the short term, the balance of trade actually worsened. Import volumes remained steady - but were more expensive following the decline in the exchange rate. Exports took time to respond to the more competitive value of sterling.

But in 1993-94 there was a clear acceleration in export volumes and a slower growth of imported goods and services as the effects of the exchange rate depreciation started to take effect. The net result was an improvement in the balance of trade in goods - although not sufficient to take the balance from deficit into surplus.

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.