IB ECONOMICS A Course Companion p 300 The J-CURVE IB ECONOMICS A Course Companion p 300

THE J CURVE If the Marshall-Lerner conditions are satisfied then we would expect an improvement in the CAD in the long term. However in the short run, this is not he case and the CAD actually gets worse before it gets better. This is known as the J-curve effect. The J-Curve shows what happens to the CAD over time, when the exchange rate is devalued or depreciated.

Z X Y http://welkerswikinomics.com/blog/wp-content/uploads/2008/12/j-curve.png

Explanation of Graph Assume that a country’s CAD is a X and the government lowers the exchange rate. The price of exports will fall, but communication is not perfect and will take time for other countries to realize that the prices in the country has fallen. Also, other countries will have entered into contracts for goods and services that cannot be broken quickly, so they cannot change their suppliers immediately.

Explanation of Graph The Short Run Impact on Exports In the short run the PED for exports will be inelastic and export revenue will fall as price has fallen by proportionally more than demand would have risen. This will increase the CAD and start moving from X to Y on the J-curve.

Explanation of Graph The Short Run Impact on Imports The price of imports will rise, but purchasers of imports will take time to find new suppliers. Also they may be tied into contracts and will have to wait for them to expire before they can move to other suppliers. The PED for imports will also be inelastic and import expenditure will increase as prices have risen by proportionally more than demand will have fallen. This will further increase the CAD and add to the movement from X to Y on the J-Curve.

Explanation of Graph Long Run The value of PED for exports and imports increases with time. By the time the CAD reaches point Y, the values of PED for exports and imports has increased to a point where, when added together, they are greater than one, so the Marshall-Lerner Condition (MLC) is satisfied. From this point onwards the less expensive exports and more expensive imports should lead to increased export revenue and decreased import expenditure and therefore an improvement in the CAD as shown by the movement from Y towards Z on the J-curve