J-Curve Effect
Candlefocus EditorIt is a visible graphical pattern that shows how the foreign exchange rate´s depreciation and increased export competitiveness causes a dramatic drop in imports and a dramatic rise in exports. This economic trendline starts with a sharp drop, followed by a sharp rise which eventually exceeds the starting point, thus forming a letter “J.” The J-Curve Effect is also known as the ‘Mundell-Fleming J-Curve’.
The J-Curve Effect can be understood better with a simple example. Let´s say, Country A has an initial trade deficit of $10 billion and exports to Country B amount to $50 billion, amounting to a trade deficit of $10 billion. Now, if Country A´s currency, the A$, depreciates and its value drops compared to the B$, Country B´s currency, the exports to Country B rises to $60 billion. In turn, this causes the trade deficit to drop to $3 billion, showing an improvement in the current account balance of the country. The country has a net increase of exports to Country B, thus showing that even a depreciation in a country’s currency can improve its balance of trade.
The J-Curve Effect is a reflection of two economic forces at work. On one hand, currency depreciation causes an increase of domestic goods in foreign markets, which in turn boost exports. On the other hand, higher production cost (including labour) results in an decrease of domestic manufacturing and imports, which diminishes imports and eventually increases the country´s balance of trade.
In summary, it can be stated that the J-Curve Effect is a fascinating, yet complex concept that explains how even a depreciation in a country's currency can result in an improvement of its trade balance. While there are some limitations to the J-Curve Effect, it provides an insight into the trade dynamics of a country, particularly with an understanding of the underlying economic forces.