The J Curve Effect and the Balance of Payments

If a country is committed to a fixed, or semi-fixed exchange rate schemes such as the Bretton Woods system, it may seek to solve a balance of payments problem by devaluing its currency. This might happen because the currency is suffering from a fundamental disequilibrium.

The term fundamental disequilibrium is used by the International Monetary Fund (IMF) to describe a situation in which a persistent discrepancy exists between the official exchange rate of a currency and its actual purchasing power. The IMF is the body created in 1944 to administer the Bretton Woods exchange rate scheme. Under its rules countries were allowed to devalue their currencies by agreement if there was a fundamental disequilibrium.

If national inflation rates vary, the official rates of exchange will no longer reflect the value of a currency and an adverse current account on the balance of payments will develop until the exchange rates are altered. If the imbalance persists, it is considered fundamental.

If a currency is allowed to float freely, and it loses value we say it depreciates rather than devalues. Whether a currency is fixed or floats the effect of a sudden devaluation or depreciation will have the same effect. A lower exchange rate should mean imports become more expensive, and exports become cheaper for foreigners to buy. The imbalance on the current account should correct itself.

However, in the short run contracts made by UK firms to buy products from overseas will still have to be bought and paid for. Firms that have capital equipment bought from abroad will still need spare parts for it and UK holiday makers going abroad may have already booked flights and hotels. What this argument proposes is that imports, in the short run, are price inelastic in demand. So in the short run, the quantity of imports may not fall, and because the exchange rate is now lower than it was these imports will require more, not less, spending. Thus the balance of payments current account deficit may in fact worsen.

Over time, firms and citizens will be able to react to the devaluation. They will find alternatives to the imports, buying domestically produced goods and perhaps staying at home for holidays. Demand for imports are therefore thought to be more price elastic in the long run. Gradually, the current account should improve over time.

Because of this short-run problem a graph of the current account balance might look like the letter J, hence the term J-curve.

The effect of a currency devaluation on the balance of payments current account

The Marshall Lerner Condition
Under what circumstances would a devaluation or depreciation of a currency lead to an improvement in the current account? If demand for imports and exports were both price elastic then if their prices were lower, then there would be a bigger proportionate change in quantity demanded. It requires some complicated mathematics to prove the point, and for A level students there is no need to do so, but you do need to be able to state the Marshall Lerner condition.
Named after Alfred Marshall
(1842-1924) and Abba Lerner (1905-1982), the Marshall-Lerner principle states the conditions under which a change in exchange rate will improve the balance of payments: the combined price elasticity of demand for imports and exports must be greater than one for improvements to be effected in the balance of payments.