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Tuesday, 20 September 2011

The J Curve Effect

When imports and exports are less elastic, devaluation of the currency can lead to a worsening effect on the balance of payments (BoP). This is because as the exchange rate falls, imports are more expensive, thus spending more on imports results in a larger deficit. Demand for imports does not fall immediately after devaluation because:

·     There may be lack of substitutes available (e.g. raw materials, oil…)
·     Deals already agreed have to be fulfilled
·     Manufacturers of substitutes need time to adjust their manufacturing process/production.

After T1, spending on imports fall and the BoP deficit starts to improve. However this improvement may be short lived because higher import prices can lead to greater inflation, decreasing the country’s export competitiveness.

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