This is to do with the policies to reduce the balance of payments deficit and hopefully get it into a surplus for the future. ‘Depreciation’ is an example of a expenditure switching policy( policies to help influence the change of exports increasing imports decreasing)
The J Curve effect shows what happens to the Balance of Payments when there is a depreciation.
This can be split into both short and long run. From the Marshall Lerner condition if the elasticities of exports and imports are more than 1, a depreciation would lead to an improvement in the balance of payments. Likewise if the elasticities were less than 1 depreciation would lead to a deteriotion.
Short Run: Lets say there is already a deficit and there is a depreciation in our currency
- Normally a depreciation would mean exports go up and imports go down.
- However due to the change it would take consumers time to firstly know about the price changes and time to act on it i.e. find substitutes.
- There the price elasticities of both exports and imports are less than 1. Therefore a depreciation leads to the worsening of the balance of payments as shown by the diagram.
- However over time people would realise that the foreign goods would be more expensive than domestic goods.
- So they would tend to reduce their consumption on imports and increase on domestic goods. Our price elasticity for both export and imports is now greater than 1.
- Therefore we would see a rise in our balance of account and hopefully reach a surplus as shown by the diagram.
However the question is what will happen next? The answer is it is likely to fall again as our exports will be in higher demand leading to an appreciation in our currency due to more demand. So this could potentially mean less exports and more imports in the future.