A Note on the J-Curve

Abstract

The current theory of the J-curve states that the response of the trade balance to exchange rate changes has a J-shape over time; e.g. in the case of devaluation the trade balance deteriorates before it gets better, and vice versa for revaluation (unless unrealistic combinations of the currency of invoice are assumed).' This pattern is caused by the contracts outstanding during the exchange rate change. The theory is based on the implicit assumption that the currency of invoice is always the exporter's currency; i.e. the country's exports are invoiced in domestic, and its imports in foreign currency. However, empirical evidence on all the countries studied shows this assumption to be grossly violated in reality. Carse et al. (1980, p. 18) summarize the existing evidence on the currency of invoice. It suggests that for all the countries, the share of exports invoiced in foreign currency is lower than the respective share of imports. The shares appear to increase, the smaller the role of the country's currency in international trade. Accordingly, 59 % of Danish exports and 81 % of Danish imports are invoiced in foreign currency,2 while most of the trade between the United States and Canada is invoiced in U.S. dollars.3 The authors suggest that there exists a hierarchy of currencies in international trade. The higher the currency is in this hierarchy, the higher the probability that it is used as the currency of invoice, other things equal. Conversely, currencies on the bottom of the hierarchy-all but some ten currencies-have no international role. That is, most countries in the world both pay and invoice in foreign currency. Indeed, Nars (1979, p. 198) reports that 96.6 % of Finnish exports and 97.4 % of Finnish imports are invoiced in foreign currency. (Recently, both shares have declined to 90%.) This has important implications for the J-curve itself. Assume that the country's exchange rate change does not affect the cross-rates between foreign currencies. In the short run, the quantities do not have time to adjust so that the currency of invoice determines the change in the domestic currency values of export and import contracts