Devaluation and the J-Curve: Some Evidence from LDCs

Abstract

Within the international trade literature it is not uncommon to find arguments about whether devaluation will improve the trade balance. It is argued that the flows of goods respond only with time lags to changes in the exchange rate. The terrn is used to describe the movement over time of the trade balance: it may deteriorate at first and improvement may come later. This paper presents a method by which one could detect the existence of the J-Curve. The method is applied to four developing countries. The empirical evidence supports the pattern of movemnent described by the J-Curve. A major policy option for a country facing a persistent balance of payments deficit is said to be devaluation of its currency. Within the international trade literature it is not uncommon to find arguments about whether devaluation will improve the trade balance or the balance of payments. For example, proponents of the elasticities approach describe the necessary and sufficient conditions for an improvement in the trade balance in terms of elasticities of demand and supply referred to as the Marshall-Lerner condition.' While there is abundant empirical evidence to suggest that these conditions are indeed met (at least for industrial countries), there have been circumstances under which 2 devaluation has not been successful. For example, one might wonder why the U.S. trade balance deteriorated so much in 1972 despite the devaluation of the dollar in 1971. This unfavorable effect of devaluation on the trade balance is termed the J-Curve phenomenon Received for publication August 23, 1984. Revision accepted for publication November 26, 1984. *The University of Wisconsin-Milwaukee. I would like to thank two anonymous referees for their valuable comments on the initial draft of this paper. 1 Proponents of the absorption approach (e.g., Alexander, 1952) describe how devaluation may change the terms of trade, increase production, and switch expenditures from foreign to domestic goods, thus improving the trade balance. International monetarists argue that devaluation reduces the real value of cash balances and/or changes the relative price of traded and nontraded goods, thus improving both the trade balance and the balance of payments. 2 For an cstimate of the elasticities, see Houthakker and Magee (1969) and Warner and Kreinin (1983). The former study provides the elasticities estimates under fixed exchange rates and the latter under floating rates. This content downloaded from 157.55.39.17 on Wed, 31 Aug 2016 04:39:37 UTC All use subject to http://about.jstor.org/terms