Macro

Looking at dynamics: the J-curve
We have ignored dynamics so far in this chapter. It is time to reintroduce them. The dynamics
of consumption, investment, sales and production we discussed in Chapter 3 are as relevant to
an open economy as they are to a closed economy. But there are additional dynamic effects
as well, which come from the dynamics of exports and imports. We focus on these effects
here.
Return to the effects of the exchange rate on the trade balance. We argued earlier that a
depreciation leads to an increase in exports and to a decrease in imports. But this does not
happen overnight. Think of the dynamic effects of, say, a 10% dollar depreciation.
In the first few months following the depreciation, the effect of the depreciation is likely to be
reflected much more in prices than in quantities. The price of imports in the UK goes up, and
the price of UK exports abroad goes down. But the quantity of imports and exports is likely
to adjust only slowly: it takes a while for consumers to realise that relative prices have
changed, it takes a while for firms to shift to less expensive suppliers and so on. So a
depreciation may well lead to an initial deterioration of the trade balance; ε decreases, but
neither X nor IM adjusts very much initially, leading to a decline in net exports (X − IM/ε).
As time passes, the effects of the change in the relative prices of both exports and imports
become stronger. Less expensive UK goods cause UK consumers and firms to decrease their
demand for foreign goods: UK imports decrease. Less expensive UK goods abroad lead
foreign consumers and firms to increase their demand for UK goods: UK exports increase. If
the Marshall–Lerner condition eventually holds – and we have argued that it does – the
response of exports and imports eventually becomes stronger than the adverse price effect,
and the eventual effect of the depreciation is an improvement of the trade balance.
Figure 18.5 captures this adjustment by plotting the evolution of the trade balance against
time in response to a real depreciation. The pre-depreciation trade deficit is OA. The
depreciation initially increases the trade deficit to OB: ε decreases, but neither IM nor X
changes right away. Over time, however, exports increase and imports decrease, reducing the
trade deficit. Eventually (if the Marshall–Lerner condition is satisfied), the trade balance
improves beyond its initial level; this is what happens from point C on in the figure.
Economists refer to this adjustment process as the J-curve because – admittedly, with a bit of
imagination – the curve in the figure resembles a ‘J’: first down, then up.
The importance of the dynamic effects of the real exchange rate on the trade balance was
seen in the USA in the mid-1980s: Figure 18.6 plots the US trade deficit against the US real
exchange rate in the 1980s. As we saw in Chapter 6, the period from 1980–1985 was one of
sharp real appreciation, and the period from 1985–1988 one of sharp real depreciation.
Turning to the trade deficit, which is expressed as a ratio to GDP, two facts are clear:
1. Movements in the real exchange rate were reflected in parallel movements in net exports.
The appreciation was associated with a large increase in the trade deficit, and the later
depreciation was associated with a large decrease in the trade balance.
2. There were, however, substantial lags in the response of the trade balance to changes in the
real exchange rate. Note how from 1981–1983, the trade deficit remained small while the
dollar was appreciating. And note how the steady depreciation of the dollar from 1985
onward was not reflected in an improvement in the trade balance before 1987: the dynamics
of the J-curve were very much at work during both episodes.
In general, the econometric evidence on the dynamic relation between exports, imports and
the real exchange rate suggests that in all OECD countries, a real depreciation eventually
leads to a trade balance improvement. But it also suggests that this process takes some time,
typically between six months and a year. These lags have implications not only for the effects
of a depreciation on the trade balance but also for the effects of a depreciation on output. If a
depreciation initially decreases net exports, it also initially exerts a contrac- tionary effect on
output. Thus, if a government relies on a depreciation both to improve the trade balance and
to expand domestic output, the effects will go the ‘wrong’ way for a while.
2) There is no need to worry about the debt when the pandemic ends. The priority right now
that we have an economy that has a lot of people who are not able to do what they want to do
and normally do for a living. The goal is to make that tolerable and possible for people to
continue to afford what they need and both for their own sake. Because that contains the
spillovers means that the parts of the economy are operating are not suffering from a collapse
and demand from the parts that are not. Maintaining the support, emergency relief is
important and after that the economic recovery is going to be a lot easier. This crisis is
different, like an external headwind. It is just the thing that hit us and stopped the whole
economy and the process because it was a shock. As soon as it is removed, expecting the
economy to recover is the best way.
3) Paul Krugman says that austerity contracts the economy. There is now growing evidence
that austerity in these conditions doesn’t even work in fiscal terms because it shrinks the
economy now and also shrinks the economy in the future. We've seen first of all is that
austerity really does contract the economy that the notion that it would inspire a business
confidence and and lead to expansion not contraction has been decisively proved wrong by
experience all across Europe. It hurts the economy long-run potential which reduces the
revenues, worsens long-run budget position. If you try to have a situation which everyone is
trying to slash at the same time which the private sector is trying to slash spending because it
feels it has too much debt and in which then the government is also saying that they have too
much debt. If we are both trying to do this slashing at the same time what we end up doing is
producing a depression that leaves us worse off. The crime is that all of these students are
graduating from college with no job prospects are graduating from college with debts. This
guided austerity right now that jobs will be generated when people move from the public
sector to the private sector. What we need to be doing is really making it easier for young
people to start their own businesses making it far easier for new entrepreneurs. We should be
about enabling the economy to create jobs by low tax regime and to create opportunities for
people to start up new businesses.

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Looking at dynamics: the J-curve

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