Question

In a monetary model with fixed exchange rates, discuss short run and long run effect of a devaluation on balance of payments.

Answer 1

A devaluation means there is a fall in the value of a currency. The immediate effects of devaluation are an increase in exports and reduction in imports so that the balance of payments deficit can either be reduced or completely eliminated.

The J Curve is an economic theory which states that, under certain assumptions, a country's trade deficit will initially worsen after the depreciation of its currency—mainly because higher prices on imports will be greater than the reduced volume of imports. The J Curve operates under the theory that the trading volumes of imports and exports first only experience microeconomic changes. But as time progresses, export levels begin to dramatically increase, due to their more attractive prices to foreign buyers. Simultaneously, domestic consumers purchase less imported products, due to their higher costs.