What is a J curve?
Curve J is an economic theory which states that, according to certain assumptions, the trade deficit of a country will initially worsen after the depreciation of its currency, mainly because the rise in import prices will be greater than the reduced volume of imports.
Curve J works according to the theory that the volumes of trade in imports and exports first undergo only microeconomic changes. But over time, export levels begin to rise dramatically, due to their more attractive prices for foreign buyers. At the same time, domestic consumers buy fewer imported products due to their higher costs.
These parallel actions finally shift the trade balance, to present an increased surplus and a weaker deficit, compared to these figures before devaluation. Of course, the same economic logic applies to opposite scenarios, where a country experiences currency appreciation, which would therefore result in an inverted J curve.
A closer look at the J-curve theory
There is a gap between the devaluation and the response on the curve. This delay is mainly due to the effect that even after a depreciation of the national currency, the total value of imports is likely to increase. However, the country’s exports remain static until the end of pre-existing commercial contracts. In the long term, a large number of foreign consumers can increase their purchases of products entering their country from the country with the devalued currency. These products are now becoming cheaper compared to products of national origin.
Key points to remember
- Curve J is an economic theory that says the trade deficit will initially worsen after the currency depreciates.
- Then the response to the curve, which is an increase in imports while exports remain static, is a rebound, forming a “J” shape.
- The J curve theory can be applied to other areas in addition to trade deficits, notably in risk capital, the medical field and politics.
Where curve J can be applied
The J Curve concept is a tool used in several disciplines. In private equity circles, J Curves shows how private equity funds have historically generated negative returns in their first few years after launch, and then started to see gains after finding their place. Private equity funds can experience anticipated losses because investment costs and management fees absorb the money initially. But as funds mature, they begin to show previously unrealized gains, through events such as mergers and acquisitions (M&A), initial public offerings (IPOs) and effect recapitalizations. leverage.
In medical circles, J curves appear in graphs, where the X axis measures one of two possible treatable conditions, such as cholesterol or blood pressure, while the Y axis indicates the probability that a patient develops cardiovascular disease.
Finally, in political science, the famous American sociologist James Chowning Davies incorporated the J curve into models used to explain political revolutions, where he claims that riots are a subjective response to a sudden reversal of fortune after a long period of growth. economic, known as relative deprivation.
Example from the real world
Look no further than Japan in 2020 for a practical example of the J curve. This example illustrates how the trade balance deteriorated after a sudden depreciation of the yen, mainly due to the fact that the volume of exports and imports has took a long time to react to price signals.
In 2020, the USD / yen exchange rate reached 100 – the first time since 2009 – and has remained above this level since.
The Japanese government made major purchases of its currency to get out of a deflationary state. Japan’s trade deficit hit a record 1.63 trillion yen (US $ 17.4 billion) on energy imports and a weaker yen.