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IAI Actuarial Core Principles · Business Economics · Importance of international trade

A country's currency depreciates sharply. Demand for its exports and imports is highly inelastic in the short run. According to the J-curve idea, what is the most likely immediate effect on its trade balance?

The trade balance is likely to worsen at first. With inelastic short-run demand, volumes hardly change, but imports cost more in domestic currency, so the import bill rises. Only later, as volumes adjust, may the balance improve, giving the J-curve shape.

  1. AIt worsens at first, because import costs rise while volumes barely changeCorrect
  2. BIt improves immediately, because exports become cheaper abroad
  3. CIt is unchanged, because prices and volumes offset exactly
  4. DIt improves because import volumes fall sharply at once
  5. It worsens permanently, whatever the elasticities later

Explanation

With inelastic short-run demand, volumes adjust slowly, so the higher domestic-currency price of imports raises the import bill and the deficit widens. Over time volumes respond and the balance may improve if the Marshall-Lerner condition holds. Hence the J shape.

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