Trade Balance and Exchange Rate: The J-Curve

Abstract

Abstract The objective of this paper is to test empirically the effect of a devaluation of a currency on the trade account of the country, the J-curve effect, by using the trade between the U.S. and six countries (Euro-zone, Canada, United Kingdom, Switzerland, Japan, and Australia). A devaluation (depreciation) of the U.S. dollar is increasing the spot exchange rate ($/FC) and increases the price of imports and reduces the price of exports. Then, imports are falling and exports are increasing and the trade account is improved in the long-run. In the short-run, the trade account is deteriorated because imports are pre-arranged and continue to increase with the higher spot rate. This J-curve hypothesis is tested by using a regression and a VAR model, where the volatility of the real exchange rate (TOT) is specified with a GARCH-M process. The empirical results mostly are supporting the J-curve effect. JEL classification numbers: E4, F31, F32, F47, G14, G15. Keywords: Demand for Money and Exchange Rate, Foreign Exchange, Current Account Adjustment, Forecasting and Simulation, Information and Market Efficiency, International Financial Markets.