The J Curve Effect


What Has Happened?

Australia’s Recent BOP and $AUD relationship

Analysing Australia’s recent economic history it is evident that the trends in Australia’s BOP are significantly impacted by fluctuations in the exchange rate.

Figure 1 - CAD as a % of GDP

Figure 2 - Trade balance

Figure 3 - AUD

From the graphs above, we can highlight the following trends: 

  1. From 2000 - 2008, there was a steady appreciation from $0.4 USD to $0.93,  creating a BOGS surplus. 
  2. Then in 2009, after the GFC and a major depreciation in the exchange rate, where the AUD dropped by 1⁄3, the BOGS then fell into deficit. 
  3. From 2010 to 2011 the exchange rate was appreciating due to the continuation of the mining boom in Australia, peaking at $1.10 USD in 2011 and this resulted in a major short term improvement in the CAD, with a $14.7B BOGS surplus. However, as supported by the reverse J-Curve (see later) , this very demand for the AUD eventually became too strong such that Australian firms lost their international competitiveness and less exports were demanded, combined with increased imports, an economic phenomena referred to as dutch disease. 
  4. Finally Australia’s present low dollar ($0.68) contributed significantly  to Australia’s historic CAS of 0.4% in Q3 of 2019. Hence, it is evident that the trends in Australia’s BOP are largely due to the fluctuations in the exchange rate.

Syllabus Links

Depreciation -  What is the J curve?

The J-Curve

The J curve demonstrates the effects of a depreciation of the exchange rate on the Current Account position. Furthery, the J curve conveys the relationship between a relatively low $AUD and an improved Current Account position. Specifically the J Curve and the, later discussed , Reverse J-Curve focus on the BOGS account of the CAD.

Why does the exchange rate affect the Balance of Payments?

Movements in the exchange rate have a significant impact on the Balance of  payments because it affects the international competitiveness of Australia’s exports and the relative price of goods and services Australia imports.  A depreciation of the $AUD decreases the foreign currency price of Australia’s exports, thus increasing the international competitiveness of the exports. It also increases the Australian dollar price of imports and discourages consumers from purchasing imports, in turn improving the BOGS account. Comparatively, an appreciation of the $AUD worsens Australia’s international competitiveness, decreasing the demand for Australia’s exports and increasing import expenditure as consumers switch to imported substitutes, in turn worsening the BOGS account. 

Why is there an initial trough?

The trough in the CAD following a currency depreciation can be quite confusing for a lot of students who might otherwise assume a depreciation immediately improves the country’s international competitiveness which in turn should improve the BOGS account and as such the CAD account. While this is true in the long term, due to a number of fixed short term factors the opposite is true, “things get worse before they get better” and the BOGS and CAD worsen. For the most, this initial trough can be explained by fixed supply and demand contracts with the eventual improvement indicating the effect of price elasticity. Due to the nature of business and manufacturing, firms and manufactures agree upon contracts in advance often > 12 months. As such when the currency depreciations, Australian firms and individuals have to pay higher prices for imported intermediate production inputs and imported goods. In the short-term firms have to accept this cost, but as time goes on and flexibility for  international consumers increases foreign importers seeking the lowest prices will increase their demand for Australian exports as the lower $AUD, improves Australia’s international competitiveness , making it relatively cheaper for foreign importers to buy Australian Goods contributing to the eventual improvement in the Current account position, seen above.

Appreciation- What is the Reverse J curve?

The Reverse J curve is an inverted J curve, demonstrating the effect of an appreciation of the exchange rate on the Current Account position. Further, the Reverse J curve conveys the relationship between a relatively high $AUD and a weakened Current Account position

Why is there an initial peak?

Similarly to a depreciation, due to a number of fixed short term factors, somewhat counter intuitively, in the short term an appreciation of the currency improves the BOGS and CAD. Likewise due to fixed manufacturing and supply contracts when the currency appreciates, Australian firms and individuals pay lower prices for imported intermediate production inputs and imported goods, reducing production costs. At the same time, firms generally don’t experience reduced export volumes for some time until the price elasticity of consumers generally kick in, reducing Australia's export volumes because of  weakened international competitiveness, contributing to the eventual deterioration in the current account position, seen below.

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