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      Question

      When a country devalues its currency to improve its

      trade balance, the J-Curve effect suggests that the trade deficit will initially worsen before it begins to improve. What is the primary reason for this initial decline?
      A Foreigners immediately stop buying the country's exports. Correct Answer Incorrect Answer
      B The cost of existing import commitments rises immediately, while it takes time for export volumes to increase. Correct Answer Incorrect Answer
      C The government imposes new taxes on exports at the same time. Correct Answer Incorrect Answer
      D Domestic consumers start buying more expensive foreign luxury goods. Correct Answer Incorrect Answer
      E The country’s central bank runs out of foreign exchange reserves. Correct Answer Incorrect Answer

      Solution

      The J-Curve effect describes the phenomenon where a country's trade balance initially deteriorates following a currency devaluation before eventually improving. The primary reason for this initial decline is the time lag in how trade volumes respond to price changes: 

      • Immediate Price Effect: When a currency is devalued, the price of imports in the local currency rises instantly. Because many imports are tied to existing contracts or represent essential goods with inelastic demand, (like oil imports) the country continues to buy similar volumes but at a much higher total cost.
      • Delayed Volume Effect: Conversely, while exports become cheaper for foreign buyers, it takes time for businesses to increase production, find new buyers, or for foreign consumers to shift their habits. Consequently, export revenues do not rise fast enough to offset the immediate spike in import spending. 
        Note - The Marshall-Lerner condition explains why devaluing a currency does not always fix a trade deficit. It states that a currency depreciation or devaluation will improve a country's balance of trade only if the sum of the absolute values of the price elasticities of demand for its exports and imports is greater than one. This means that trade volumes must be sufficiently responsive to price changes to outweigh the initial higher costs of imports.

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