Cambridge International as and a level Economics Ebook

J-curve eff ect: 
a fall in the exchange rate causing an 
increase in a current account deficit before it reduces it due 
to the time it takes for demand to respond.
KEY TERM
Depreciation: 
a decrease in the international price of a 
currency caused by market forces.
Devaluation: 
a decision by the government to lower the 
international price of the currency.
KEY TERMS
Figure 4.16 
The eff ect of a rise in net exports
0
Real GDP
AS
AS
P
1
P
Y
1
Y
AD
1
AD
1
Price level
AD
AD
99

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Cambridge International AS Level Economics
There are a number of other factors that can 
inf luence the effect of a fall in the exchange rate on 
the current account position. For instance, exports 
may be cheaper but the impact on the quantity sold 
may be limited by a low price elasticity of supply, trade 
restrictions imposed by foreign governments and 
declines in the relative quality of the products made by 
the country’s firms.
An appreciation/revaluation
An 
appreciation
or 
revaluation
– a rise in the 
exchange rate – will make exports more expensive in 
terms of foreign currencies, and imports cheaper in 
terms of the domestic currency. Such a change is likely to 
result in a fall in demand for domestic products. Lower 
aggregate demand may result in a rise in unemployment 
and a slowdown in economic growth. Its main impact, 
however, may be to cause a reduction in infl ationary 
pressure if the economy is operating close to or at 
maximum capacity. 
Figure 4.18
 shows that in the absence 
of a rise in the exchange rate, 
AD
might increase to 
AD
1
causing the price level to rise to 
P
1
. A rise in the exchange 
rate may reduce the growth of 
AD
to 
AD
2
and so the 
infl ation rate would be lower than would be the case if 
the exchange rate had remained unchanged.
A higher exchange rate may also reduce infl ationary 
pressure by shift ing the aggregate supply curve to the right 
because of lower costs of imported raw materials. Th
e price 
of imported fi nished products would also fall and there 
would be increased competitive pressure on domestic fi rms 
to restrict price rises in order to try to maintain their sales at 
home and abroad.
A higher exchange rate may increase a current account 
defi cit or reduce a current account surplus but the 
outcome will depend mainly on the price elasticities of 
demand for exports and imports. Th
e Marshall-Lerner 
condition and the J-curve work in reverse. So a current 
account surplus will only be reduced if the sum of the 
price elasticities of demand for exports and imports is 
greater than 1. A rise in the exchange rate may increase a 
current account surplus in the short run before reducing 
it in the longer run as shown in 
Figure 4.19.