Currency depreciation and J curve analysis: a case study based on Sri Lanka

Abstract

Introduction

The variability of foreign exchange rates affects many economic activities in all over the world. Currency depreciation or currency devaluation directly affects to decrease imports and increase exports. Therefore trade balance will be favorable. The currency devaluation immediately raises the domestic currency price of imports. The quantities of imports and exports don’t adjust right away. Therefore trade balance deficit increases in the short run. As time passes, the quantity of imports fall and quantity of exports rises. Eventually, the trade balance moves toward a surplus. This type of system can be called a J curve (Yarbrough and Yarbrough, 2003).

Real exchange rate devaluation badly affects on trade balance in the short run but it favorably affects in the long run. Therefore, there is a J curve effect regarding bilateral trade in Thailand (Bahmani-Oskooee and Kantipong, 2001). Although in long run bilateral real exchange rate devaluation or depreciation favorably affects on trade balance but not in the short run (Dash, 2013). However, according to Perera (2009) and Vijayakumar (2014), bilateral foreign exchange rate positively affects on trade balance between Sri Lanka and USA in both long run and short run. But no studies have been conducted to examine the effect of currency depreciation (Sri Lanka introduced freely floating exchange rate system in 2001) on bilateral trade balance between Sri Lanka and her main trading partner India using J curve analysis.