THE DYNAMIC EFFECT OF DEVALUATION ON THE BALANCE OF PAYMENTS OF A SMALL DEBT-RIDDEN OPEN-ECONOMY

This paper derives a precise necessary and sufficient condition for de valuation to eventually improve the balance of payments in domestic cu rrency, using assumptions more appropriate for a small open economy th an those of Marshall-Lerner. It will be shown that, following devaluat ion, the balance of payments deteriorates over a short period before i t gradually improves-the so-called J-curve effect. The duration of thi s short period will be shown to depend on the magnitude of trade elast icities, lag-coefficients, unhedged foreign debt denominated in foreig n currency, interest rate and current account deficit.