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 devaluation to eventually improve the balance of payments in domestic currency, using assumptions more appropriate for a small open economy than those of Marshall-Lerner. It will be shown that, following devaluation, the balance of payments deteriorates over a short period before it gradually improves– the so-called J-curve effect The duration of this short period will be shown to depend on the magnitude of trade elasticities, lag-coefficients, unhedged foreign debt denominated in foreign currency, interest rate and current account deficit