Money, Banking, and International Financecurrency to depreciate starting at time period t 1. Unfortunately, the trade deficit initially worsens
before improving. Time span ranges from three to six months, denoted as t 1 and t 2 on the graph.
If a country experiences a balance-of-payment surplus, then it allows its currency to
appreciate. Consequently, its exports decrease while its imports increase while the balance-of-
payments approaches zero.
Figure 1. The J-curve Effect
Most countries use a managed float, where a government or central bank varies the interest
rate to intervene in the foreign exchange market. For instance, a country is experiencing a
balance-of-payments deficit. Consequently, the central bank contracts the money supply,
boosting the interest rate. Next, the international investors invest in a country, earning the
greater interest rate and causing the financial account to rise until the balance of payments
equals zero again.
A central bank or government can finance a balance-of-payments surplus easily under a
managed float system. Central bank expands the money supply, lowering the interest rates.
Hence, the international investors reduce their investments in the country because they can earn
higher returns elsewhere. Consequently, the financial account falls until the balance-of-
payments surplus approaches zero.
A country can have difficulties financing a balance-of-payments deficit for all exchange
rate regimes. Consequently, a government might impose foreign-exchange rate controls to
correct the imbalance. A government can alter the rules and regulations, especially for
foreigners such as prohibiting the foreigners from transferring their money out of the country. A
government can impose special taxes and fees on interest earnings and dividends. Then
government collects revenue, instead of money flowing out of the country.
A country could experience capital flight, when the foreign investors become spooked, and
they quickly withdraw investments from a country. They believe they will lose their investments