DEFINITION of J Curve effect
A J curve is an initial loss followed by exponential growth. This curve is used in medicine, political science, economics, and business. The quicker you grow, the quicker your burn through cash.
The J Curve effect is a depreciation in the exchange rate. It can cause a decline in the current account in the short-term. However, in the long-term, demand becomes more price elastic and therefore, the current account begins to improve.
WHAT IT IS IN ESSENCE
The J-curve effect is a phenomenon in which a period of negative or unfavorable returns is followed by a progressive recovery that stabilizes at a higher level than before the decline. The progression of this phenomenon appears as a “J” pattern on a time-series graph.
Essentially, J Curve Effect means there is a decrease in sales, then there is an unexpected growth. This growth ties up cash flow. Inventory requires significant cash to supply the demand. But if the company invoices the customer, then there is a risk of not being paid for 15, 30, or 60 days. Even if the company collects the cash up front, it doesn’t always align with when payments are due.
The J-Curve is related to the Marshall-Lerner condition, which states:
If (PEDx + PEDm > 1) then a devaluation will improve the current account.
The J-Curve is an example of how time lags can affect economic policy. It also shows the link between microeconomic principles (elasticity) and macroeconomic outcomes (current account)
The current account on the balance of payments measures the net value (X-M) of exports and imports of goods, services and investment incomes.
HOW TO USE
A country’s trade balance experiences the J-curve effect if its currency devalued. The country’s total value of imports exceeds its total value of exports, resulting in a trade deficit. But finally, the currency devaluation reduces the price of its exports. In connection, the country’s level of exports recovers, and the country moves back to a trade surplus.
Equity fund returns typically experience the J-curve effect in the first years following their formation. Initially, equity funds yield negative annual returns resulting from start-up costs and high management fees. However, once a fund stabilizes, its value gradually rises into positive territory and beyond its initial value.