A Formal Model of Krugman's Intuition on the J-Curve

CORE Discussion Paper No. 2004/43

67 Pages Posted: 25 Oct 2006

See all articles by Olivier Cardi

Olivier Cardi

Université Paris II - Panthéon-Assas - ERMES

Luisito Bertinelli

Universite du Luxembourg

Date Written: June 2004

Abstract

We use a two-good dynamic intertemporal general equilibrium model to formalize the economic intuition of Krugman about the explanation of the J-curve phenomenon in terms of habit persistence in consumption and sluggishness in capital adjustment. The results differ markedly according to the permanence or temporary nature of the shock. A short-lived terms of trade worsening may give rise to a once-for-all decrease in the marginal utility of wealth, a hump-shape response of real expense when the perturbation is at work and a definitely higher level of consumption at the new steady-state. Habitual standard of living and welfare are raised through the combination of an intertemporal speculation, habit persistence, and hysteresis effects. In accordance with recent empirical results, investment is procyclical, H-L-M effect holds, net foreign assets adjustment exhibits a J-curve, current account surplus is associated with a fall in real income. From an analytical viewpoint, a new consistent procedure to study temporary shocks in continuous time leads to formal solutions that allow to investigate accurately transitional dynamics in a complex dynamic system, comparing transitory and permanent perturbations analytically, underscoring hysteresis phenomenon, and bringing out the determinants of short and long-term reactions of macroeconomic aggregates.

Keywords: current account, habit formation, temporary shock, J-curve

JEL Classification: F41, E22, E21, F32

Suggested Citation

Cardi, Olivier and Bertinelli, Luisito, A Formal Model of Krugman's Intuition on the J-Curve (June 2004). CORE Discussion Paper No. 2004/43, Available at SSRN: https://ssrn.com/abstract=939529 or http://dx.doi.org/10.2139/ssrn.939529

Olivier Cardi (Contact Author)

Université Paris II - Panthéon-Assas - ERMES ( email )

12 Place du Panthéon
Paris, Cedex 5, 75005
France

Luisito Bertinelli

Universite du Luxembourg ( email )

L-1511 Luxembourg
Luxembourg