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