I promise not to bother you much with my “lag” thoughts, although I can’t help writing some more about it.
Another common situation is a devaluation. Usually when a country devaluates its currency it does so thinking about competitivity. That means it will be able to sell more and improve its trade balance.
But, it is really going to improve? Well, in the short run it’s going to have to pay more for its imports, and its exports are going to be just the same. So, while improvements still lie ahead, the short run means more trouble.
That’s what the students of international economics know as the J-curve. I’ve modelised the curve from a Poisson distribution (the inmediate effect) plus a step function (the long run) and it looks like this:
So, if politicians decide a devaluation in their second term, situation will worsen enough not to show any benefit before their reelection campaign. That means trouble: lag matters. And that means that some countries are more able to use this kind of resources than others: the ones whose rulers don’t have to face reelection.
But I bet reality won’t be so simple. Other countries are able to react and will, in time, adjust their currencies to match. That means that, on the long run, the changes will be minimal, if any. I’ve tried to modelise that too with two Poisson distributions of different parameters:
That means that there will be a net gain based on the first-mover strategy: in the example chosen the area that is below the axis is smaller than the area above (exactly one half), but there will be no yearly gain on the long run.
Going back to the point, this is a dynamic model. Things don’t happen the same day, time matters and there are several effects counteracting each other. The order matters cos there is not advantage on the long run but just gains.
And every decision will have its consequences that, in time, will mix with more decisions. If we observe economic reality we may not be able to see the consequences of just one action but a continuous mix of different decisions of several participants.
Let’s go back to our politician. He lost his reelection to his rival that decided to do the opposite and restore the previous exchange rate. Now we imagine that the same ripple effect happens the other way round and the economic system just responds the same (opposite) way:
Look from terms 4 to 8. A new boom? Did the new politician save the country? Who will be elected in next election due for year 8? What will happen in the long run? Funny how lag matters.