Trade Balance and the Real Exchange Rate

Article
Trade Balance and the
Foreign Trade Review
49(2) 117–139
Real Exchange Rate:
©2014 Indian Institute of
Foreign Trade
An Empirical Analysis
SAGE Publications
Los Angeles, London,
of Multilateral and
New Delhi, Singapore,
Washington DC
Bilateral Relationship
DOI: 10.1177/0015732514525222
http://ftr.sagepub.com
Suranjali Tandon
Abstract
Literature on international trade has been inconclusive on the matter of exchange
rate and its impact on trade. The article finds that for a panel of regions, during
the period 1980–2010, the imports in all countries respond to changes in real
exchange rate, as predicted in theory. Exports on the other hand exhibit value
and volume adjustments. A similar analysis of the bilateral trade shows exchange
rate matters for only a few countries, to the extent that they lead to adjustments
in exports. These results provide the basis for further analysis of the causes
underlying such mechanisms and availability of the possibility of using exchange
rate as an instrument to correct imbalances in the external account.
JEL: F1, F14
Keywords
Real exchange rate, trade balance, GDP, panel regression, bilateral trade
Introduction and Literature Review
The central theme of the article is to dwell on the effects of changes in exchange rate
on merchandise trade. Trade is determined by relative prices and the value of a coun-
try’s domestic currency. In trying to understand how international demand for goods
responds to a set of prices, which are domestic price level and domestic price of
foreign currency, the two are usefully amalgamated into one and referred to as real
exchange rate. The possible causation between the domestic prices and the nominal
exchange rate necessitates that the movements in price levels as a consequence of a
movement in nominal exchange rate be empirically verified. Once that has been
Suranjali Tandon is a Research Scholar at Jawaharlal Nehru University, New Delhi,
India. E-mail: suranjali03@gmail.com

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Suranjali Tandon
established, the repercussion of such changes on exports, import and trade balance
can be examined. Therefore, the article proceeds by first analyzing movements in
Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate
(REER) for individual countries selected on the basis of the following criteria:
1. The share of exports and imports of the country are in excess of 1 per cent
of global exports and imports respectively. That is, whether the country
makes significant contribution to global merchandise trade.
2. The country has unique macroeconomics experiences such as devaluation,
debt crisis or is a member of a currency union.
3. Availability of data for all years and all variables.
Based on the above criteria Austria, Brazil, China, Denmark, France, Germany,
Italy, Japan, Malaysia, Mexico, the Philippines, Norway, the Netherlands,
Singapore, Switzerland and United Kingdom were selected.
The correlation is useful in gaining a preliminary understanding of the possi-
bility of adjustments in trade account, following a change in exchange rate. In
literature there is a lack of consensus on the matter of exchange rates and their
effect on the merchandise trade, with equal evidence supporting the presence and
the lack of it. For example, Rodrik (1994) and Elbadawi (1998) found that
exchange rate depreciation and equilibrium exchange rate are not significant
determinants of exports respectively. On the other hand, many papers such as
Coes (1981), Cushman (1983, 1988), Thursby and Thursby (1987), Arslan and
Van Wijnbergen (1993), Chaudhary (1993), Arize et al. (2000) and Mohamad and
Nair (2009) found that exchange rate volatility depresses the volume of exports.
A similar discussion exists in the context of imports and trade balance. For exam-
ple, Rose and Yellen (1989) and Rose (1991) found no relationship between trade
and exchange rate. While Wang (1993) and Ghosh et al. (2008) show that the real
exchange rate (RER) depreciation improves trade.
The present analysis is a reconsideration of this relationship for major coun-
tries. To evaluate the same, countries have been grouped into panels based on
regions—Europe, Latin America and Asia. These have further been segregated
into panels based on special characteristics such as—membership of currency
union (Europe) and level of income (Asia). These have been constructed with the
purpose to illustrate the differences in responses owed to each of these character-
istics. While the exchange rate is a crucial factor it does not work in isolation. The
interplay of other factors is well-recognized in literature and theory. Income
amongst these is relatively significant in its influence on the level of trade. Studies
such as Zhang (1999) and OECD (2011) have found domestic income to have a
bearing on trade. As is evident there is no dearth of literature, the present study
takes a step forward to understand the various ways in which the exchange rate
could potentially affects an economy’s trade in goods.
Real exchange rate and Gross domestic product (GDP) have been discussed in
great detail in the following sections. The theoretical and empirical evidence
Foreign Trade Review, 49, 2 (2014): 117–139

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Trade Balance and the Real Exchange Rate
119
provide the rationale for including the two as the core of the models used in the
present study. These relationships have been analyzed not only in the multilateral
context but have also been extended to the bilateral case (see the section ‘Empirical
Model for Trade Balance and Real Exchange Rate’).
Real and Nominal Effective Exchange Rate
The real exchange rate is a conceptual measure of prices and nominal exchange
rate. Extent of comovement in real and nominal exchange rate can demonstrate
corresponding movement in relative prices. In this section the movements in
prices are examined using REER1 and NEER.
Theories such as purchasing power parity (PPP) propose that domestic prices
adjust to changes in nominal exchange rate, as expressed in the equation given
below.

D Real Exchange rate = De + DP* – DP
(1)
It follows from Equation (1) that an offsetting change in prices following a
change in the nominal exchange rate leaves real variables unchanged. Such an
explanation has been supported by many including Cassel (1921), Friedman
(1953) and Mundell (1987). Depreciation of domestic currency will be, by the use
of such logic, followed by an increase in domestic price level and vice versa.
Alternatively, the changes in nominal exchange rate may, due to several factors2
(Balassa, 1964). Frenkel (1981), Krugman (1978, 1990) and Frankel and Rose
(1978) lead to no offsetting movement in prices, or be associated with less than
equivalent changes in prices. The latter is corroborated by graphical presentation
in Figure A 1 in the appendix where for all countries relative price movements are
negligible, if not absent, making it reasonable to state that movements in NEER
translate into similar movements in REER.
In order to assess the extent to which prices respond, immediately or subse-
quently, to changes in nominal exchange rates, a country-wise correlation was
calculated for each country during 1980–2010. While trying to discern a delayed
response of domestic prices using pre constructed REER and NEER it is impor-
tant to note that simply taking a correlation between REER in t+1 and NEER in
period t is incorrect since REER is calculated using the nominal exchange rate
prevailing in period t+1. So the ratio of REERt1 is taken to derive the relative
NEERt1
prices in period t+1. The same is applied to NEER of previous period t. The
resultant REER is then used to see if the domestic prices change over a year to
accommodate for changes in NEER. Table 1 summarizes the country-wise cor-
relation between changes in REER and NEER (see column 2) and changes in
NEER in period t and REER in period t+1 (see column 3).
High correlation between the nominal and real exchange rate is indicative of
lack of relative price movements which fully negate the changes in nominal
Foreign Trade Review, 49, 2 (2014): 117–139

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Suranjali Tandon
Table 1. Correlation between Real and Nominal Exchange Rates
Correlation between
Correlation between Changes in
Changes in REER and
REER in Period t+1 and Changes
Country
NEER in Period t
in NEER in Period t
Austria
0.94*
0.95*
Brazil
0.11
0.04
China
0.87*
0.82*
Denmark
0.93*
0.93*
France
0.92*
0.92*
Germany
0.94*
0.96*
Italy
0.86*
0.87*
Japan
0.98*
0.9*
Malaysia
0.98*
0.97*
Mexico
0.59*
0.38
The Netherlands
0.92*
0.91*
Norway
0.82*
0.83*
The Philippines
0.76*
0.41*
Singapore
0.97*
0.95*
Switzerland
0.97*
0.98*
United Kingdom
0.98*
0.97*
Source: Own calculations based on data from IFS, IMF.
Note: *refers to the significance of correlation at 5 per cent.
exchange rate. Only in Brazil and Mexico, there is no significant correlation
between nominal and real exchange rate. While the lack of correlation can be
construed as a sign of movement in domestic prices, it is not certain whether
exchange rates are the source of relative price movements.
Based on the evidence provided in Table 1 the proposition that movements in
relative price completely offset movements in nominal exchange rate in the same
or following period can be rejected, at least for these countries, instead it can be
proposed that the real exchange rate generally moves in the direction of nominal ...