Trade balance and exchange rate relationship

trade balance and exchange rate relationship

PDF | This study addresses the question of whether exchange rate changes have any significant and direct impact on trade balance. By examining the trade. review of the theoretical literature on the relationship that exists between the trade balance and exchange rates. Secondly, the main purpose of this study is to. The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country's.

The Mercantilist approach to international trade assumed that the wealth of a nation depends chiefly on its ability to possess precious metals such as gold and silver. The possession of those metals took place through supporting exports and encouraging metal discoveries in the Americas and, on the other hand, suppressing imports through imposing excessive tariffs [ 9 ].

After almost three centuries of instability and economic failure, Mercantilism was strongly criticized by what became to be known later as the Standard Theory of International Trade [ 10 ].

The two books heralded the formulation of a theory of free trade, based on the unprecedented success of England in the respective fields of industry and trade [ 13 ]. Standard Trade Theory relates merchandise with the movements of real exchange rate following a simple common sense approach. Setting all other variables fixed, a fluctuation in exchange rate affects both the value and volume of trade.

If real exchange rate increases in home country, that is, real depreciation, the households can get less imported goods in exchange for a unit of domestic goods and services. Thereby, a unit of imported goods would give higher number of units of domestic goods.

Eventually, domestic households buy fewer imports while foreign households purchase relatively more domestic goods. Ultimately, the higher the real exchange rate for the home country, the more the trade surplus the country obtains [ 14 ]. Lerner further extended the typical trade theory by accounting for demand price elasticities of imports and exports as instrumental elements in measuring the effect of real exchange rate variations on trade balance.

Thus, a rise in exports and a reduction in imports due to depreciation in real exchange rate do not necessarily mean a correction of trade balance deficit. According to Lerner, trade balance is not concerned with the volume of physical goods but with their actual values [ 15 ]. Elasticities Approach, Marshall-Lerner Condition, and J-Curve Theory In elasticities approach, trade balance adjustment path is viewed on the basis of elasticities of demand for imports and exports.

Exchange Rate and Trade Balance Relationship: The Experience of ASEAN Countries

The elasticity of demand is defined as the quantity responsiveness of demanded goods or services to changes in price [ 16 ]. Although the Elasticity Approach is commonly known as Bickerdike-Robinson-Metzler Condition [ 17 ], Bickerdike [ 18 ] was actually the one who originally developed and laid the foundations of this approach by modeling nominal import and export prices as functions of import and export quantities [ 1920 ]. Bickerdike-Robinson-Metzler Condition implies that the change in the foreign currency value of the trade balance depends upon the import and export supply and demand elasticities and the initial volume of trade.

As can be seen, all discussions in the elasticities approach revolve around the questions of volume and value responses to changes in real exchange rate. Figure 1 summarizes the case of domestic elasticity of supply in a devaluating country. Elasticities approach the case foreign demand. As shown, the same logic also applies to the domestic demand. However, as depicted in Figure 1lower prices in the domestic country as a result of currency devaluation will normally increase foreign demand for domestic goods, but only when foreign demand is elastic.

On the other hand, if foreign demand elasticity for domestic goods is weak, the quantity of domestic goods will not rise to the extent that it exceeds the decline in the value of exports caused by the cheaper prices [ 23 ].

trade balance and exchange rate relationship

Following the same notions, the case of domestic elasticity of demand can be understood in the same context. The consumers will then compensate by consuming domestic rather than foreign goods forcing the value of imports to decline. In summary, if the decline in value of domestic imports is greater than the decline in value of domestic exports, the trade balance will improve.

trade balance and exchange rate relationship

Policymakers apply the Elasticity Approach in reality when a country faces trade balance deficit. They would have to consider the responsiveness of imports and exports for a change in exchange rate to measure to which extent devaluation would affect the trade balance. However, if foreign and domestic demands for imports and exports are elastic, a small change in the spot exchange rate might have substantial impact on trade balance [ 24 ].

Marshall-Lerner Condition is a further extension of the elasticities approach. The condition could be seen as an implication of the work of Bickerdike [ 18 ]. Nevertheless, it was named after Alfred Marshall who was born in and died insince he is considered as the father of the elasticity as a concept and Lerner [ 15 ] for his later exposition of it [ 19 ].

trade balance and exchange rate relationship

Assuming trade in services, investment-income flows, and unilateral transfers are equal to zero, so that the trade account is equal to the current account, Marshall-Lerner Condition states that the sum of the absolute values of the two elasticities must exceed unity [ 25 ]. Conversely, if the sum is less than one, trade balance worsens when a depreciation takes place [ 15 ]. The first is that trade was initially balanced when exchange rate depreciation took place, so that the foreign currency value of exports equals the foreign currency value of imports.

The effect can be explained as depicted in Figure 2. Following a currency depreciation, the trade balance is to improve only when the volume effect shown in A and B outweighs the price effect denoted as C. However, the Marshall-Lerner Condition is also indicative of stability.

If the sum of the two import and export demand elasticities does not exceed unity, the equilibrium is unstable and an economic model with an unstable equilibrium could be inefficient for measuring the outcome of exchange rate depreciation on trade [ 27 ]. Almost three decades after the generalization of the Marshall-Lerner Condition, the J-Curve theory came into existence. Thus, it is considered as a dynamic view of Marshall-Lerner Condition [ 29 ] or, more generally, the elasticities approach.

In the short-run, instantly after currency devaluation, domestic importers face inflated import prices as paid in domestic currency; thus, the net exports decline.

trade balance and exchange rate relationship

On the other hand, the domestic exporters in the devaluating country face lower export prices since the demand for exports and imports is fairly inelastic in the short-run.

In other words, in the short-run when prices are relatively constant the balance of trade faces a decline due to the stickiness of prices and sluggishness to demand change. Prices stickiness is when goods are still traded at the price levels prior to devaluation [ 30 ]. The trade balance worsens by the value of total imports in foreign currency multiplied by the magnitude of the rise in the price of foreign currency since contracts made before the depreciation force fixed prices and volumes.

Furthermore, the markets in home country experience an increase in exports volume due to the decrease in exports prices. However, the J-Curve phenomenon predicts the trade balance to improve in the long-run to a higher level compared to its level before depreciation.

The dynamic reaction of trade balance as a short-run dip and long-run recovery takes the shape of the flattened J letter, hence the J-Curve phenomenon.

Milton Friedman - Imports, Exports & Exchange Rates

The J-Curve is depicted in Figure 3. As an implication on monetary policy, the exchange rate devaluation should be sufficiently large to have a favorable long-run impact on trade balance. In relation to Marshall-Lerner Condition, if trade balance improves in the long-run due to currency devaluation to a level higher than the level before devaluation under the J-Curve assumptions, we can consider the Marshall-Lerner Condition fully satisfied [ 7 ].

If not, the Marshall-Lerner Condition is not satisfied and the J-Curve is expected to flatten on lower level compared to the level before devaluation [ 32 ]. The time frame for the J-Curve, before the Marshall-Lerner Condition kicks in and improves the trade balance, is said to be anytime between a few months to two or three years [ 3033 ].

As such, an alternative explanation to the observed behaviour of ASEAN-5 trade balances in the selected sample period has been postulated. In particular, we propose that trade balance is affected by real money, rather than nominal exchange rate. A mathematical framework that provides theoretical background to our proposition is presented. Our empirical data analysis suggests that the real money effect proposition could consistently explain the observed trade balances in Malaysia, Singapore, Thailand and the Philippines during the period of study, with respect to Japan.

Thus, in order to cope with trade deficits, the governments of these ASEAN countries might resort to policy measures focusing on the variable of real money.

Thus, it is not surprising to learn that the study of exchange rate has been one of the most important areas of economic research over the past few decades.

The Effect of Exchange Rate Movements on Trade Balance: A Chronological Theoretical Review

This body of research has experienced tremendous growth, especially in the post-Bretton Woods era in which foreign exchange rate has been highly volatile after the inception of the floating exchange rate regime in One of the areas of research that has drawn the attention of researchers is the exchange rate- trade balance relationship.

The elasticity model of the balance of trade Krueger, has shown the existence of a theoretical relationship between exchange rate and the trade balance. In theory, nominal depreciation appreciation of 2 exchange rate is assumed to change the real exchange rate see, for instance, Himarios, ; Bahmani-Oskooee, and thus has a direct effect on the trade balance. Specifically, Bahmani-Oskooee noted that in an effort to gain international competitiveness and help to improve its trade balance, a country may adhere to devaluation or allow her currency to depreciate.

Devaluation or depreciation increases exports by making exports relatively cheaper, and discourage imports by making imports relatively more expensive, thus improving trade balance.

A common explanation for this time path adjustment is based on the existence of contracts in international trade, in particular export contracts are written in domestic currency units and import contracts are written in foreign currency units.

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This study attempts to investigate whether exchange rate changes have significant and direct impact on the trade balances of ASEAN-5 countries Indonesia, Malaysia, the Philippines, Singapore and Thailand with Japan, one of their major trading partners. However, from our plots of the exchange rate and trade balances for these ASEAN-5 countries, it seems that the role of exchange rate changes in initiating changes in the trade balances has been exaggerated.

These results come as no surprise because various studies have found weak statistical evidence connecting exchange rate changes and the trade balance see for example, Greenwood, ; Rose and Yellen, ; Mahdavi and Sohrabian, ; Buluswar et al. In other words, appreciation of the dollar implies that U.

On the other hand, appreciation of the dollar tends to make goods imported from other countries cheaper for U.

(PDF) Exchange Rate and Trade Balance Relationship: The Experience of ASEAN Countries

Because of these changes in relative prices, appreciation of the dollar tends to increase imports and decrease exports, thereby deteriorating the trade balance. The trade balance is the total value of imported goods minus the total value of exported goods. Depreciation of the dollar has the opposite effect, likely improving the trade balance. The graph above shows this relationship between the trade balance and the exchange rate. The green line plots the trade-weighted U.

The blue line is the trade balance-to-trade volume ratio.