Exchange Rates and Trade Balance: Testing the Short- and Long-Run Relationship Using Data for Small Semi-Open Economies

Abstract

The main result is that in a majority of the countries examined exchange rates do play a role in determining the long-run equilibrium behavior of the trade balance. This implies that the trade balance should not be treated a priori as exogenous with respect to the exchange rates. The evidence on the role of the exchange rate was stronger when the reduced form for the trade balance included exchange rate, income, and money. The estimations reported that in 13 of 17 countries there is at least one long-run (cointegrating) relationship between the exchange rate and trade balance. The results show also that, in most of the cases where cointegration was found, the BRM or ML conditions were supported by the data. The results also show that the effect of an exchange rate devaluation on the trade balance is enhanced if accompanied by reduction of excess domestic credit and/or an opening of the economy. For all but one of the countries examined, the J and S curve short-run hypotheses were rejected. The findings with respect to income and money variables did not uniformly reject or accept hypotheses from the absorption or monetary approaches either for the short run or the long run. What was generally found, however, was that money stock and income are important determinants of the long-run trade balance behavior.