The impact of exchange rate fluctuation on trade balance in short and long run

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HOCHIMINH CITY

PHAM THI TUYET TRINH

THE IMPACT OF EXCHANGE RATE FLUCTUATION

ON TRADE BALANCE IN SHORT AND LONG RUN

THESIS OF MASTER IN ECONOMICS

HO CHI MINH CITY – 2011


MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HOCHIMINH CITY

PHAM THI TUYET TRINH

THE IMPACT OF EXCHANGE RATE FLUCTUATION

ON TRADE BALANCE IN SHORT AND LONG RUN

Major: Finance and Banking
Major code: 60.31.12

THESIS OF MASTER IN ECONOMICS

ACADEMIC SUPERVISOR: Ph.D NGUYEN VAN PHUC

HO CHI MINH CITY – 2011

ACKNOWLEDGEMENTS
I would like to send special thanks to all the teachers who gave interesting lecture
to me for their devoted instruction during my studying in this master course.

I am specially thankful to Ms. Ha Thi Thieu Dao for her precious data without
which I could not finish this study and for her carefully reading, editing and
detailed comments on my study.

I express my profound sense of gratitude and sincere thanks to Mr. Nguyen Van
Phuc, academic supervisor, for suggesting research problems, giving valuable
guidance and providing constant encouragement.

I am particularly indebted to my family, especially my mother and my daughter,
who have given me great emotion and encouragement.

i


ABSTRACT
This study shows the short and long-run impact of exchange rate on trade
balance in Vietnam. Following a depreciation of real exchange rate, trade balance
initially deteriorates. Trade balance will improve after two quarters and new
equilibrium will be set after twelve quarters. Johansen’s cointegration analysis and
autoregressive distributed lag (ADRL) are respectively used to explore long-run
impact, giving similar estimation results, showing trade balance improvement
following a depreciation. Corresponding error correction modes (ECM) based on
long-run cointegration equations also come to consistent results, indicating
immediate deterioration of trade balance after a depreciation. Impulse response

functions based on ECM and unrestricted Vector AutoRegression (VAR) exhibit
J-curve pattern of trade balance when there is a permanent depreciation.
Key word: exchange rate and trade balance, cointegration, autoregressive
distributed lag, J-curve

ii


CONTENTS
Acknowledgement ................................................................................................. i
Abstract ................................................................................................................ ii
Content ................................................................................................................ iii
List of tables ....................................................................................................... vii
List of figures .................................................................................................... viii
Abbreviations ...................................................................................................... ix
CHAPTER 1: INTRODUCTION
1.1 Background to the study and statement of problem ......................................... 1
1.2. Research question .......................................................................................... 2
1.3 Research objectives ......................................................................................... 2
1.4. Methodology .................................................................................................. 3
1.5. Limitation ...................................................................................................... 3
1.6. Organization of the study ............................................................................... 3
CHAPTER 2: LITERATURE REVIEW
2.1. General arguments about exchange rate ......................................................... 5
2.1.1. Exchange rate concepts .......................................................................... 5
2.1.2. Nominal exchange rate and real exchange rate ....................................... 6
2.1.2.1. Bilateral nominal and real exchange rate ....................................... 6
2.1.2.2. Real effective exchange rate .......................................................... 7
2.1.3. Main determinants of exchange rate movement ..................................... 9
2.1.3.1. Differential in inflation .................................................................. 9

2.1.3.2. Terms of trade ............................................................................. 10
2.1.3.3. Differential in interest rates ......................................................... 10
2.1.3.4. Political stability and economic performance ............................... 10
2.1.3.5. Condition of balance of payment ................................................. 11
2.2. Trade balance concepts ................................................................................ 11
2.2.1. Trade balance as an account on the balance of payment ....................... 11
2.2.2. Determinants of trade balance .............................................................. 12

iii


2.3. Relationship between exchange rate and trade balance ................................. 13
2.3.1. The elasticities approach ...................................................................... 13
2.3.1.1. Marshall-Lerner condition ........................................................... 13
2.3.1.2. The J-curve effect ........................................................................ 14
2.3.2. Keynesians multiplier approach ........................................................... 15
2.3.3. Theoretical model ................................................................................ 16
2.3.4. Empirical evidences ............................................................................. 17
2.3.4.1. Brief of empirical studies on developed countries ........................ 17
2.3.4.2. Brief of empirical studies on developing countries....................... 18
2.3.4.3. Summary of empirical studies on Vietnam .................................. 19
2.4. The role of exchange rate policy to trade balance ......................................... 20
2.4.1. Exchange rate policy concepts ............................................................. 20
2.4.2. Exchange rate regimes ......................................................................... 21
2.4.3. Instruments of exchange rate policy ..................................................... 23
2.4.3.1. Direct instruments ....................................................................... 23
2.4.3.2. Indirect instruments ..................................................................... 23
2.4.4. The importance of exchange rate policy to trade balance ................... 24
Chapter summary ................................................................................................ 26
CHAPTER 3: PERFORMANACE OF TRADE BALANCE AND

EXCHANGE RATE IN VIETNAM IN 2000-2010
3.1. The background of Vietnam’s economy in 2000-2010 period ...................... 28
3.2. The performance of trade balance in 2000-2010 period ................................ 30
3.2.1. In terms of value .................................................................................. 31
3.2.2. In terms of structure by products .......................................................... 34
3.2.3. In terms of structure by trading partners ............................................... 36
3.3. The fluctuation of exchange rate in 2000-2010 period .................................. 38
3.3.1. Nominal exchange rate under management of The State bank of
Vietnam and the role of US Dollar ...................................................................... 38
3.3.2. Movement of real exchange rates ......................................................... 41

iv


3.3.2.1. Real exchange rates computation ................................................. 41
3.3.2.2. Analysis bilateral real exchange rate and real effective
exchange rate ...................................................................................................... 44
Chapter summary ............................................................................................... 48
CHAPTER 4: ESTIMATING THE IMPACT OF REAL EXCHANGE
RATE ON TRADE BALANCE IN VIETNAM IN 2000-2010
4.1. Model specification ...................................................................................... 49
4.2. Data description ........................................................................................... 50
4.2.1. Technical data description.................................................................... 50
4.2.2. Econometric characteristics of the data ................................................ 51
4.2.2.1. Seasonality .................................................................................. 51
4.2.2.2. Stationarity .................................................................................. 52
4.3. Model for estimation .................................................................................... 53
4.4. Estimation of long-run effect ........................................................................ 54
4.4.1. Johansen’s cointegration analysis ......................................................... 55

4.4.2. Autoregressive distributed lag (ARDL) approach................................. 57
4.5. Estimation of short-run effect ....................................................................... 63
4.5.1. Error-correction model (ECM) ............................................................. 64
4.5.2. Impulse response ................................................................................. 66
Chapter summary ................................................................................................ 67
CHATER 5: CONCLUSION AND POLICY RECOMMENDATION
5.1. Conclusion ................................................................................................... 69
5.2. Policy recommendation ................................................................................ 70
5.2.1. Exchange rate policy should take

into account trade

competitiveness .................................................................................................. 70
5.2.2. Determining value of VND based on currency basket .......................... 73
5.2.3. Establishing condition for a successful depreciation............................. 74
5.2.4. Depreciating currency to improve trade balance ................................... 77
5.3. Limitation .................................................................................................... 78

v


REFERENCES ................................................................................................. 80
APPENDIX A: REER computation ................................................................. 86
APPENDIX B: Estimation output and relevant test for long-run impact of
real exchange rate on trade balance ................................................................. 99
APPENDIX C: Estimation output of Johansen’s cointegration test for longrun impact of real exchange rate on exports and imports ............................ 102
APPENDIX D: Output of ECM model estimation based on cointegrating
equation obtained by Johansen’s procedure and ARDL approach.............. 103
APPENDIX E: Narayan’s new set of critical values for the bound F-test ... 106

vi


LIST OF TABLES
Table
2.1. Exchange rate regime classification by IMF ................................................. 22
3.1. GDP, Inflation, FDI, FII, ODA, Current transfer in 2000-2010 .................... 28
3.2. Structure of exports by foreign trade standard in 2000-2010 ........................ 34
3.3. Structure of imports in 2000-2010 ................................................................ 35
3.4. Trade balances (million USD) with 17 largest trading partners ..................... 37
3.5. Real exchange rates of some currencies........................................................ 38
3.6. Fluctuation bands applied from 1999-2010 .................................................. 39
3.7. Nominal exchange rate between VND and USD in 2000-2010..................... 39
3.8. VND/USD RER and REER.......................................................................... 44
4.1. ADF and PP tests results for non-stationarity of variables ............................ 53
4.2. Correlation matrix of variables ..................................................................... 54
4.3. Cointegration Rank Test: Trace and Maximum Eigenvalue Statistics ........... 55
4.4. Granger Causality Test in Vector AutoRegression (VAR) ............................ 56
4.5. Statistic of selecting lag order (SBC and AIC) and F-Statisctics for
testing the existence of a levels trade balance equation ....................................... 59
4.6. Estimated ARDL(2,3,0) model ..................................................................... 60
4.7. Ramsay RESET test for estimated ARDL(2,3,0) model ............................... 60
4.8. Breusch-Godfrey Serial Correlation

LM Test

for estimated

ARDL(2,3,0) model ............................................................................................ 61
4.9. ECM for trade balance based Johansen’s procedure ..................................... 64

4.10. ECM for trade balance based on ARDL (2,3,0) .......................................... 64
4.11. Breusch-Godfrey Serial Correlation LM Test for ECM .............................. 65
4.12. Ramsey RESET Test for ECM ................................................................... 65
4.13. Impulse response of trade balance following real exchange rate shock ....... 66
5.1. Shares of main trading partners (percent) of neighboring countries, 2004 .... 72

vii


LIST OF FIGURES
Figure
2.1. The J-curve effect ........................................................................................ 15
3.1. The trade balance, current account of Vietnam in 2000-2010 ....................... 30
3.2. Values of exports and imports (million USD) in 2000-2010 ......................... 32
3.3. Growth of export and import (percent) in 2000-2010 ................................... 32
3.4. Trade balance in FOB prices and CIF prices in 2000-2010 ........................... 33
3.5. VND/USD exchange rate and trade balance in 2000-2010 ........................... 41
3.6. RER and trade balance ................................................................................. 45
3.7. VND/USD RER, VND’s REER and USD’s REER ...................................... 46
3.8. REER and trade balance with major trading partners.................................... 47
4.1. Series used in empirical analysis: TB, REER, GDP,GDP* ........................... 51
4.2. Seasonally adjusted series: TB, REER, GDP,GDP* ..................................... 52
4.3. CUSUM test for estimated ARDL(2,3,0) model ........................................... 61
4.4. CUSUM Test for ECM ................................................................................ 65
4.5. Evolution of trade balance following real depreciation ................................. 67
5.1. VND/USD exchange rate and RER, NEER, REER of VND 2000-2010 ....... 71
5.2. NEER, REER of some countries .................................................................. 79

viii

ABBREVIATION
ADB:

Asian Development Bank

ADF:

Augmented Dickey-Fuller

ADRL:

Autoregressive Distributed Lag

AIC:

Akaike Information Criterion

CPI:

Consumer Price Index

ECM:

Error Correction Model

GDP:

Gross Domestic Product

GSO:

General Statistical Office

IFS:

International Financial Statistics

IMF:

International Monetary Fund

NEER:

Nominal Effective Exchange Rate

NER:

Bilateral Nominal Exchange Rate

OECD:

Organization for Economic Cooperation and Development

PP:

Phillips-Perron

PPI:

Producer Price Index

REER:

Real Effective Exchange Rate

RER:

Bilateral Real Exchange Rate

SBC:

Schwarz Bayesian Criterion

SBV:

State Bank of Vietnam

TB:

Trade Balance

USD:

United States Dollar

VAR:

Vector AutoRegression

VND:

Vietnam Dong

WPI:

Wholesale Price Index

ix


CHAPTER 1

INTRODUCTION
1.1. Background to the study and statement of problem
Vietnam is a young open economy on the process of industrialization in which
exports are considered to be motivation for developing. The export-driven
industrialization of Vietnam has achieved success with impressive increase in export
volume at 20 percent on annual average during the past ten years. However, that
figure is still lower than annual average increase of import volume for the same
period, about 22 percent, which leads to lasting trade-balance deficit. The
performance of Vietnam’s trade balance is the consequence of low competitiveness
which could be changed by two approaches: internal and external. While internal
approach relies on supply-side policies such as influencing labor productivity or
wages, the latter deals with exchange rate policy to devaluating/ appreciating local
currency against foreign currencies. In this study, we take the latter approach to
explore the trade balance.
In literature, there are many empirical studies focusing on the relationship between
exchange rate and trade balance which have come to various conclusions. Some
studies show undeniable evidences on long-run and short-run relationships between

exchange rate and trade balance. Some come to contrary conclusion that there is no
relation between them. The others conclude existing relation in the long run but not in
the short run. Reasons standing behind these different results mainly rest on countries,
observation periods and econometrics methodologies employed. However, all
researches concluding that exchange rate fluctuation has significant influence on trade
balance also prove that depreciation would increase export, restrain import, and
improve trade balance.
In Vietnam, since trade-balance deficit became serious, some researchers have
turned their attention to examine the role of exchange rate. Although most studies
conclude the fluctuation of exchange rate in Vietnam has impacts on trade balance in
the long run, the short-run impact is still an open question. Besides, the most popular
1


method used to explore relationship between exchange rate and trade balance in
global literature has not been applied for the case of Vietnam. The traditional method
as Ordinary Least Square (OLS) which is popularly used in studies in Vietnam on
exchange rate-trade balance relationship is proved to be inappropriate to explore this
relationship because of time series’ characteristics. The purpose of this thesis is to
find a robust and reliable quantitative relationship between exchange rate and trade
balance for Vietnam’s case. In order words, the thesis examines the role of exchange
rate in long-lasting trade deficit. Based on its exploration, the thesis also proposes
solutions in order to improve the trade balance by using exchange rate measurement.
1.2. Research question
The study tries to explore complete impact of exchange rate on trade balance in
both short and long run. Correspondingly, the study aims to answer the following
questions:
1. Whether there is a stable long-run relationship between the exchange rate and
the trade balance of Vietnam? If that stable long-run relationship does exist,
whether a permanent depreciation of exchange rate would lead to improvement of

the trade balance?
2. Whether depreciation of exchange rate causes negative short-run impact on
trade balance? How long does it take for positive impact of that depreciation to
occur? (Does J-curve effect exist in Vietnam’s exchange rate-trade balance
relationship?).
3. What are the solutions to improve the trade balance of Vietnam by using
exchange rate tool?
1.3 Research objectives
To answer research questions, the study proceeds
-

To calculate real effective exchange rate (REER) of Vietnam Dong against

main trading partners’ currency as a proxy for measuring the competitiveness of
merchandise trade.
2


-

To test the robust relationship between REER and trade balance and estimate

the responsiveness of trade balance to REER fluctuation in the long-run.
-

To test the existence of negative short-run impact of REER depreciation on

trade balance and measure the duration of negative short-run impact as well as
estimate the time for trade balance to setup a new equilibrium level.
-

To find out the reasons behinds the response of trade balance to exchange

rate’s impact for the purpose of suggesting practical and feasible solutions for
policy makers to manage exchange rate to improve trade balance
1.4. Methodology
Due to the fact that results related to the long-run and short-run relationships
between exchange rate and trade balance often depend upon the observation period
and the economic technique employed, three (3) econometric modeling are employed
in this study to obtain sound results
 Firstly, Johansen’s cointegration analysis and Autoregressive Distributed Lag
(ARDL) approach developed by Hashem M.Pesaran, Yongcheol Shin, and
Richard J.Smith (2001) are employed to explore the long-run impact of
exchange rate on trade balance.
 Secondly, error-correction models (ECM) based on the long-run estimating of
the cointegration trade balance equations in the long run are used to explore
short-run impact related J-curve pattern.
1.5. Limitation
This study tries to figure out the impact of exchange rate fluctuation on trade
balance in Vietnam. Based on estimated results, exchange rate measurement is
proposed to use at appropriate time and level to improve trade balance. However,
exchange rate fluctuation brings to not only trade balance change but also other
unfavorable impacts on the economy. In this study, we do show how exchange rate
change can make benefit trade balance but cannot show adverse impacts of that
change on the economy (if any). In order words, we cannot weight between benefit of
trade balance and other potential loss of the economy following a depreciation. Thus,
3


the solution to depreciation currency to improve trade balance seems to be less

persuasive in the context of a whole economy.
1.6. Organization of the study
The study is organized into 5 chapters
Chapter 1: Introduction
Chapter 2: Literature review
Chapter 3: Performance of exchange rate and trade balance in Vietnam in 2000-2010
Chapter 4: Estimating the effect of exchange rate on trade balance in Vietnam
Chapter 5: Conclusion and policy recommendation

4


CHATER 2

LITERATURE REVIEW
This chapter contains traditional theories about exchange rate and trade balance
and their relationships. Based on these fundamental theories, the most popular model
used to explore the impact of exchange rate on trade balance is then discussed. That
how this model is applied to quantify the relationship in developed and developing
countries and in Vietnam is also reviewed for the purpose of introducing a general
result when estimate this impact. Finally, experiences from some typical countries
when managing exchange rate policy to improve trade balance are necessary to
complete a general picture about this famous relationship.
2.1. General arguments about exchange rate
2.1.1. Exchange rate concepts
In general and popular acknowledgement, exchange rate (also known as foreign
exchange rate) between two currencies specifies the price of one currency in term of
another currency (Maurice D.Levi,1996).
Components of an exchange rate between two currencies comprise quote currency
and base currency. The former is currency measuring the value of the other (base

currency). The latter is expressed value through term currency and usually equals a
unit in quoting.
When quoting exchange rate, there are indirect quotation or direct quotation and
US style quotation or Europe style quotation. Indirect and direct quotation is based on
country chosen to be home currency. Thereby, indirect quotation expresses value of
home currency in term of foreign currency and direct quotation expresses value of
foreign currency in term of home currency. US – Europe style quotation is based on
the role of US dollar in quotation. In US style quotation, US dollar is term currency.
In Europe style quotation, US dollar is base currency.
According to Foreign Exchange Ordinance (2005), in Vietnam, exchange rate of
Vietnam Dong (VND) against foreign currency is the amount of VND per one foreign
5


currency unit. This implies direct quotation is used in Vietnam. Also, all mentioned
exchange rate in this study is quoted directly.
2.1.2. Nominal exchange rate and real exchange rate
2.1.2.1. Bilateral nominal and real exchange rate
The bilateral nominal exchange rate (NER) between two currencies is defined as
the price of one unit foreign currency in domestic currency terms (Hinkle et al. 1999).
NERs are popular because they are daily quoted by commercial banks for the
purpose of serving customers who have demands for buying and selling currencies.
Therefore, depending upon supplies of and demands for currencies, NERs of currency
pairs are determined. One main problem with these NERs is they could not show what
people can buy when they hold a unit of foreign currency. The bilateral real exchange
rate (RER) between two currencies can solve that problem.
RER is defined as the ratio of the domestic price of tradables to non-tradables
goods within a single country (Hinkle et al., 1999)1. It measures the units of nontradable goods that can be converted into one unit of tradable goods in a country. An
increase in RER in domestic currency terms implies an improvement in the country’s
competitiveness since there is an increase in relative price. Under the assumption that

the prices of the tradables will be equal all around the world, the real exchange rate
defined on the basis of tradable and non-tradable goods distinction can be
mathematically represented as:

(2.1)

Where NER represents for nominal exchange rate between two currencies in index
form; Pt and P*t represents domestic and international price of tradables respectively;
Pn represents for price index in home country.
1

This concept is considered to be internal terms of RER. That RER, in external term is defined as the NER
adjusted for price level differences between countries, i.e. as the ratio of the aggregate foreign price (or cost)
level to home country’s aggregate price (or cost) level measured in a common currency is not concerned in this
study.

6


RER computed in equation (2.1) tells how it changes value over the time relative
to a base year. If RER is higher than 1 (RER>1), home currency is undervalued,
average prices in home country are lower than those in foreign country, domestic
goods have gained competitiveness. In reverse, if RER is lower than 1 (RER<1),
home currency is overvalued, average prices in home country are higher than those in
foreign country, domestic goods have lost competitiveness.
When computing RERs, researchers face with many problems among which the
choice of empirical price and cost indices makes most confused. This problem is
common to both developed and developing countries but tend to be more severe in
developing countries. Edwards (1989) noted that issues such as the existence of
parallel foreign exchange markets, substantial smuggling and unrecorded trade and

wide fluctuations in the terms-of-trade, trade policies and patterns, introduce
complexities in the measurement of real exchange rate in developing countries, which
are not commonly encountered in industrial countries. Theoretically, RER on the
basis of tradables and non-tradables is computed with wholesale price index (WPI) (or
sometimes, producer price index (PPI)) and consumer price index (CPI) as proxy (for
example Edwards (1988), Edwards (1989), Baffes et al. (1999), Elbadawi (1994).
There are two relevant arguments for this statement. Firstly, the CPI is compiled from
the change in price of consumption goods to domestic consumers. Therefore, it is
heavily affected by most of non-traded goods and thus able to stand for a measure of
non-traded price. In contrast, based on the assumption of the law of one price, the
prices of exports and imports are determined by the law of one price in the
international market. The WPI itself possesses greater proportion of traded goods, it is
then chosen from main trading partners. Such WPIs multiplied by the bilateral
nominal exchange rates generate an appropriate measure of traded goods price in the
home country (Edwards, 1989, Baffes, 1999). Thereby, in this study we use WPI and
CPI as proxy for tradables and non-tradebles, respectively.
2.1.2.2. Real effective exchange rate
7


Although RERs can tell the competitiveness of home country relative to one
foreign country, a country, in practice, does not trade with only one foreign country
but many foreign countries. To compare the competitiveness of domestic goods
relative to all trading partners, the concept of real effective exchange rate (REER) is
used.
REER (in order words multilateral real exchange rate) is an average of the RERs
between home country and each of its trading partners, weighted by the respective
trade shares of each partner. Being an average, a country’s REER may be in
―equilibrium‖ (display no overall misalignment) when its currency is overvalued
relative to that of one or more trading partners so long as it is undervalued relative to

others (Luis A.V. Catão, 2007).
Theoretically, there are Arithmetic Mean (AM) method and Geometric Mean
(GM) method of averaging to calculate REER (Maxwell, 2004) defined respectively
as follow :

AM method:

(2.2)

GM method:

(2.3)

Where RERi denotes real exchange rate of home currency against foreign currency
i computed according to equation (2.1), wi denotes weights attached to currency i, t
denotes time periods.
According to these methods, when REER is lower than 1 (REER<1), home
currency is overvalued relative to chosen based period, domestic goods have lost
competitiveness. In reverse, REER is higher than 1 (REER>1), home currency is
undervalued relative to chosen based period, competitiveness of domestic goods
increases.
Obviously, these two alternative ways of defining the REER index are different in
methods of averaging which causes strength and weak in computing. As Maxwell
8


(2004) pointed out that the major strength of the AM is its ease of computation, which
makes it more appealing to researchers and practitioners, including those in Vietnam.
The GM even though not as easy to compute as the AM, also has certain useful
properties such as its symmetry and consistency. The AM is influenced greatly by the

base year chosen in the computation of the index and researcher has to rebase when
trend analysis needs to be done. The analysis of misalignment is relative to the base
year and therefore limited when the AM index is used. However, the GM indices are
not influenced by the base period chosen. While the AM gives larger weights to
currencies which have appreciated or depreciated to a significant extent alongside the
home country currency, the GM treats depreciation and appreciation symmetrically.
This makes the GM more efficient in capturing trends in REER. For all reasons
above, this study uses the GM method of averaging to calculate REER of Vietnam
Dong.
2.1.3. Main determinants of exchange rate movement
There are numerous factors effecting exchange rate movement between two
currencies. This part discusses five (5) factors which are theoretically and practically
evidenced to cause fluctuation of exchange rate. Although the ways these factors
effect exchange rate are various, in general, all that give rise to supply of a currency
will reduce it value and vice versa and all that give rise to demand for a currency will
increase it value and vice versa.
2.1.3.1. Differential in inflation
In the 1920s, Gustav Cassell popularized the PPP theory which generally states
that a country with a consistently lower inflation rate exhibits a rising currency value,
as its purchasing power increases relative to other currencies.
For example, if inflation rate in country A is lower than that in country B, prices
of goods in country B is relatively higher than prices of goods in country A. The
effect, then, exhibits in trade between two countries. Exports of country A to country
B will increase and imports of country A from country B will decrease. As a result
demand for currency A increases and demand for currency B decreases. The value of
9


currency A will increases against value of currency B or exchange rate between the
two currencies decreases in country A.

2.1.3.2. Terms of trade
The price of a country’s exports relative to the price of its imports is call the
country’s terms of trade (Edwards, 1987). If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favorably improved. An
increasing terms of trade shows greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.
2.1.3.3. Differential in interest rates
The relationship between interest rate and exchange rate is complex, but at the
core, currency with higher real interest rate will appreciate against currency with
lower real interest rate (Maurice D.Levi, 1996). Because, the higher real interest rate
offers investors in an economy a higher return relative to the other. Therefore, higher
interest rate attracts foreign capital and cause the exchange rate to rise.
For example, real interest rate of currency A is higher than that of currency B.
Assume that capital movement is allowed between two country then investors interest
to invest in currency A. As a result, demand for currency A ups (investors exchange
currency B for currency A) which rises the value of currency A or exchange rate in
country A decrease).
2.1.3.4. Political stability and economic performance
Political condition and economic performance directly effect allocation funds of
investors. Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with positive attributes will
draw investment funds away from other countries perceived to have more political
and economic risk. The more investors invest in a country, the more they demand for
its currency and cause rise in value to that currency against the others. Political
10

turmoil, for example, can cause a loss of confidence in a currency and a movement of
capital to the currencies of more stable countries.
2.1.3.5. Condition of balance of payment
The balance of payment account of a country is a record of the flows of payment
between the residents and the rest of the world in a given period. Entries in the
account that give rise to a demand for the country’s currency are identified by a plus
sign. Entries giving rise to supply of the country’s currency are identified by a minus
sign. Therefore, the balance of payment reflects all the supply of and demand for a
country’s currency.
The balance of payment includes two main divisions: current account and capital
account. While the current account records international performance in trade of the
country with other nations, the capital account records the volume of capital flowing
in and out the country. Because the balance of payment itemizes all the factors behind
the demand for and supply of a currency, the condition of balance of payment would
cause pressure on appreciation or depreciation of that currency. In details, a deficit on
balance of payment implies that demand for foreign currency is higher than supply of
foreign currency in that country which causes exchange rate to rise. In reverse, a
surplus on balance of payment implies that demand for foreign currency is lower than
supply of foreign currency in that country and cause exchange rate to fall.
2.2. Trade balance concepts
2.2.1. Trade balance as an account on the balance of payment
The trade balance is a component of the current account, which also includes other
transactions such as income from the international investment position as well as
international aid (or unilateral transfer). The trade balance is the difference between
the value of exports and imports in an economy over a certain period (hence, also
named net export). A positive or favorable trade balance is known as a trade surplus if
it consists of exporting more than is imported; a negative or unfavorable trade balance
is referred to as a trade deficit or, informally, a trade gap. The trade balance is
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sometimes divided into a goods and a services balance. In this study, the trade balance
is referred to merchandise trade.
TB = X – M

(2.4)

Where TB denotes the trade balance, X denotes the values of merchandise exports
and M denotes the value of merchandise imports.
The trade balance is usually the largest transaction on the current account of a
country therefore it mainly decides the status of the current account. The current
account condition is very important to a country because it shows how much the
country will have to borrow or lend to make ―balance‖ the balance of payment. If a
country spends a deficit on its current account, it have to borrow from the outside to
pay for the extent to which its imports exceed its exports or to which it gives away
more than it earns or receives from abroad. There are warnings for country lasting
long on deficit current account. When a country runs a current account deficit, it is
building up liabilities to the rest of the world that are financed by flows in the
financial account. Eventually, these need to be paid back. Atish Ghosh and Uma
Ramakrishnan (2006) suggests that if a country fritters away its borrowed foreign
funds in spending that yields no long-term productive gains, then its ability to repay—
its basic solvency—might come into question. Therefore, ―close attention should be
paid to any current account deficit in excess of 5% of GDP, particularly if it is
financed in a way that could lead to rapid reversals‖ (Lawren Summers, 1996). As the
heart of current account, trade balance should be managed prudently.
2.2.2. Determinants of trade balance
The trade balance of a country includes the value of exports and imports which
are, according to Maurice D.Levi (1996), determined by 6 factors. In general, all
factors that increase/ decrease exports improve/ deteriorate the trade balance, all
factors that increase/ decrease imports deteriorate/ improve the trade balance.

-

The prices in home country and those in foreign country. If inflation in home
country exceeds inflation elsewhere, cost of production in home country is
higher than that in others, then, ceteris paribus, goods of home country become
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less competitive and thus the quantity of home country’s exports declines
while imports rises. As a result trade balance becomes deficit.
-

The exchange rate movements. For a particular level of domestic and foreign
prices of internationally traded goods, the lower the exchange rate is the more
deficit trade balance is. In details, ceteris paribus, when home currency’s value
increase, exchange rate decrease, prices of goods in home country become
more expensive while prices of goods in foreign countries become cheaper.
The result is exports decrease, imports increase, net export decrease.

-

Change in world prices. Changes in the worldwide prices have two-way
impacts on trade balance. If prices of what home country exports rise, then the
value of exports increases. Ceteris paribus, the trade balance improves. If
prices of what home country imports rise, then the value of imports increase.
Ceteris paribus, the trade balance deteriorates.

-

Foreign incomes. In case foreign buyers experience an increase in their real

incomes, the result is an improvement in the export market for raw materials
and manufactured goods of home country. Ceteris paribus, this increase home
country’s exports and therefore improve the trade balance.

-

Import duties and quotas. A higher import tariffs (taxed on imported goods) or
a lower import quotas (the quantity of imports permitted into a country) and
higher non-tariff trade barriers (such as quality requirements and red tape) will
reduce import into that country. In case foreign countries apply these methods,
exports of home country will decrease. In case home country applies these
methods, imports into home country will decrease.

2.3. Relationship between exchange rate and trade balance
2.3.1. The elasticities approach
2.3.1.1. Marshall-Lerner condition
The elasticities approach is rooted in a static and partial equilibrium approach to
the balance of payments which can be typical by Alfred Marshall (1842-1924), Abba
Lerner (1903-1982) and Joan Robinson (1903-1983). The Marshall-Lerner condition
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(also called the Marshall-Lerner-Robinson) is independently discovered by them
seeks to answer the question: when does a real devaluation (in fixed exchange rate) or
a real depreciation (in floating exchange rate) of the currency improve the current
account balance of a country?
This condition rests on two assumptions. The first assumption is that trade in
service, investment-income flows, and unilateral transfers are equal to zero, so that
trade balance is equal to current account. This assumption turns this condition to
examine relationship between trade balance and exchange rate. The second

assumption is that the supply elasticity is infinite.
With definition of elasticity of demand for exports (in other words, percentage
change of exports when exchange rate changes 1 percent), ηx, and the elasticity of
demand for imports (in other words, percentage change of imports when exchange
rate changes 1 percent), ηm as follow:
(2.5)
The Marshall-Lerner condition states that a real devaluation (or a real
depreciation) of the currency will improve the trade balance if the sum of the
elastictities (in absolute values) with respect to the real exchange rate is greater than
one (ηx+ ηm>1).
So far, the Marshall-Lerner condition has been tested in many studies which come
to different results. Most studies, however, conclude that Marshall-Lerner condition is
met in the long-run elasticity but not met in the short-run elasticity (for example see
Hooper et al. 2000). That means real devaluation seems to improve the trade balance
in the long run but not in the short run. Explanation for the statement is that elasticity
is large in the long run but small in the short run. Scientists now prove this theory
contains defectiveness, among which the distinction between short-run and long-run
elasticitities is crucial and leads to what is known as the below J-curve effect.
2.3.1.2. The J-curve effect
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