Exchange rate and trade balance a new approach using big mac index for the case of thailand

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

EXCHANGE RATE & TRADE BALANCE:
A NEW APPROACH USING BIG MAC INDEX
FOR THE CASE OF THAILAND
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

VO THE ANH

Academic Supervisor:
Dr. VO HONG DUC

HO CHI MINH CITY, DECEMBER 2014


ACKNOWLEDGEMENTS
It is assistance, guidance, and encouragement that contribute to the success of this
thesis. Therefore, I would like to express my gratitude to those who always stand by
me during periods of writing thesis.

My profound appreciation and sincere thanks must first be expressed to my
academic supervisor, Dr. Vo Hong Duc, Director of Economic Regulation Authority in
Perth, Australia, for his interest, encouragement, and guidance throughout thesiswriting process from initial themes to entire finish, especially during boring time of
reading the final draft.
I would like to express my grateful thanks to Assc. Prof. Dr. Nguyen Trong Hoai,
Dr. Truong Dang Thuy, Dr. Phung Thanh Binh, and Dr. Pham Khanh Nam, Lectures at
Department of Economics Development at University of Economics (HCMC), for their
helpful commands and valuable pieces of advice during the time I write the thesis.
Special thanks are extended to Dr. Le Van Chon for his invaluable econometric
guidance. Thanks to such academic commands, advice, and guidance, I could finish the
thesis on the best way.
I am be grateful to not only staff members at Department of Economics
Development at University of Economics (HCMC) but also my classmates at VNPMDE 19 for their help and support and for offering such a warm and friendly studying
atmosphere.
Most importantly, I am indebted to my parents for financing my study as well as
for their constant love and moral support. This thesis could not be finished without
their comprehension.

i


ABSTRACT
This thesis focuses on achieving two main objectives: (i) an evaluation of the
Thailand’s currency to confirm whether a currency is over- or undervalued during the
period from 1980 to 2013 for the case of Thailand; and (ii) a consideration of the
effects of a currency’s devaluation on trade balance for the case of Thailand. In this
study, these effects are considered in different aspects such as the determinants of a
trade balance of Thailand; and the long run relationship between bilateral exchange
rate and Thailand’s trade balance.
In relation to the first objective, the prominent feature of the study is to use the

Big Mac Index (BMI), the first ever study of this kind conducted in Vietnam, for
evaluating Thailand’s currency and to apply this evaluation in the context of the link
between exchange rate and trade balance. Nevertheless, the common-used index, the
Consumer Price Index (CPI), is also utilized to compare the effectiveness of BMI with
that of the CPI.
Theoretical grounds for evaluating a currency in term of purchasing power parity
(PPP) theory are first presented, together with the theory of the link between currency’s
devaluation and trade balance. Next, the empirical studies associated with such theory
are discussed. Empirical models and results are reported accordingly.
To obtain the first objective, the PPP hypothesis is required to be satisfied in
terms of panel cointegration tests. The fully modified OLS (FMOLS) technique is
adopted to determine the equilibrium exchange rate for evaluation process. On the
grounds of the tests of PPP, the panel-based unit root tests as developed by Breitung
(2001) and the panel cointegration tests by Pedroni (1999, 2001, 2004) and Kao (1999)
are adopted. The empirical results confirm a solid validity of PPP for the case of CPIbased exchange rate and a weak evidence of the PPP for BMI-based exchange rate. In
the relation to evaluate Thailand’s currency, the results illustrate that (i) the valuation
ii


of Thailand currency using CPI-based exchange rate is fairly consistent to that of BMIbased exchange rate with an exception of the outcomes during the 1997 Asian
financial crisis; and (ii) the Big Mac exchange rate is better when bilaterally evaluating
the Thailand Baht to US dollar.
The second main objective - a consideration of the effects of a currency’s
devaluation on trade balance - could be achieved by the two procedures. The first
procedure is to analyze how changes on exchange rate policy, fiscal policy, and
monetary policy affect Thailand’s trade balance. In this task, effects of devaluation on
trade balance are examined on various scenarios: (i) the entire sample of 62 countries
who are trading partners with Thailand; (ii) different geography (between regions and
regions of countries); (iii) different income levels; and (iv) during different periods in
which Thailand’s currency is over- or under-valued. Both OLS method and IV

technique are employed because of an endogeneity problems as mentioned in previous
studies. The empirical findings indicate that the exchange rate policy plays a central
role in explaining Thailand’s trade balance and the fiscal and monetary policies are
beneficial in some cases.
The second procedure is to examine the long run relationship between a
devaluation of Thailand’s currency and trade balance with the applications of the
panel-based co-integration tests by Pedroni (1999, 2001, 2004) and Kao (1999) and the
FMOLS model. The panel FMOLS estimations illustrate that a devaluation of Thailand
Baht could provide positive effects on trade balance in the long run, especially for the
groups of country with high income, upper middle income, in America, and Europe.
The individual FMOLS regressions between Thailand and each of her 62 trading
partners indicate that the devaluation of Thailand’s currency would stimulate
Thailand’s trade performance with over 20 trading partners, but hurt its performance
with the other 10 countries and inconclusive conclusion for the others.
iii


ABBREVIATIONS
PPP

Purchasing Power Parity

BMI

Big Mac Index

CPI

Consumer Price Index

M-L

Marshall-Lerner

OLS

Ordinary Least Squares

FMOLS

Fully Modified Ordinary Least Squares

IMF

International Monetary Fund

VND

Vietnam Dong

IV

Instrumental Variable

OECD

Organization for Economic Cooperation and Development

VAR

Vector Autoregressive

ARDL

Autoregressive Distributed Lag

ECM

Error Correction Model

iv


Contents
LISTS OF FIGURES ........................................................................................... viii
CHAPTER 1 ............................................................................................................ 1
INTRODUCTION ................................................................................................... 1
1.1

Problem Statement ................................................................................... 1

1.2

Research Objectives ................................................................................. 3

1.3

The Structure of the Thesis ...................................................................... 3

CHAPTER 2 ............................................................................................................ 5

LITERATURE REVIEW ........................................................................................ 5
2.1

Theoretical Grounds ................................................................................. 5

2.1.1 PPP Theory ........................................................................................... 5
2.1.2 Alternative approaches to devaluation theory ...................................... 6
2.2

Conceptual framework ........................................................................... 12

2.3

Empirical reviews ................................................................................... 13

2.3.1 Test of PPP Theory ............................................................................. 13
2.3.2 Evaluation of a currency ..................................................................... 15
2.3.3 Determinants of a Trade Balance ....................................................... 16
2.3.4 Devaluation and Trade Balance .......................................................... 17
CHAPTER 3 .......................................................................................................... 25
THAILAND’S TRADE BALANCE AND ........................................................... 25
v


ITS BIG MAC INDEX .......................................................................................... 25
3.1

Thailand’s Trade Balance ....................................................................... 25

3.2

Big Mac Index ........................................................................................ 27

CHAPTER 4 .......................................................................................................... 31
RESEARCH METHODOLOGY .......................................................................... 31
4.1

Panel unit root test .................................................................................. 31

4.2

Panel cointegration test .......................................................................... 32

4.2.1 Kao’s cointegration test ...................................................................... 32
4.2.2 Pedroni cointegration test ................................................................... 33
4.3

Fully modified OLS approach ................................................................ 36

4.4

Empirical models .................................................................................... 37

4.4.1 Test of PPP theory .............................................................................. 37
4.4.2 Evaluation of Thailand’s currency ..................................................... 39
4.4.3 Determinants of Thailand’s Trade Balance ........................................ 39
4.4.4 Devaluation and Thailand’s Trade Balance ....................................... 45
CHAPTER 5 .......................................................................................................... 47
DATA AND RESEARCH FINDINGS ................................................................. 47
5.1

Data description ...................................................................................... 47

5.2

Empirical results ..................................................................................... 49

5.2.1 Test of PPP theory .............................................................................. 49
5.2.2 Evaluation of Thailand’s currency ..................................................... 52

vi


5.2.3 Determinants of Thailand’s trade balance .......................................... 56
5.2.4 Devaluation and Thailand’s Trade Balance ....................................... 63
CHAPTER 6 .......................................................................................................... 73
CONCLUSION ..................................................................................................... 73
6.1

Conclusions ............................................................................................ 73

6.2

Implications for research and policies .................................................... 76

6.3

Limitations .............................................................................................. 77

REFERENCE ........................................................................................................ 79

APPENDIX ........................................................................................................... 86

vii


LISTS OF FIGURES
Figure 2.1: Conceptual framework for exchange rate effects on trade balance............. 12
Figure 3.1: Thailand’s trade balance during 1995-2013 periods ................................... 26
Figure 5.1: Misalignments of nominal exchange rate based on CPI and BMI .............. 53

LISTS OF TABLES
Table 3.1: The structure of Thailand’ trade classified by currency ............................... 27
Table 5.1: Data Description ........................................................................................... 48
Table 5.2: Unit root test for PPP testing ........................................................................ 50
Table 5.3: Panel cointegration test for PPP.................................................................... 51
Table 5.4: Results of OLS and IV estimation for determinants of Thai trade balance .. 57
Table 5.5: Estimation results for undervaluation and overvaluation periods ................ 59
Table 5.6: Estimation results for countries within each of the seven sub-samples........ 61
Table 5.7: Results of Breitung (2001) unit root test - level and first difference ............ 64
Table 5.8: Cointegration test .......................................................................................... 65
Table 5.9: Panel results of FMOLS estimation .............................................................. 67
Table 5.10: Individual results of FMOLS estimation .................................................... 70

viii


CHAPTER 1
INTRODUCTION
1.1 Problem Statement
Exchange rate is possibly one of the most concerned subjects among academics,

exporters, importers, investors as well as policy-makers because its vitally important
roles played in the international economics. While academics have concerned and
developed theories of disequilibrium and equilibrium real exchange rate, the policymakers concentrate more on exchange rate adjustment in order to examine its effects
on the economy. Additionally, exchange rate risk is a key element related directly to
the costs and profits for importers, exporters as well as foreign investors. Furthermore,
it is argued that developing countries have tendency to devaluate their currency in
order to gain the relative competition. Given the importance of exchange rate in the
economy, issues in relation to exchange rate attract my interest and that this a key
reason for my choice to make a topic for the thesis.
In February 2014, with the opening of the first ever branch of McDonald’s, a
giant US fast-food company in Ho Chi Minh City, Viet Nam, the Economists
Magazine have added the Vietnam Dong (VND) to its collection of Big Mac Index
(BMI). This index provides McDonald’s burger prices in all different parts of the world
in terms of local and foreign currencies. The index is considered as a lighthearted guide
in order to evaluate whether a currency of a particular country of interest is at its
correct level. The index has been increasingly well-recognized as a global standard
with its existence in several international economics books and many academic studies.
The thesis aims to evaluate the real value of Thailand Baht and to consider the
link between Thailand Baht depreciation and Thailand’s trade balance. Thailand is
opted to study due to several reasons. First, according to Bahmani-Oskooee and
1


Kantipong (2001), Thailand has an intense motivation to devaluate her currency owing
to the fact that after Asian currency crisis, Thailand was one of the most suffered
countries in comparison with other nations in the Asian region. Consequently, it lost
market shares of many export products and services to China and other ASEAN
countries. As a consequence, the country suffered a severe deficit in its trade of
balance. Therefore, the strategy of devaluation would allow Thailand increasing her
regional competitiveness, recovering her lost market shares, and improving the trade

balance (Bahmani-Oskooee and Kantipong, 2001). Second, earlier researchers cast
doubt on whether the Consumer Price Index (CPI) reflects the real exchange rate in the
economy. In this study, the Big Mac Index (BMI) is used as an appropriate substitute in
lieu of the CPI to re-examine the roles of the exchange rate to the Thailand economy.
The use of the BMI, the first attempt of this kind in emerging country, is argued to be
an advance. From that, a comparison between BMI-based exchange rate and CPIbased exchange rate in regardless of Thailand’s trade balance is made.
This thesis provides key advantages compared to previous studies. First, earlier
works investigated the link between real devaluation and trade balance without testing
whether the currency used in the study is over- or under-value, so their results are
ambiguous. In this paper, the valuation of a currency is conducted before it is used to
consider the influences of devaluation on trade balances for a particular nation. Second,
the Big Mac index is initially applied in the contexts of real exchange rates and trade
balances although a majority of authors have exploited this index for testing purchasing
power parity (PPP), forecasting the trend of exchange rate (Ong, 1997; Yang, 2004;
Cumby,1996; Clements & Lan, 2010). Clements and Lan (2010) and Ong (1997)
argued that Big Mac index offers a sense of simplicity and creates a surprisingly
accurate result. Third, to control the fact that exchange rates are endogenous to trade
balances, this study applied panel data estimation using the fully modified ordinary
least squares (FMOLS) method offered by Phillips and Hansen (1990) and expanded
2


by Pedroni (2000) to re-examine the link between currency devaluations and trade
balances.

1.2

Research Objectives
This thesis aims to consider two main objectives. The first objective is to evaluate

whether Thailand currency is under or over- valued in comparison with other
currencies during surveyed periods on the Purchasing Power Parity (PPP) theory in the
case of Thailand Baht. In addition, the comparison of real bilateral exchange rate based
on BMI and CPI is made. The second aim of this thesis is to consider the link between
a currency’s devaluation on trade balance in Thailand.
To achieve the above-mentioned objectives, specific research questions are
raised, including:
i.

Does PPP hold in the case of Thailand currency?

ii.

Is the Thailand Baht under- or over-evaluated against other currencies?

iii.

Are there any differences between BMI-formed and CPI-based real exchange
rates in the test of PPP and the evaluation of Thailand Baht?

iv.

What factors determine the Thailand trade balance?

v.

Is there any long run relationship between real bilateral exchange rate and
Thailand’s trade performance?

1.3

The Structure of the Thesis
This thesis concludes six main chapters. Following the Introduction chapter, the

rest of the thesis is organized as follows.


Chapter II presents literature review with both theoretical and empirical
considerations. The chapter begins with the discussion on a theory of PPP and
the devaluation theory on trade balance. Then, the framework of
3


determination of trade balance is depicted. Next, the relationship between
bilateral exchange rate and trade performance is analyzed. Finally, empirical
studies in relation with these theories are also presented.


Chapter III provides a brief overview of trade performance in Thailand and
the development of Big Mac Index in recently decades.



Chapter IV discusses the methodology adopted in the thesis. This chapter
focuses on the research methodology, which leads to mathematical equations
and empirical models.



Chapter V presents description of data and research findings. Sources of data

are acknowledged, together with description of statistics. Empirical findings
from this study are then presented following a comparison between the
findings from this study and those from previous studies.



Chapter VI provides a summary of conclusions, which are drawn from this
study for Thailand. Limitations of this study and ways for future research are
added at the end of the thesis.

4


CHAPTER 2
LITERATURE REVIEW
This chapter presents theoretical backgrounds and empirical studies associated
with purchasing power parity (PPP) theory, determinants of trade performance, and the
relationship between a currency devaluation and trade balance.

2.1 Theoretical Grounds
2.1.1 PPP Theory
This section provides an overview of the PPP theory by presenting two versions
of the theory, known as the absolute PPP and the relative PPP.
The absolute PPP relates to the relationship between nominal exchange rate and
the corresponding to relative price level in terms of level form. Meanwhile, the relative
PPP expresses this relationship as the first difference form, meaning that percentage
change in the exchange rate between two currencies over any period approximately
equals the difference between the percentage changes in the national price levels
(Krugman et al 2012, p.387).
In term of the absolute PPP, where 𝑞𝑖𝑡 represent the real exchange rate of country

i in year t; 𝐶𝑃𝐼𝑖𝑡 and 𝐵𝑀𝐼𝑖𝑡 are the Consumer Price Index and the Big Mac Index in
country i in year t. 𝐶𝑃𝐼𝑡𝑇ℎ𝑎𝑖 and 𝐵𝑀𝐼𝑡𝑇ℎ𝑎𝑖 are the Consumer Price Index and Big Mac
Index in Thailand in year t. The ratio of 𝐶𝑃𝐼𝑖𝑡 to 𝐶𝑃𝐼𝑡𝑇ℎ𝑎𝑖 and the proportion of
𝐵𝑀𝐼𝑡𝑇ℎ𝑎𝑖 to 𝐵𝑀𝐼𝑖𝑡 illustrate the relative prices between a foreign country and Thailand
in term of CPI and BMI. ERit is the bilateral nominal exchange rate, defined as a
number of Thailand Baht per unit of partner i’s currency.
5


The original equations are presented as follow:
𝐸𝑅𝑖𝑡 = 𝐶𝑃𝐼𝑖𝑡 − 𝐶𝑃𝐼𝑡𝑇ℎ𝑎𝑖 + 𝜖_𝑐𝑝𝑖𝑖𝑡
𝐸𝑅𝑖𝑡 = 𝐵𝑀𝐼𝑡𝑇ℎ𝑎𝑖 − 𝐵𝑀𝐼𝑖𝑡 + 𝜖_𝑏𝑚𝑖𝑖𝑡

(2.1.1)
(2.1.2)

Taking natural logarithms, the equation become
𝑞_𝑐𝑝𝑖𝑖𝑡 = 𝑙𝑜𝑔

𝐶𝑃𝐼𝑖𝑡
𝐶𝑃𝐼𝑡𝑇ℎ𝑎𝑖

𝑞_𝑏𝑚𝑖𝑖𝑡 = 𝑙𝑜𝑔

− 𝑙𝑜𝑔 𝐸𝑅𝑖𝑡

𝐵𝑀𝐼𝑡𝑇ℎ𝑎𝑖
𝐵𝑀𝐼𝑖𝑡

− 𝑙𝑜𝑔 𝐸𝑅𝑖𝑡

(2.1)
(2.2)

Where 𝑞_𝑐𝑝𝑖𝑖𝑡 and 𝑞_𝑏𝑚𝑖𝑖𝑡 respectively represent the error terms of CPI and BMI
in terms of natural logarithms.
A currency is considered to be overvalued if 𝑞𝑖𝑡 is positive, undervalued if 𝑞𝑖𝑡 is
negative, and at parity if 𝑞𝑖𝑡 equals zero.
When it comes to the relative PPP, equation (2.1) and (2.2) are transformed as
follows:
∆𝑞𝑖𝑡_𝑐𝑝𝑖 = ∆𝑙𝑜𝑔

𝐶𝑃𝐼𝑖𝑡
𝐶𝑃𝐼𝑡𝑇ℎ𝑎𝑖

∆𝑞𝑖𝑡_𝑏𝑚𝑖 = ∆𝑙𝑜𝑔

− ∆𝑙𝑜𝑔 𝐸𝑅𝑖𝑡

𝐵𝑀𝐼𝑡𝑇ℎ𝑎𝑖
𝐵𝑀𝐼𝑖𝑡

− ∆𝑙𝑜𝑔 𝐸𝑅𝑖𝑡

(2.3)
(2.4)

The law of one price states that without transaction cost and international trade
barriers, identical goods traded in different nations must sell at the same price when
their prices are expressed in term of the same currency (Krugman et al 2012, p.385).

2.1.2 Alternative Approaches to Devaluation Theory
On the theoretical ground, the effect of currency devaluation could be established
on three approaches including elasticity, income-absorption, and monetary. Each of
these approaches is briefly discussed in turn below.
6


2.1.2.1 The Elasticity Approach
The traditional exchange rate model is the elasticity approach, which puts the
emphasis on the condition of supply and demand sides to exports and imports. On the
export side, it is assumed that the depreciation has a tendency to initially decrease
foreign prices of the export county so that the price reduction would increase foreign
demand for the devaluating nation. How much the export would adjust depends upon
the foreign demand and domestic supply elasticity for exports. Concomitantly, on the
import side, when a devaluation of domestic currency causes a rise in the domestic
price of imports. Thus, this leads to a reduction in a country’s demand for imports,
which in turn may seem to decrease the foreign price of imported products. How much
the import would alter relies on the domestic demand and foreign supply for imports.
Hence, in the context of the elasticity approach, the responds of trade flows to
exchange rate adjustment depend on the elasticity of demand and supply both of
domestic and of foreign country. The key issue of this method is postulated as
Marshall-Lerner (ML) condition. This widely-recognized condition states that when
the current account begins at an equilibrium position, the devaluation will increase
trade flows in the case of the total of (i) price elasticity of domestic demands for
imports and (ii) price elasticity of foreign demand for exports in absolute terms exceeds
unity. In such situation, the greater of the total of the two elasticities is, the more
significant the exchange rate depreciation influences on the trade balance.
In contrast, the devaluation would deteriorate the balance of trade when the total
of these two elasticities is smaller than unity (Salvatore 2012 p.516). After

depreciation, it is observed that the balance of trade initially worsens before achieving
an improvement This is known as the so-called J-curve phenomenon. This
phenomenon happens because of time lags in recognition, decision, delivery,
replacement, and production (Junz & Rhomberg, 1973). The J-curve phenomenon also
7


results from currency pass-through, meaning that the depreciation’s influence on trade
balances might rely on how quickly manufacturers transfer changes in costs to their
consumers (Salvatore 2012 p.524).
On the ground of the mathematical model (Johnson, 1975; Salvartore, 2012
p.524), the effect of devaluation on the trade balance will be modelled in term of the
elasticity approach.
1

𝑝

𝑟

𝑟

𝐵𝑓 = 𝑝𝑥 𝑋 {𝑋𝑠 (𝑝𝑥 ) = 𝑋𝑑 ( 𝑥)} − 𝑝𝑚 𝑀{𝑀𝑑 (𝑟𝑝𝑚 ) = 𝑀𝑠 𝑝𝑚 )}

(2.5)

where 𝐵𝑓 is the trade balance expressed in foreign currency, r is the foreign
exchange rate defined as number of units of domestic currency per unit of foreign
currency, 𝑝𝑥 and 𝑝𝑚 are respectively import and export prices in term of domestic
currency, and X and M are correspondingly import and export volume, d and s
represent for the demand and supply function.

Differentiating equation (2.5) by r, the result is as below:
𝑟 2 𝑑𝐵𝑓
𝑝𝑥 𝑋 𝑑𝑟

=

𝑟 𝑑(𝑝𝑥 𝑋)
𝑝𝑥 𝑋

𝑑𝑟

+

𝑝𝑚 𝑀
𝑝𝑥 𝑋

(− 𝑝

𝑟

𝑚𝑀

𝑑(𝑝𝑚 𝑀)
𝑑𝑟

)−1

(2.6)

Assuming 𝑟 = 𝑝𝑥 = 𝑝𝑚 = 1 and trade is initially balanced (X=M), equation (2.6)

then becomes:
1 𝑑𝐵𝑓
𝑋 𝑑𝑟

= 𝐸𝑑𝑓 + 𝐸𝑑𝑑 − 1

(2.7)

where 𝐸𝑑𝑓 , 𝐸𝑑𝑑 are respectively the elasticity of foreign and domestic demands.
To derive the Mashall-Lerner condition mathematically, equation (2.5) is
differentiated in term of individual good markets to quantity. The elasticity of the
domestic price of export with respect of the exchange rate is:
𝑟 𝑑𝑝𝑥
𝑝𝑥 𝑑𝑟

=

𝑛𝑥

(2.8)

𝑛𝑥 +𝑒𝑥

8


where 𝑛𝑥 , 𝑒𝑥 are the price elasticity of demand and supply for exports, measured
by the percentage change in export quantity for a given percentage change in export
price.
𝑝𝑥

𝑛𝑥 = −

𝑑𝑋𝑑

𝑟

𝑋

𝑝
𝑑( 𝑟𝑥 )

𝑎𝑛𝑑 𝑒𝑥 = −

𝑝𝑥 𝑑𝑋𝑠
𝑋𝑠 𝑑𝑝𝑥

(2.9)

Similarly, the elasticity of the domestic price of import with respect of the
exchange rate is as follows:
𝑟 𝑑(𝑟𝑝𝑚 )
𝑟𝑝𝑥

𝑑𝑟

=

𝑒𝑚

(2.10)

𝑛𝑚 +𝑒𝑚

where 𝑛𝑚 , 𝑒𝑚 are the price elasticity of demand and supply for imports,
measured by the percentage change in import quantity for a given percentage change in
import price.
Finally,

−

𝑟

𝑑(𝑋𝑠 𝑝𝑥 )

𝑋𝑠 𝑝𝑥

𝑑𝑟

𝑟

𝑑(𝑀𝑑 𝑝𝑚 )

𝑀𝑑 𝑝𝑚

𝑑𝑟

= (𝑒𝑥 + 1)

𝑟 𝑑𝑝𝑥

(2.11)

𝑝𝑥 𝑑𝑟

= 1 − (1 − 𝑛𝑚 )

𝑟

𝑑(𝑟𝑝𝑚 )

𝑟𝑝𝑚

𝑑𝑟

(2.12)

Substituting equation (2.11) and (2.12) into equation (2.6) with the presumption
of 𝑟 = 𝑝𝑥 = 𝑝𝑚 = 1 and X=M, it could be obtained that:
1 𝑑𝐵𝑓
𝑋 𝑑𝑟

=

𝑛𝑥 (𝑒𝑥 +1)
𝑛𝑥 +𝑒𝑥

+

𝑛𝑚 (𝑒𝑚 +1)

𝑛𝑚 +𝑒𝑚

−1

(2.13)

After transforming, equation (2.13) becomes
1 𝑑𝐵𝑓
𝑋 𝑑𝑟

=

𝑒𝑥 𝑒𝑚 (𝑛𝑥 +𝑛𝑚 −1)+𝑛𝑥 𝑛𝑚 (𝑒𝑥 +𝑒𝑚 +1)
(𝑛𝑥 +𝑒𝑥 )(𝑛𝑚 +𝑒𝑚 )

9

(2.14)


From equation (2.14), the trade balance enjoys an improvement when 𝑛𝑥 𝑛𝑚 >
𝑒𝑥 𝑒𝑚 and the Marshall-Lerner stability condition is satisfied. In the case of the sum of
the elasticities of demand for imports and demand for exports exceed than 1 (𝑛𝑥 +
𝑛𝑚 > 1), the effectiveness of devaluation is experienced when elasticities of supply for
imports and supply for exports are infinitely elastic (𝑒𝑥 = 𝑒𝑚 = ∞).
If the depreciation takes place from the condition of trade deficit (X>M), the trade
balance would improve as if the elasticity of demand for imports should be given a
proportionally greater weight than the elasticity of demand for exports.
𝑛𝑥 +

𝑀𝑝𝑚
𝑋𝑝𝑥

𝑛𝑚 > 1

(2.15)

2.1.2.2 The Absorption Approach
The second approach explaining influences of devaluation on trade balance is the
absorption approach, which stresses how the devaluation affects expenditure behaviors
of domestic nation, and thus affects trade balances. The trade balance is estimated by
taking the difference between total aggregate demands and domestic absorption,
measured by consumption, investment, and government purchases. Therefore, if total
output exceeds internal absorption, the balance trade is positive and vice versa. The
absorption approach states that the devaluation increases the trade balance when the
economy is performing under its capacity. However, the economy produces more
domestic output than its capacity; devaluation would increase not only trade balance
but also inflation.
The absorption approach is proposed by Alexander (1952) and further developed
in Alexander (1959). The trade balance is generally defined as the difference between a
total domestic production and a sum of goods and services domestically consumed. On
the light of devaluation effects on trade balance, Alexander (1952) proposed two
channels. The first is an indirect channel, in which a currency’s devaluation leads to a
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change in the production of goods and services before altering the absorption of goods
and services, and the second is a direct path, in which the devaluation may
straightforwardly change the amount of real absorption at any real income level. On the
direct channel, the principle influence of devaluation on output is related to an increase

in exports, and thus resulting in an induced stimulation of internal demand, together
with the terms of trade effects under which presumed that devaluation causes a
decrease in export prices greater than a fall in import prices in term of foreign
currency. On the direct channel of devaluation to absorption, devaluation has generally
resulted in rising price level to discourage consumption or investment at a given real
output level. The most generally recognized impact associated with direct absorption is
the cash balance effect. When price rises and money supply is inflexible, individuals
have to accumulate cash to satisfy their desire to maintain their wealth at certain real
level, consequently leading to a reduction in their real spending relative to their real
income. The cash balance effect may either influence directly the income-spending
association through a reduction of spending in order to build up cash, or indirectly
through the interest rate on the purpose of transferring assets into cash (Alexander,
1952).

2.1.2.3 The Monetary Approach to Devaluation Theory
The most third common-used approach is the monetary approach studying in a
broaden concept of balance of payments. This approach had been emerged during
1960s by Robert Mundell and Johnson and fully developed during 1970s. The
monetary approach considers balance of payments as an essentially monetary
phenomenon on the view of international economics (Salvatore, 2012 p.509)
This approach supposes that devaluation may lead to a temporary increase in the
balance of payments rather than a permanent improvement. An explanation is that
devaluation would push up the domestic consumer price, raise the demand for money,
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and eventually lead to an increase in interest rate. As a result, this draws the capital
inflows from abroad. However, in the long run, capital inflows would result in an
increase in domestic expenditure and imports of goods and services, and this makes
balance of payments return to its initial level. Hence, depreciation has effects on

balance of payments temporarily, and it causes the higher consumer prices
permanently.

2.2 Conceptual Framework
Based on the theoretical ground, the conceptual framework is presented in Figure
2.1 below.
Figure 2.1: Conceptual framework for exchange rate effects on trade balance
Government

Money supply

expenditure

Income (GDP)

Interest rate

Exchange rate

Term of Trade

Trade balance

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Price index


2.3 Empirical Reviews
2.3.1 Test of PPP Theory

It is indispensable that exchange rate have been seen one of the most popular
issues in international economics, which gains a numerous interest in economics
researchers. Recently, there are two emerging schools using panel data for the test of
PPP theory: (i) panel unit root tests and (ii) panel co-integration tests.
On the first school, Oh (1996) made an argument that unit root tests using the
panel data were more powerful in comparison with that of conventional univariate time
series. The author explicitly found the evidence in favor with PPP for G-6 and OECD
nations during the period of flexible exchange rate. Wu (1996) offered further support
for Oh’s (1996) argument by demonstrating that the failure to prove an evidence of
long-run PPP as reported by early researcher may result from the low power of
standard univariate unit root tests. With the same technique as Oh (1996) and Wu
(1996), Papell (1997) examined the long-run PPP for industrial nations over the period
of floating exchange rate regimes. The findings showed that the null hypothesis of unit
roots had a stronger tendency to be rejected for large than small panels, for monthly
than for quarterly data, and for German mark using as a base currency rather than for
the US dollar. Similarly, Connell (1998) was in support of the stationary of unit root
with the quarterly panel data of 64 countries. The author found the similar results when
divided the whole sample into four subsamples including Europe, Asia, South
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America, and Africa. In comparison with earlier studies, his method had an advantage
of controlling cross-sectional dependences in the data, which raised significance level
of tests with a normal size of 5 percent up to 50 percent. To sum up, on the first school,
the majority of studies found the supportive proof of PPP thanks to the power of panelbased unit root tests although the results tend be sensitive to inclusion of different
subsamples.
Another school of examining long run PPP has been employed the panel
cointegration test, developed and published in Pedroni (2000, 2001, 2004). There are a
numerous researchers of this school, representative are Cazoneri et al (1999), and
Pedroni (2001, 2004). Such researchers found valid evidences to reject the null

hypothesis of no cointegration, thus reinforcing the weaker version of PPP with
heterogeneous slope coefficients.
With the development of panel econometrics technique, a number of empirical
papers provide a supportive confirmation that the PPP holds in the long run. A
common explanation for the support of PPP is the power of panel tests (Oh, 1996; Wu
1996; & Connell 1998). Papell (2002) offered a different reason why PPP holds with
panel data; the great appreciation and depreciation of currencies adhere to typical
patterns of the dollar’s fall and rise. However, it should be noted other issues hurting
the validity of PPP tests. Benergiee et al (2005) put an emphasis on an important
underlining of cross-unit cointegrating relationship with panel-based unit root tests so
that the use of panel methods for testing unit roots should be cautious. Papell and
Theodoridis (2002) pointed out that the choice of a currency in panel methods
significantly influenced results of PPP testing, together with distances between nations
and the volatility of exchange rate. Taylor and Taylor (2004) presented a summary of
debate associated with PPP that have been challenged academic researchers during
three recent decades.
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2.3.2 Evaluation of a Currency
The basic idea of evaluating a currency is to find out the difference between the
equilibrium exchange rates and its actual value or “misalignment”. The currency is
called overvaluation if the equilibrium levels exceed its actual values and
undervaluation if the equilibrium levels are smaller than actual values. Based on the
principle, researchers attempt to identify the equilibrium of exchange rates with a
variety of approaches.
Chinn (2000) implemented three major procedures including (i) long-run PPP, (ii)
a productivity-based model, and (iii) a monetary model to estimate the equilibrium
exchange rate of East Asian currency. The authors attempted to prove the East Asian
financial crisis in 1997 owing to currency overvaluation. The results found that most

selected currencies had been overvalued before the 1997 financial crisis happened. The
PPP and productivity-based approaches indicated closely conclusions in which
currency of Hong Kong, Thailand, Malaysia, Indonesia, and Taiwan were overvalued
and the Korea’s Won was undervalued. The overvaluation of Malaysia’s Ringgit and
Thailand’s Bath were small. The study of Jonwanich’s (2008) for evaluating of
Thailand Bath provides consistent findings of Chinn (2000).
Unlike Chinn (2000) studies, Rajan et al (2004) identified misalignments of
Thailand’s currency in terms of economic fundamental model and examined effects of
misalignments on trade performance during 1980s and 1990s. The authors used both
real effective exchange rate and bilateral real exchange rate against US dollar and
Japanese Yen. The findings indicated that the real exchange rate and bilateral exchange
rate against US dollar had a moderate misalignments while the misalignments was
significant for bilateral exchange rate against Japanese Yen, thus leading to a widening
deficit in trade between Thailand and Japan during 1990-1996 periods.

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On the base of equilibrium exchange rate theory, Zhang (2001) estimated
behavior of China’s currency, Renminbi, and its misalignments. The evidence
illustrated that the Renminbi was overvalued during central planning periods in China
and converged to the equilibrium level after China’s economic reforms. Yang (2004)
first applied BMI to analyze of China’s currency and showed that the Renminbi was
undervalued. However, Cheung et al (2007) casted doubt on the conventional wisdom
of undervaluation of Renmini, asserting that when the uncertainty and serial correlation
in data accounted for, there was little evidence that China’s currency was undervalued.
To summarize, there are numerous approach for evaluation of a currency.
Depending on valuation methods and periods, results have been mixed.

2.3.3 Determinants of a Trade Balance

As previously discussed in the theoretical sections, the trade balance is
determined on the ground of three well-known approaches including elasticity,
absorption and monetary. The elasticity approach indicates that exchange rate serves as
a main factor of trade balance and proposes depreciation as an effective way to deal
with trade deficit. The absorption approach provides income as a major element in
explaining trade performance and suggests that any income-related policy like
contractionary fiscal policy could cope with trade deficit (Alexander, 1952).
Meanwhile, monetary approach takes money supply into consideration of trade
disequilibrium and favors the use of monetary policy to correct deficit of balance of
payments. Therefore, exchange rate, income, money supply are such fundamental
determinants of trade balance. Additionally, it is worth noting that factors associated
with fiscal and monetary policy that have been used to correct trade deficit are vitally
important.

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