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R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e

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Table of Contents
1.

2.

3.

BACKGROUND................................................................................................. 2
1.1.

Introduction............................................................................................... 2

1.2.

Statement of Problem............................................................................... 3

1.3.

Objectives of the Study.............................................................................3

1.4.

Organization of the Study.........................................................................4

LITERATURES REVIEW...................................................................................... 5
2.1.

Introduction............................................................................................... 5

2.2.

Theoretical Literature................................................................................5

2.3.

Empirical Literature................................................................................... 6

METHODOLOGY............................................................................................... 9
3.1.

Introduction............................................................................................... 9

3.2.

Data.......................................................................................................... 9

3.3.

The Model................................................................................................. 9

3.4.

Methods of Estimation............................................................................. 12

4.

FINDINGS AND DISCUSSION..........................................................................15

5.

CONCLUSION................................................................................................. 15

REFERENCES........................................................................................................ 16

1. BACKGROUND
1.1.Introduction
There is this tacit understanding in devaluation of a currency where it is
used as a mechanism to improve balance of trade. Exports prices become
cheaper while imports prices increase as the value of local currency drops.
Consequently, the trade balance improves. However, the effect of exchange rate
on trade balance might vary from a country to a country due to different level of
economic development. One of the notable effects is the Marshall-Lerner
condition. This condition states that when the sum up value of import and export
demand elasticity is equal to, or greater than 1, the devaluation in currency
exchange rate will cause trade balance to increase (Chen & He, 2011).
Malaysia's ringgit had the biggest two-day decline since the 1997-98 Asian
financial crisis recently as reported by Y-Sing and Han (2014). The ringgit fall 2.4
percent to 3.4300 per US Dollar on Monday December, 1 st at closing, from 3.3465
per US Dollar on Thursday November, 27th at closing. The depreciation in ringgit
is due to a ripple effect of declining in world price of oil. The declining in price of

and tax for the government also will increase. This whole scenario is known as J-curve. none could be found comparing these effects between Malaysia. and Thailand. these numbers might improve after some time. salaries. He mentioned that the ringgit would remain stable in the long term and Malaysia's economy would grow within government's expectation in 2015. On the other hand. Ministry of Finance (MOF) and the Economic Planning Unit (EPU) of the Prime Minister's Department to analyse the advantages and disadvantages of depreciation in ringgit towards the economy.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 2 Brent crude oil of 38 percent from its June high thus reducing the country’s revenue as oil is one of Malaysia's main exports.Statement of Problem Devaluation in currency would increase the price of imported goods and at the same time decrease the price of domestic goods. bonuses. this situation is said to be beneficial for tourism and exports as well as certain sectors. Indonesia. Deputy Finance Minister Datuk Ahmad Maslan said to Bernama that it will not harmfully affect Malaysia's economy. manpower. It is also significant for researchers to determine whether J-Curve effect exists following the depreciation in currency. Despite shrinking in ringgit. Minister of International Trade and Industry. however. . Due to the above situation. Hence. Indonesia and Thailand have been chosen due to the fact that they are Malaysia’s neighbouring countries and the two countries share similar economic environment. He also mentioned that there is no possibility to peg the ringgit against US dollar as the move has its own benefits and drawbacks. Besides that. Due to the expansion in export sector.2. This situation has made it harder for government to achieve its fiscal deficit target. a country's export sector also could be developed as its exports to foreign countries will be much cheaper. it is important for government and related regulatory bodies to come hand in hand investigating the relationship between real exchange rate and trade balance and check whether the depreciating currency is good or bad and if it has a positive effect towards the economy. the amount of export and import may not react at initial period of devaluation. Worse thing to happen is that trade balance may be falling first due to decrease in value of export and increase in value of import. Datuk Seri Mustapa Mohamed said to Bernama that currently a joint study has been conducted between Bank Negara Malaysia. company profit. However. There have been numerous studies focusing on the impacts of exchange rate volatility on balance of trade. It must be noted that although the currency's devaluation might have positive influences towards economy. Main focus of this paper would be Malaysia while Indonesia and Thailand will be used to compare their results with Malaysia. In addition. local manufacturing sector can be expanded. 1.

Organization of the Study This paper is structured into several sections. Finally. this study also targets to determine whether Marshall-Lerner condition and J-Curve exist in these three countries during the study period.4.Objectives of the Study The main aim of this paper is to investigate the relationship between the real exchange rate and trade balance in Malaysia.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 3 1. In addition.3. 1. section 4 will be the findings and discussion. section 3 will have discussion on model and methods of estimation being used in this study. Next. and Thailand from year 1990 until 2014. section 2 discuss further on theoretical and empirical literature review. . Indonesia. section 5 will be the conclusion from this study. After that. After introduction.

On the other hand. As a result.2. export volume and value also rise over time because the price elasticity of foreign import demand is larger in the long run than in the short run. the balance of trade in real terms deteriorates in the short run. and Thailand. There is only a small immediate impact on the volume of trade flows. less foreign goods are obtained because of their higher prices. the Marshall-Lerner condition is a condition of stability. A J-curve as defined by Rose and Yellen (1989) is the combination of a negative short-run derivative with a positive long-run derivative. little studies could be found on comparing the intended results between the three sample countries. If the real exchange rate increases for the home country i. As a result. Lerner (1944) mentioned that lower prices in the domestic country will generally increase foreign demand for domestic country’s good. Malaysia. The next subsections will discuss on theoretical literature and empirical literature related to the topic of this research. the price change in the domestic market will change the domestic consumer’s behaviour. A fluctuation in the exchange rate affects both the value and volume of trade. The consumers will then switch to consume domestic goods rather than foreign goods causing the value of imports to decrease. Indonesia. If the elasticity of demand for imports is greater than zero by the same amount as the elasticity of demand for exports is less than one.1. because prices of export goods are sticky in sellers’ currencies. the depreciation will have no effect on the trade balance. Therefore. According to Borkakoti (1998).R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 4 2. thus the short-run response . but only if the foreign elasticity of demand is elastic. then the two elasticity of demand will add up to one. the value of exports rises only slightly. A typical J-curve scenario according to the authors is illustrated as follows: the initial effect of depreciation is to raise the domestic prices of imported goods. if the domestic demand for foreign goods is elastic. LITERATURES REVIEW 2. the trade theory declares that the exchange rate can affect a country’s imports and exports.e.e. Therefore. i. the increased price of imports eventually reduces import volume.Theoretical Literature Setting all other variables fixed. if there is a real depreciation. the effect is upturned over time although the depreciation has an initially negative impact on the real trade balance. whereas the value of imports rises substantially due to the increased cost of an unchanged quantity of imports. 2. resulting to a cumulatively positive effect.Introduction Despite so many studies done on finding the relationship between real exchange rate and balance of trade. the households in the home country can obtain less foreign goods and services in exchange for a unit of domestic goods and services. Henceforth. As time passes.

The author mentioned that these effects might be caused by “small” country pricing of exports in foreign currency. quarterly data also was used to confirm the annual results. Malaysia. Nevertheless. The author used annual data that covered 30 countries from 1970 until 1988. He found that there is no significant impact of real exchange rate on the real trade balance.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 5 is ‘perverse’. he discovered that there are some J-curve effects for Korea pertaining to both Japan and the USA. The graph below is author’s own interpretation based on Rose and Yellen (1989). and Korea to the USA and Japan on a quarterly basis over the period 1970 to 1996. t0 is the time of depreciation. however. It was discovered that the exchange rate does not have perverse impact on the trade balance. 2. The graph of the response of the trade balance over time to a onceand-for-all real depreciation resembles a ‘J’ tilted to the right.3. 2001) derived from the two-country imperfect substitute model. He also mentioned that there is no evidence for J-curve on Singapore and Malaysia. he found no evidence that imports later fell as the lag length on the . Besides that. TB Trade t0 t Figure 1 Sketch of the J-curve effect.Empirical Literature Rose (1990) examined the empirical impact of the real exchange rate on the trade balance on various developing countries. They used partial reduced form model of Rose and Yellen (1989) (as mentioned in Wilson. Wilson (2001) studies the effect of real exchange rate on the real trade balance for bilateral trade in merchandise goods for Singapore.

the exchange rate depreciation does improves trade balance. They used Johansen co-integration analysis to investigate the long run impact of the exchange rate on trade balance together with the autoregressive distributed lag (ARDL) approach. The error correction model is used to determine the short term impact and the related J-curve pattern. no Jcurve effect was found on the short-run analysis. In addition. the depreciation in exchange rate giving rise to a J-curve effect. There was a delayed J-curve effect during the 1997:1 to 1998:2. 2001). Another study has been done by previous researcher that explored the balance of trade model on Indian data from 1960 to 1995 using a reduced-form specification similar to Rose (1991) (as mentioned by Singh. Instead of focusing on nominal exchange rate. This is might be due to the fact that there is a weak relationship between changes in the exchange rate and changes in export and import prices and volumes for Singapore. there were similarities of exchange rate impact on the balance of trade as well as the domestic output. 1977:1-1998:2 and the extended model from 1977:1 to 2001:4 which includes the period of fixed exchange rate regime. Yusoff (2010) examined the impacts of changes in the real exchange rate on the real Malaysian trade balance and the domestic output using quarterly data during the pegged exchange rate regime. specifically the trade weighted real effective exchange rate. Singh (2002) suggested that policy makers and authorities focus more on the real exchange rate. the authors discovered there is little evidence of a J-curve effect. In addition. . The researcher found that in the long run.S. however. The authors found out that in the long run. 2002). The researcher found that the real exchange rate has significant impact on the trade balance compared to nominal exchange rate. It was not clear whether “small country” pricing by exporters in U. balance of trade in India also being influenced by domestic income. They found that there is no significant impact of the real exchange rate on the bilateral trade balance for Singapore and the USA. Petrović and Gligorić (2010) were interested in finding whether and how depreciation in exchange rate as well as its appreciation affects trade balance in Serbia. Besides that. which would be required to support a strict interpretation of the J-curve. both in the long run and short run which covers from January 2002 to September 2007. whilst in the short run. Wilson and Tat (2001) studied the relationship between the real trade balance and the real exchange rate for bilateral trade in merchandise goods between Singapore and the USA on a quarterly basis over the period 1970 to 1996 using the partial reduced form model of Rose and Yellen (1989) (as mentioned by Wilson and Tat. depreciation in real exchange rate improves the Malaysia's trade balance.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 6 real exchange rate increased. dollars masked J-curve effect from initial rise in import values when Singapore dollar depreciated.

R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 7 .

determining the relationship of real exchange rate on balance of trade as well as finding the existence of J-curve effects between the three countries. ε ) .1.3.r )+G−ℑ ( Y . Har and Tan (2009) as well as Gómez and ÁlvarezUde (2006) which emphasized in exchange rate on bilateral trade balance evidence. rate. signifies government spending. this is one of the reasons that support this research to study whether there is relationship between real exchange rate and the balance of trade. For this paper. 3. 3. In general. G I C signifies consumer spending. where: Y and T signifies total domestic income. Consumers spending ( C ) is derived from total income minus income tax. equilibrium goods market in an open economy can be explained by the following equations: Y =C (Y −T )+ I ( Y .R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 8 3. ε signifies export. X r signifies investment.The Model The modelling on the relationship between exchange rate and trade balance is discussed by various papers. METHODOLOGY 3. interest rate. or in other words the disposal income ( Y −T ) . domestic and foreign incomes are all in real terms. ε ) + X (Y ¿ .2. There was some striking adjustment in real exchange rate and trade imbalance.e. There is positive relationship occurs between total domestic income and consumer spending due to the fact that higher disposal income result in higher consumer spending besides to increase total domestic income. i. while the consumer price index (CPI) represents as the price deflator. and symbolizes as signifies real exchange Y ¿ signifies foreign income.Data The annual data for this study is obtained from International Monetary Fund (IMF) as well as World Bank. The trade balance. ℑ signifies import. Therefore. signifies income tax. The data used constitutes information from year 1990 until year 2014. .Introduction This section discusses the model and methods of estimation that author used in order to satisfy the objectives of this study. the author specifically refers to research done by Ng.

Therefore. ¿ Export ( X ) depends on the foreign income ( Y ¿ and real exchange rate ( ε ). Hence. Higher ε signifies lower quantity of imports due to the fact that foreign goods become relatively expensive. There is a positive relationship between domestic income and import as the higher the domestic income. On the other hand. people would invest more. it can be reckoned that there is a positive relationship between trade balance. As the objective of this paper is to observe the trade balance (net export: NX ) and the exchange rate. there is a negative relationship between investment and interest rate. foreign income. and real exchange rate. giving: ε= ( E P¿ ) (1) P Import ( ℑ ) is stimulated by domestic income or output ( Y ). Foreign demand for all goods and services will increase when the foreign income is high. when there is an increase in real exchange rate. If there is an increase in total personal income. thus leads to an increase in exports. Nominal exchange rate ( E ) is defined as the number of unit domestic currency exchange for one unit of foreign currency. there is also a negative relationship between import and total domestic income as quantity of import depends on the real exchange rate ( ε ). The real exchange rate ( ε ) is obtained by multiplying the nominal ¿ exchange rate ( E ) with the foreign price level ( P ) and then divide them by the domestic price level ( P ). other variables are assumed constant. there is a positive relationship between investment and total income. it can be concluded that. Thus. The net export is: . In contrast. higher interest rate would decrease total domestic investment. On the other hand.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e Page | 9 Investment ( I ) is a function of total income and interest rate. the higher the imports. In contrast. the relative price of foreign foods in terms of domestic goods also causes export to be increased. It is widely known that lower interest rate attracts more investment as it reduces cost of capital. interest rate ( r ) imposed might distress investment decision.

process. ( 4) P P ) ( ) ¿ is stationary. ln TB t =β 0+ β1 ln Y t + β 2 ln Y ¿t + β 3 ln RERt +ut (6) where ln stands for natural logarithm. The sign of β 1 could be either positive or negative. real exchange rate ( RER t ) is expressed by Malaysian Ringgit (MYR) against United States Dollar (US$) and Y ¿ t is the gross domestic product of United States. Assume EP P E P¿ E P¿ −ℑ Y . following the classical theory.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e EX=I M P a g e | 10 (2) By substituting the function of export and import into equation (2). it means that there is an increase in Yt in the production of import-substituted goods. β 1 is positive. TB t ut is assumed to be a white-noise symbolise the ratio of exports to imports allows all variables to be explained in logarithm form and removes the need for appropriate price index to explain the trade balance in real term. Y ¿ . increase in import volume if the estimate of if Yt which is β 1 is negative. There is an increase in Malaysian real income. In this paper. ε ) (5) Equation (6) shows below is the balance of trade as a function of the levels of domestic and foreign income and the real exchange rate. On the other hand. ε ) −ℑ ( Y . and trade balance. we can rewrite the equation (4) as NX =NX ( Y . ε ) (3) After that. The sign of due to an increase β 2 would depends . it shows NX=X ( Y ¿ . substitute equation (1) into equation (3) ( ¿ NX =X Y .

∆Y t . ∆ RER t . and Johansen-Juselius Test. i. real exchange rate. but there is a tendency to move towards equilibrium. I(0) with E( ut ) = 0. Thus. ut should be tested. If there is any co-integrating regression.Methods of Estimation Augmented Dickey-Fuller (ADF) test and Philips-Perron (PP) is the unit root test that will be used to test the stationary in economic data following the work of Ng. This whole process is to be repeated for Thailand and Indonesia data. RER t . the order of integration of the estimated residual. Error Correction Model. Co-integration analysis is used to determine the long run relationship between TB t . Three methods are used in order to test for co-integration. the Kwiatkowski-Philips-Schmidt-Shin (KPSS) test is used as decisive results. Har and Tan (2009) . Engle-Granger Test. domestic and foreign income. The long run equilibrium may be rarely observed. and have a zero mean. Error Correction Model is used to denote the long-run (static) and short-run (dynamic) relationships between trade balance. the ut should be stationary. MarshallLerner theory holds when β 3 is positive. The equation (8) represents Error Correction Model as: ∆ lnTB t =lagged ( ∆TB t . Unit root test is used to test of stationary. In order to know the disequilibrium error. ∆ Y ¿t ) −λ ut −1+ v t (8) where ut −1 represents the residual term at t−1 in long term. Har and Tan (2009). then disequilibrium errors in equation (7) should form a stationary time series.4. it indicates that depreciation leads to the improvement in the Malaysia’s balance of trade. we rewrite equation (6) as: ut =ln TB t −β 0−β 1 ln Y t −β 2 lnY ¿ t −β3 ln RER t (7) In order to perform Engle-Granger test. Y t and Y ¿t in order to solve the spurious regression problem and violation of the Classical Regression Model. 3.e. If ADF test and PP test show different results.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e P a g e | 11 on whether the supply side factors dominate demand side factors. Engle-Granger Test and VECM are tests to check whether the long-run relationship exists in equation only. Vector Error Correction Model (VECM) is suitable to estimate the effect of exchange rate on trade balance. Following the work of Ng.

For trace statistic. ith ordered eigenvalue from the Π matrix. the number of co-integrating equilibrium relationship between the logarithms of trade balance. and ^λ represents the eigenvalue. r signifies number of long run relationship exist. included of trade balance ( TB ). To use Johansen-Juselius’s method.t=1. where k = 4 (k represents the number of endogenous variables in this research). the Vector Autoregressive (VAR) of the form needed to turn first. the null hypothesis is the number of cointegrating vectors is less than equal to r against an . Two statistics for co-integration used: the trace statistic. ¿ domestic income ( Y ) and foreign income ( Y ). The rank of a matrix is equal to the number of its characteristic roots (eigenvalues) that are different from zero. Both test statistics are the estimated value for the eigenvalue statistic. Z t =[TB RER Y Y ¿ ] . The symbol Π The vector shows how many linear combinations of Zt Zt that are stationary. Johansen-Juselius test will be used to perform hypothesis tests about the number of the long-run relationship exists in equation. Next. The r set from zero to k – 1. the test statistic for co-integration is formulated as g λtrace ( r )=−T ∑ i=r +1 ln ⁡( 1− λ^ i) where T signifies the sample size. Z t =β 1 Z t−1 + β 2 Zt −2+ K + β k Z t−k + v t . For trace statistic. K . and the maximal- λmax .R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e P a g e | 12 as well as Gomez and Alvarez-Ude (2006). T ( 9) into a Vector Error Correction Model (VECM). domestic and foreign national income and real exchange rate should be tested following the Johansen-Juselius’ approach. λtrace . The number of lags is selected based on Akaike Information Criterion (AIC) and Schwarz Criterion (SIC). Thus. real exchange rate ( RER ). which can be written as ∆ Z t=Π Z t −k + Γ 1 Z t−1 + Γ 2 Z t −2+ Γ k−1 Z t−(k −1) + v t (10) The test for co-integration between the Z is computed by looking at the Π rank of the matrix via its eigenvalues.

R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e unspecified alternative. Indonesia. There will be various diagnostic tests to be done before forecasting with the final model in order to confirm the adequacy of representation of the model. impulse response analysis will be used for forecast purpose because the analysis tells the information about interaction among the variables in the system. Autocorrelation LM (LM) test. Portmanteau Autocorrelations (Q) test. in order to analyse the residual. The impulse response function is then will be used to verify whether Jcurve effects exist in Malaysia. r +1 )=−Tln (1− ^λ i) The null hypothesis for maximal-eigenvalue statistic is the number of cointegrating vectors is r against an alternative of r + 1. and Jarque-Bera residual normality test via Cholesky (JBCHOL) and Urzua (JBURZ) factorizations are employed. Finally. the t-test is used. White heteroskedasticity (White). If λtrace equal to zero. For maximal-eigenvalue statistic. so it is a joint test. Afterward. To test the parameter. Pairwise Granger Causality Test will be used to test the direction of causality between two variables. . the test statistic for co-integration is formulated as λmax ( r . thus. all λi P a g e | 13 are also equal to zero. and Thailand.

. indicating that depreciation does improves the trade balance. The results obtain are expected to support the empirical literatures on the Marshall-Lerner condition through VECM. CONCLUSION This paper will focus on the short run and long run effect of the real exchange rate on balance of trade of three countries. i. the author omits this section. 5. Malaysia. It is hope that the results obtained from this research study will help the government and other related bodies to create a policy that focusing on the variable of real exchange rate.e. Indonesia. . This is to ensure that it achieve the desired effects on trade balance.R e a l E x c h a n g e R a t e a n d Tr a d e B a l a n c e P a g e | 14 4. In addition. FINDINGS AND DISCUSSION Disclaimer: Since there is no econometrical or statistical estimation is needed for this term paper. J-curve effects are expected not to exist during the short run period. which is the nominal exchange rate to aggregate price level. In addition. and Thailand in order to test whether Marshall-Lerner condition and J-curve effects exist. the authorities must cooperate between the devaluation-based policies (affected through changes in nominal exchange rate) and stabilization policies (to ensure domestic price level stability) to achieve their targeted level of trade balance.

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