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Currency Devaluation and Trade Balance: Evidence from the US

Services Trade

Ka Ming Cheng

PII: S0161-8938(19)30125-5
DOI: https://doi.org/10.1016/j.jpolmod.2019.09.005
Reference: JPO 6559

To appear in: Journal of Policy Modeling

Received Date: 20 December 2018

Revised Date: 22 August 2019
Accepted Date: 2 September 2019

Please cite this article as: Cheng KM, Currency Devaluation and Trade Balance: Evidence
from the US Services Trade, Journal of Policy Modeling (2019),
doi: https://doi.org/10.1016/j.jpolmod.2019.09.005

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Currency Devaluation and Trade Balance: Evidence from the US
Services Trade
Ka Ming Cheng

Contact Author: Ka Ming Cheng, Department of Economics and Finance, The Hang Seng University of Hong Kong,
Siu Lek Yuen, Shatin, Hong Kong.

E-mail: kmcheng@hsu.edu.hk Tel: 852-39635451

February 2019

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Abstract

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This study aims to revisit the effectiveness of using currency devaluation as a policy tool to improve trade balance
by estimating the exchange rate elasticities of services trade between the US and rest of the world with quarterly
disaggregated services trade data from 1999 to 2015. Empirical results reveal that the impacts of currency

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devaluation on individual services trade are mixed and largely depend on the nature of services. Using currency
devaluation to raise export services trade and reduce import services trade seems to be more effective in the long-run
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but not in the short-run. It is interesting to note that some individual services trades are insensitive to exchange rate
changes. The estimates also reveal that most categories of services trade are income elastic and economic growth
plays a key role in determining the imports and exports of services trade.
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Keywords: Services Trade; Exchange Rate Elasticity; Income Elasticity; Autoregressive Distribution Lag Model
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JEL Classification: C22, F14

1. Introduction
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Using currency devaluation (depreciation) as a policy tool to improve a country’s trade

balance, especially for a country facing persistent trade deficit, has been extensively studied in
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the trade literature. Alexander (1952) points out that the improvement of trade balance may be a

result of switching expenditure from foreign to domestic goods due to a change of terms of trade

following currency devaluation. It is documented that the US trade balance reversed from a

trade surplus in 1970 to a trade deficit in 1971. The US policy makers decided to devalue the
dollar to correct the trade deficit in 1971. However, the trade deficit had not been reduced and

even worsened in the following year. Magee (1973) points out that there exists a J-curve effect

due to pre-arranged currency-contracts followed by pass-through and quantity adjustment lags.

Junz and Rhomberg (1973) also argue that the adjustment of trade flows in response to currency

devaluation is composed of five lags, namely recognition lag, decision lag, delivery lag of

payments, replacement lag and production lag. Magee (1973) and Junz and Rhomberg (1973)

provide reasonable explanations to the short-run deterioration and long-run improvement of trade

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balance following currency devaluation.

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To investigate the effectiveness of currency devaluation as a policy tool to improve a

country’s trade balance, the conventional practice is to estimate the exchange rate (price)

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elasticities. If the sum of absolute value of the exchange rate (price) elasticities of export and
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import demand exceed unity, then it satisfies the Marshall-Lerner condition for an improvement

of trade balance following currency devaluation. In the short-run, both price elasticities of
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export and import demand are inelastic and the sum is less than unity that deteriorates the trade

balance. In the long-run, the price elasticities become more elastic with the sum exceeds unity
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that improves the trade balance. The seminal paper by Magee (1973) sparks a series of studies

on the J-curve phenomenon to investigate the short- and long-run dynamics of trade balance after
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currency devaluation. A vast amount of studies has investigated the impacts of dollar

devaluation to US trade balance, however, empirical results and policy implications are mixed
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(Magee, 1973; Moffett, 1989; Rose and Yellen, 1989; Mahdavi and Sohrabian, 1993; Demirden

and Pastine, 1995; Bahmani-Oskooee and Brooks, 1999; Bahmani-Oskooee and Ratha, 2004;

McKinnon, 2007; Qiao, 2007; Chiu et al., 2010).

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 Most early empirical studies of price or income elasticities are confined to the balance of

trade or trade in goods. Some recent studies start utilizing services trade data to estimate price

and income elasticities (Deardorff et al., 2001; Mann, 2004; Marquez, 2006). Marquez (2006)

points out that services and goods are different in nature and the exchange rate (income) impact

on the trade in goods does not necessary apply to the trade in services. To this end, this study

employs a new approach developed by Cheng, Kim and Thompson (2013) to revisit the

effectiveness of using currency devaluation to improve trade balance by estimating the exchange

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rate (price) elasticities of services trade between the US and rest of the world with quarterly

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disaggregated services trade data from 1999 to 2015. In addition, we also follow the

conventional trade model specification to estimate the income elasticities of services trade.

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Aggregation bias is a major shortcoming of estimating a trade model with aggregate trade
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data (Goldstein and Khan, 1985; Marquez, 2006; Ardalani and Bahmani-Oskooee, 2007).

Estimations with disaggregated trade data may uncover new evidence for the dynamic
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adjustment of individual trade flow to an exchange rate or income shock. In this study, we use

the newly reclassified disaggregated services trade data from the US International Transactions
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Accounts of the Bureau of Economic Analysis (BEA). The US International Transactions

Accounts is restructured in June 2014 and the aggregate services trade is reclassified from five to
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nine major categories. The objective of restructuring the International Transactions Accounts is

to bring the accounts into closer alignment with international guidelines and to provide
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additional details of individual services trade (Borga and Howell, 2014). The import and export

models of services trade are estimated with the aggregate and nine major categories of services

trade data by employing the Autoregressive Distribution Lag (ARDL) cointegration

methodology with bounds testing (Pesaran, Shin, and Smith, 2001) to capture the short- and

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long-run dynamics of the time-path of each individual services trade to an exchange rate or

income shock.

Empirical results show that the sensitivities of individual services trade to exchange rate

changes are mixed. Dollar devaluation may not raise (reduce) export (import) services trade. It

is interesting to note that some individual services trades are insensitive to exchange rate changes.

Their responses to exchange rate changes largely rely on the intangible nature of services that

requires the production and consumption of a service simultaneously (Kimura and Lee, 2006;

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Marquez, 2006). It is evident that the estimation with aggregate services trade data disguises

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more fundamental adjustments at individual services trade level. The estimates also reveal that

most categories of services trade are income elastic. Economic growth is obviously an important

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determinant of imports and exports of services trade; however, individual services trade exhibits
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different degrees of response to income changes.

The following section reviews the literature on different approaches of estimating trade
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elasticities. Section 3 discusses the disaggregated trade data and data sources. Section 4

discusses the econometric model. Section 5 reports the empirical results followed by a
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conclusion.
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2. Literature Review on Different Approaches of Estimating Trade Elasticities

Estimating price and income elasticities, testing the Marshall-Lerner condition and
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detecting the J-curve effect due to devaluation (depreciation) have produced a vast amount of

studies in the trade literature. Most studies on estimations of price and income elasticities adopt

(1) the trade balance, (2) the elasticity or (3) the inpayments and outpayments approach, and

usually under a partial equilibrium model with imperfect substitutes (Goldstein and Khan, 1985).

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 The first group of studies uses the trade balance approach to estimate the trade balance

function to examine an improvement of trade balance that satisfies the Marshall-Lerner condition

(Magee, 1973; Haynes and Stone, 1982; Bahmani-Oskooee, 1985; Rose and Yellen, 1989;

Bahmani-Oskoosee and Brooks, 1999; Boyd, Caporale and Smith, 2001; Onafowora, 2003;

Bahmani-Oskooee, Harvey and Hegerty, 2014). The trade balance model is specified as follows:

B𝑡 = 𝑎0 + 𝑎1 𝑅𝐸𝑡 + 𝑎2 𝑅𝑌𝑡 + 𝑎3 𝑅𝑌𝑡∗ + 𝛾𝑡 (1)

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where B = ratio of exports to imports = X/M = trade balance; RE = real exchange rate (local

currency per unit of foreign currency); RY = real home income; RY* = real foreign income.

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By estimating the log-linear form of trade balance model, we can obtain the exchange rate

elasticity (a1) as well as the elasticities of home income (a2) and foreign income (a3). The

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expected sign of exchange rate elasticity (a1) is positive since a rise in real exchange rate (a
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depreciation of local currency) will improve the trade balance. The expected sign of home

income elasticity a2 is negative since a rise in real home income will lead to an increase of
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imports that will deteriorate the trade balance. In contrast, the expected sign of foreign income

elasticity a3 is positive since an increase in real foreign income will lead to a rise of exports that
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will improve the trade balance.

The downside of this approach is that it only focuses on the net change of trade balance
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and fails to capture the dynamic responses of each individual export and import function to an

exchange rate shock. Since currency depreciation will affect exports (X) and imports (M)
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simultaneously, an improvement in the trade balance (X/M) due to depreciation may be a result

of one of the following five scenarios: (1) a fall in the imports with a rise in the exports, (2) a

small rise in the imports with a large rise in the exports, (3) no change in the imports with a rise

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in the exports, (4) a fall in the imports with no change in the exports, or (5) a large fall in the

imports with a small fall in the exports.

The second group of studies adopts the elasticity approach to estimate the price

elasticities directly from the export and import demand functions by utilising aggregate price and

volume indices as proxy variables for the price and quantity of exports and imports (Houthakker

and Magee, 1969; Goldstein and Khan, 1978; Rosenweig and Koch, 1988; Senhadji, 1998;

Senhadji and Montenegro, 1999; Wang and Lee, 2012).

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In the elasticity approach, the export and import demand models are specified as follows:

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RX𝑡 = 𝑏0 + 𝑏1 𝑅𝐸𝑡 + 𝑏2 𝑅𝑌𝑡∗ + 𝜈𝑡 (2)

RM𝑡 = 𝑐0 + 𝑐1 𝑅𝐸𝑡 + 𝑐2 𝑅𝑌𝑡 + 𝜔𝑡 (3)

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where RX = real exports; RM = real imports; RE = real exchange rate (local currency per unit of
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foreign currency); RY = real home income; RY* = real foreign income.

Since the exports and imports data are usually available in nominal terms, we need to
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derive the real exports (imports) by deflating the value of exports (imports) with aggregate price

indices (Houthakker and Magee, 1969; Senhadji, 1998; Senhadji and Montenegro, 1999). In
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some studies, the export and import volume indices are used as proxy variables for the exports

and imports (Goldstein and Khan, 1978; Rosenweig and Koch, 1988). The major shortcoming of
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deflating the value of exports (imports) with price indices or using volume indices as proxy

variables is the presence of aggregation biases across different goods, which results in unreliable
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estimates of export and import demand elasticities (Goldstein and Khan, 1985).

The third group of studies employs the inpayments and outpayments approach to estimate

trade elasticities on bilateral basis to avoid aggregation biases (Cushman, 1987; Bahmani-

Oskooee and Goswami, 2004; Baek and Koo, 2009; Ketenci and Uz, 2011). For bilateral trade,

5
since import and export prices are not available, the value of exports (inpayments) and value of

imports (outpayments) are simply used in the exports and imports models.

In the inpayments and outpayments approach, the exports and imports models are specified as

follows:

X𝑡 = 𝑏0 + 𝑏1 𝑅𝐸𝑡 + 𝑏2 𝑅𝑌𝑡∗ + 𝜈𝑡 (4)

M𝑡 = 𝑐0 + 𝑐1 𝑅𝐸𝑡 + 𝑐2 𝑅𝑌𝑡 + 𝜔𝑡 (5)

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where X = inpayments = value of exports; M = outpayments = value of imports; RE = real

bilateral exchange rate (local currency per unit of foreign currency); RY = real home income;

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RY* = real foreign income.

However, the deficiency of this approach is that we still need to deflate the nominal bilateral

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exchange rates and nominal incomes by aggregate price indices to obtain the real bilateral
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exchange rates and real national incomes that may lead to aggregation biases and results in

unreliable estimates.
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The remedy for the above approaches is to estimate the elasticities by using the nominal

export revenue and import expenditure models (see Cheng, Kim and Thompson, 2013). The
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model specifications assume an infinitely elastic supply of import and export services trade

under a perfectly competitive market in the US and rest of the world. Based on this assumption,
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the prices of import and export services are constant, and the only price variation is due to the

nominal exchange rate (E). Therefore, variables in the models do not need to be deflated by
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aggregate price indices, that is, all variables are in nominal terms.

The models for export revenue and import expenditure are specified as follows:

X𝑡 = 𝑏0 + 𝑏1 𝐸𝑡 + 𝑏2 𝑌𝑡∗ + 𝜈𝑡 (6)

M𝑡 = 𝑐0 + 𝑐1 𝐸𝑡 + 𝑐2 𝑌𝑡 + 𝜔𝑡 (7)

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where X = export revenue; M = import expenditure; E = nominal exchange rate (local currency

per unit of foreign currency); Y = nominal home income; Y* = nominal foreign income.

The novelty of this model specification is that it does not require price variables since

prices are implicitly incorporated into the variables of export revenue and import expenditure.

Therefore, it can avoid aggregation biases due to using aggregate price and volume indices. By

estimating the log-linear models of export revenue and the import expenditure separately, we can

obtain the exchange rate elasticities of export revenue (b1) and import expenditure (c1) as well as

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the elasticities of foreign income (b2) and home income (c2). The exchange rate elasticity (b1) is

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expected to be positive since a rise of nominal exchange rate represents an appreciation of

foreign currency that may increase the purchasing power of foreign currency overseas. The

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expected sign of c1 can be positive or negative. A positive (negative) c1 implies a price inelastic
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(elastic) due to an appreciation of foreign currency. Both income elasticities b2 and c2 are

expected to be positive since services are normal goods.

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3. Disaggregated Trade Data and Data Sources

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Goldstein and Khan (1985) point out that the use of aggregate trade data can lead to

aggregation biases across different goods and results in unreliable estimates of the export and
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import demand elasticities. Doroodian, Jung and Boyd (1999), Ardalani and Bahmani-Oskooee

(2007), Baek (2013) and Bahmani-Oskooee, Harvey and Hegerty (2014) propose the use of
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disaggregated trade data at the industry level or commodity level of bilateral trade to estimate

import and export elasticities. The advantage of using disaggregated trade data is to avoid

aggregation biases of data that combine all traded goods across all industries.

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 On the contrary, Deardorff et al. (2001), Mann (2004), and Marquez (2006) employ

disaggregated services trade data to estimate price and income elasticities to reduce the

aggregation biases across different services. Marquez (2006) estimates elasticities for U.S. trade

in services of four major categories: travel, fares, transportation, and other private services and

concludes that aggregation biases lead to unreliable estimates while disaggregation provides

more significant estimates. He suggests that employing disaggregated data is the most important

aspect of econometric modelling in future trade studies. This study follows the suggestion by

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Marquez (2006) to estimate the exchange rate and income elasticities with disaggregated services

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trade data, specifically the U.S. nine major categories of services trade quarterly data from 1999

to 2015.

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For the sake of comparison, this study will first estimate the log-linear form of trade
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balance, import and export models with aggregate services trade data. Estimating exchange rate

and income elasticities with aggregate services trade data may have the problem of aggregation
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biases. For example, a significant exchange rate (income) effect on disaggregated services trade

may be offset by insignificant exchange rate (income) effects of another disaggregated services
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trade. Therefore, next we will estimate the log-linear form of import and export models with the

disaggregated data of the nine major categories of services trade. The purpose is to uncover new
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evidence for the adjustment of individual services trade to an exchange rate or income shock.

Variables in logarithmic form are in lower case of letters. Since the relationships among the
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relevant variables are expressed in logarithmic form, the parameters are elasticities of the

respective variables.

This study will use the available aggregate and disaggregated data of import and export

services trade from the US International Transactions Accounts of the Bureau of Economic

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Analysis. In 2014, the aggregate services trade is reclassified into nine major categories, namely

maintenance and repair services, transport, travel (for all purposes including education),

insurance services, financial services, charges for the use of intellectual property,

telecommunications, computer, and information services, other business services, and

government goods and services. The Nominal Broad Dollar Index is from the Federal Reserve

Economic Data (FRED). Twenty-six currencies of US trading partners that represent over 90

percent of total US imports and exports are used to derive the Nominal Board Dollar Index. G20

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countries’ GDP and US GDP are from the OECD Statistics of Organization of Economic Co-

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operation and Development. Home income is the US GDP while the G20 countries’ GDP minus

the US GDP represents the Rest of the World (foreign) income. We use quarterly data over the

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period from the first quarter of 1999 to the third quarter of 2015 for this empirical study. The
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data span is selected based on the availability of data for services trade at the US International

Transactions Accounts. The definitions of the variables are summarized in Table 1.

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4. Econometric Model
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In this study, we employ the ARDL cointegration methodology with bounds testing

(Pesaran, Shin, and Smith, 2001). The advantage of this methodology is that it does not require
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the same order of integration of underlying variables, specifically, a mixed series of integration

of order zero I(0) and integration of order one I(1) can be used in the estimated model. Another
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advantage is that it can be used to investigate the short- and long-run dynamic interaction of

variables simultaneously and is robust for small samples (Narayan, 2005; Lee, 2010; Bahmani-

Oskooee, Harvey and Hegerty, 2014). However, if any of the series in the estimated model

exhibits an integration of order two I(2), it will invalidate the methodology (Ketenci and Uz,

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2011). Therefore, we still need to check that none of the series are I(2) by using the ADF and

KPSS tests (Dickey and Fuller, 1979; Kwiatkowski, Phillips, Schmidt, and Shin, 1992). The unit

root test results are summarized in Table 2.

Following Pesaran, Shin, and Smith (2001), we reformulate equations (6), (7) and (1) into

a conditional (unrestricted) error-correction format as follows:

Export Model:

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∆X𝑡 = 𝛼0 + ∑𝑝𝑖=1 𝛼1𝑖 ∆𝑋𝑡−𝑖 + ∑𝑝𝑗=0 𝛼2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑝𝑘=0 𝛼3𝑘 ∆𝑌𝑡−𝑘
∗
+ 1 𝑋𝑡−1 + 2 𝐸𝑡−1 + 3 𝑌𝑡−1
∗
+

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𝜈𝑡 (8)

Import Model:

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∆M𝑡 = 𝛽0 + ∑𝑝𝑖=1 𝛽1𝑖 ∆𝑀𝑡−𝑖 + ∑𝑝𝑗=0 𝛽2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑝𝑘=0 𝛽3𝑘 ∆𝑌𝑡−𝑘 + 𝜙1 𝑀𝑡−1 + 𝜙2 𝐸𝑡−1 +
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𝜙3 𝑌𝑡−1 + 𝜔𝑡 (9)

Trade Balance Model:

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∆B𝑡 = 𝜌0 + ∑𝑝𝑖=1 𝜌1𝑖 ∆𝐵𝑡−𝑖 + ∑𝑝𝑗=0 𝜌2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑝𝑘=0 𝜌3𝑘 ∆𝑌𝑡−𝑘 + ∑𝑝𝑙=0 𝜌4𝑙 ∆𝑌𝑡−𝑙
∗
+ 𝛿1 𝐵𝑡−1 +

∗
𝛿2 𝐸𝑡−1 + 𝛿3 𝑌𝑡−1 + 𝛿4 𝑌𝑡−1 + 𝛾𝑡 (10)
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where Δ is the first difference operator and p is the lag order.

The ARDL cointegration methodology allows a flexible choice for the dynamic lag
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structure as well as allowing for short-run feedbacks from the lagged dependent variables
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(Pesaran, Shin, and Smith, 2001). We use a general-to-specific approach to identify the optimal

ARDL model. For the sake of parsimony and to avoid over-parameterization, insignificant

variables are dropped, and the models are re-estimated until the most parsimonious specification

of ARDL is obtained. The lag structure is selected based on the Akaike Information Criterion

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(AIC) and Schwarz Bayesian Criterion (SBC). The appropriate lag structure of the model is

obtained based on the smallest value of AIC and SBC.

A bounds testing procedure using the F-test is employed to examine the existence of a

long-run relationship among the variables. The F-test aims to test the joint significance of the

coefficients on the one period lagged level of the variables in equations (8), (9) and (10),

specifically, it is testing the null hypotheses 𝐻0 : 1 = 2 = 3 = 0 , 𝐻0 : 𝜙1 = 𝜙2 = 𝜙3 = 0, and

𝐻0 : 1 = 2 = 3 = 4 = 0 respectively.

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An upper bound of critical values that assuming all variables are I(1) and a lower bound

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of critical values that assuming all variables are I(0) are reported in Pesaran and Shin (1998) as

well as in Pesaran, Shin, and Smith (2001) for large sample sizes of 500 and 1000 observations.

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Narayan (2005) also calculates an upper bound and a lower bound of critical values for small
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sample sizes ranging from 30 to 80 observations. These two sets of critical values will be

adopted in this study since we have a relatively small sample size with 67 observations. If the
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computed F-statistic is greater than the upper bound of critical values, the null hypothesis of no

cointegration is rejected that implies a long run relationship among variables. If the computed F-
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statistic is smaller than the lower bound of critical values, the null hypothesis is accepted. If the

computed F-statistic falls between the bounds, no conclusive decision can be made.
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In addition to the bounds test, we follow the procedure by Kremers et.al. (1992),

Banerjee et.al. (1998) and Bahmani-Oskooee and Brooks (1999) to estimate the equations (1), (6)
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and (7) by Ordinary Least Squares (OLS) regression to obtain the error-correction term (𝜀̂𝑡 ).

Then we replace the linear combination of lagged level variables in unrestricted error-correction

models (8), (9) and (10) by the lagged error-correction term (𝜀̂𝑡−1 ) to obtain the restricted Error

Correction Model as follows:

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 𝑝 𝑝 𝑝 ∗
∆X𝑡 = 𝛼0 + ∑𝑖=1 𝛼1𝑖 ∆𝑋𝑡−𝑖 + ∑𝑗=0 𝛼2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑘=0 𝛼3𝑘 ∆𝑌𝑡−𝑘 + 𝜆𝜀̂𝑡−1 + 𝜈𝑡 (11)

∆M𝑡 = 𝛽0 + ∑𝑝𝑖=1 𝛽1𝑖 ∆𝑀𝑡−𝑖 + ∑𝑝𝑗=0 𝛽2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑝𝑘=0 𝛽3𝑘 ∆𝑌𝑡−𝑘 + 𝜆𝜀̂𝑡−1 + 𝜔𝑡 (12)

∆B𝑡 = 𝜌0 + ∑𝑝𝑖=1 𝜌1𝑖 ∆𝐵𝑡−𝑖 + ∑𝑝𝑗=0 𝜌2𝑗 ∆𝐸𝑡−𝑗 + ∑𝑝𝑘=0 𝜌3𝑘 ∆𝑌𝑡−𝑘 + ∑𝑝𝑙=0 𝛼4𝑙 ∆𝑌𝑡−𝑙
∗
+ 𝜆𝜀̂𝑡−1 + 𝛾𝑡

(13)

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If the estimated 𝜆̂ of the lagged error correction term 𝜀̂𝑡−1 is statistically significant and

negative, it provides additional evidence of cointegration among the variables. The dynamics of

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the system will adjust towards equilibrium by 𝜆̂ from the error of the previous period.

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The diagnostic test provided for the estimated models is AR (1) test on the residuals. We

use the Ramsey RESET to check the model misspecification. In addition, we also employ both
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cumulative sums (CUSUM) and cumulative sums squared (CUSUMSQ) tests to check the
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stability of parameters. The estimated short-run coefficients and the diagnostic statistics are

summarized in Table 3, 4 and 5.

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In long-run equilibrium of an export model, ∆X𝑡 = 0, ∆𝑌𝑡∗ = 0 and ∆E𝑡 = 0, the long-run

elasticities of exchange rate 𝜂̂ 𝐸𝑋 and foreign income 𝜂̂ 𝑌 ∗ can be derived by the following
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formula:
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̂
𝜃 ̂
𝜃
𝜂̂ 𝐸𝑋 = − 𝜃̂2 and 𝜂̂ 𝑌 ∗ = − 𝜃̂3 (14)
1 1

For an import model, the long-run elasticities of exchange rate 𝜂̂ 𝐸𝑀 and home income 𝜂̂ 𝑌 can be

obtained by

̂
∅ ̂
∅
𝜂̂ 𝐸𝑀 = − ∅̂2 and 𝜂̂ 𝑌 = − ∅̂3 (15)
1 1

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For a trade balance model, the long-run elasticities of exchange rate 𝜂̂ 𝐸𝐵 , home income 𝜂̂ 𝑌 , and

foreign income 𝜂̂ 𝑌 ∗ can be obtained by

𝛿̂ 𝛿̂ 𝛿̂
𝜂̂ 𝐸𝐵 = − 𝛿̂2 , 𝜂̂ 𝑌 = − 𝛿̂3 and 𝜂̂ 𝑌 ∗ = − 𝛿̂4 (16)
1 1 1

The estimated long-run elasticities of exchange rate, home income and foreign income are

reported in Table 6.

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5. Empirical Results

First, we need to check that none of the series are I(2) by using the ADF and KPSS tests

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otherwise it will invalidate the ARDL methodology. Applying the ADF test to the levels and the

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first-differences of the series, most of the series are I(1) while imports of insurance services (mis)

is I(0). The imports of government goods and services (mggs) is found to be I(2) at the second-
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difference. The lag-lengths for the ADF regressions were chosen using the Schwarz Bayesian

Criterion, SBC. Applying the KPSS test we reject the null hypothesis of stationarity at the 5%
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significance level for all series that implies all series are I(1) with the only exception of mggs

that is I(2). Since mggs is I(2), the empirical results of employing the ARDL methodology on
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this series become invalid and unreliable.

The ARDL approach with bounds testing utilizes the F-test to identify a long-run
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(cointegration) relationship among the variables in equations (8), (9) and (10). The null

hypotheses of no long-run relationship, 𝐻0 : 1 = 2 = 3 = 0 , 𝐻0 : 𝜙1 = 𝜙2 = 𝜙3 = 0, and

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𝐻0 : 1 = 2 = 3 = 4 = 0, are tested. The computed F-statistics are found to exceed the

critical value of upper bound for nearly all trade models except the imports of financial services

(mfs) that reports a value of 2.02 which is below the lower bound’s critical value 2.704 at 10%

level.

13
 In addition to the bounds test, we estimate the conventional (restricted) Error Correction

Model (ECM) equations (11), (12) and (13) for the services trade models, all estimated 𝜆̂s of the

error correction term 𝜀̂𝑡−1 s are found to be negative and statistically significant at 5% level. The

result reinforces that there is a long-run relationship among the variables in each services trade

model. In contrast to the bounds test, the estimated 𝜆̂ of 𝜀̂𝑡−1 in the import model of financial

services (mfs) is found to be –0.12 and statistically significant at 5% level. The result confirms a

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long-run relationship among the variables in this model.

The diagnostic test indicates that the residuals of all models has no serial correlation

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based on the AR(1) test. The Ramsey RESET statistics confirm that the specifications of most

models are adequate. Most models have no changes in parameters based on both CUSUM and

CUSUMSQ test for stability of parameters.

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For comparison, first we estimate the short-run and long-run coefficients of trade balance,

import and export model with aggregate services trade data. The estimated short-run coefficient
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of exchange rate in trade balance model is statistically significant at 5% level. It implies that

there exists an immediate impact of exchange rate changes on the trade balance, that is dollar
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devaluation will lead to an immediate improvement in trade balance. However, this short-run

impact does not persist in the long-run. Estimating import and export models separately provide
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more information about the exchange rate impact on individual services trade. The estimated

results show that there exists an immediate impact of exchange rate changes on exports of
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services with 1% level of significance; however, its impact diminishes in the long-run. It implies

that dollar devaluation will lead to an immediate rise in exports of services. In contrast, there is

no immediate effect of exchange rate on the imports of services, but it becomes statistically

significant at 1% level in the long-run with the estimated elasticity of exchange rate (0.72).

14
Dollar devaluation will raise the imports of services after a long-term adjustment. These results

are evidence of aggregation biases of estimating a trade balance model with aggregate trade data

since the statistically insignificant exchange rate effect on the trade balance in the long-run may

be a result of a significant effect of imports of services being largely offset by an insignificant

effect of exports of services.

The estimated results show that there exists immediate home income and foreign income

impacts on the trade balance while these impacts will persist in the long-run with the estimated

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elasticities of home income (-1.66) and foreign income (1.25). Both results indicate that the

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trade balance is income elastic with expected signs. For the exports of services, there is a

significant immediate foreign income effect and this effect does hold in the long-run with a unit-

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elastic (1.00) of foreign income. In contrast, there is no immediate home income effect on the
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imports of services, but it becomes highly significant and income elastic (1.4) in the long-run.

The estimated values of home income and foreign income elasticities in the trade balance model
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are higher than the estimated values in the export and import models. The results provide

additional evidence of aggregation biases of estimating a trade balance model that may over-
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estimate the income effects.

Next, we estimate the short- and long-run coefficients of import and export models with
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disaggregated services trade data of the nine major categories of services trade. The estimated

results show that there are no immediate exchange rate effects on all nine major categories of
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import services trade. The results are consistent with the result of estimating an import model

with aggregate services trade data. In the long-run, there are statistically significant exchange

rate impacts on six categories (mmrs, mtp, mfs, mtci, mobs and mggs) while three categories (mt,

mis and mip) are insignificant. The results indicate that dollar devaluation will reduce the

15
imports of services of the six categories (mmrs, mtp, mfs, mtci, mobs and mggs) after a long-run

adjustment. However, it is not true for the three categories (mt, mis and mip). When we

estimate elasticities of an import model with aggregate services trade data, we fail to capture the

response of individual services trade to an exchange rate change. The significant long-run

exchange rate impact on the aggregate import services trade may be a result of the significant

exchange rate impacts being larger than the insignificant impacts on individual services trade.

The policy implication of the results is that dollar devaluation will reduce services trade in the

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long-run but not in the short-run.

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The estimated results of disaggregated export models of the nine major categories of

services trade show that only two categories, namely xtp and xt, demonstrate statistically

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significant immediate exchange rate effects but they get wrong signs. The rest seven categories
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(xmrs, xis, xfs, xip, xtci, xobs and xggs) do not have any exchange rate impacts in the short-run.

In the long-run, two categories (xtp and xggs) exhibit statistically significant positive exchange
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rate impacts while xmrs and xobs are significant with wrong signs. The insignificant long-run

exchange rate impact on the aggregate export services trade may be due to the cancel out of
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significant exchange rate impacts by insignificant impacts on individual services trade. This

result confirms the hypothesis that an estimation of export model with aggregate services trade
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data fails to reveal the dynamics of individual services trade to an exchange rate change. The

results indicate that dollar devaluation will raise only limited amount of export services trades
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(xtp and xggs) in the long-run.

It is interesting to note that currency policy does not have any short- or long-run impact

on insurance services (mis and xis) and charges for the use of intellectual property (mip and xip)

in both disaggregated import and export models. Insurance services, including primary

16
insurance, reinsurance, and auxiliary insurance, have the nature of long term contractual

obligation of insurers to provide services to customers while customers to make insurance

premium payments on a regular basis. These inflow and outflow of services and payments are

not sensitive to the fluctuation of exchange rates. The charges for the use of intellectual property

includes the charges for the use of computer software, trademarks and franchise fees, audio

visual and related products, and “other” intellectual property. The charges for intellectual

property are also on a regular basis, such as the annual license payment for the use computer

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software, which is insensitive to exchange rate changes. The findings confirm the argument by

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Marquez (2006) that the exchange rate impact on the services trade largely relies on the nature of

services.

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The estimated results of disaggregated import models show that there are significant
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immediate home income effects on three categories of services trade (mtp, mt and mfs). The

aggregate import model of services trade does not reveal these impacts on individual services
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trade. The results provide additional evidence for aggregation biases of estimating an import

model with aggregate services trade data. In the long-run, the import of insurance services (mis)
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is the only category that does not exhibit home income effect. The rest categories of services

trade report significant elasticities with a range of values from 0.88 to 2.42.
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Estimating disaggregated export models, only two categories of services trade (xtp and xt)

exhibit significant immediate foreign income effects. It is observed that both transportation (tp)
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and travel (t) are very sensitive to the income changes in the short-run. All categories of services

trade in the disaggregated export models have significant foreign income effects in the long-run

with a range of elasticities from 0.59 to 1.89. Economic growth of a country is obviously

playing a key role in determining the imports and exports of services trade.

17
6. Conclusions

This study aims to revisit the effectiveness of using currency devaluation as a policy tool

to improve trade balance by estimating the exchange rate elasticities of services trade between

the US and rest of the world with quarterly disaggregated services trade data. Specifically, we

employ an Autoregressive Distribution Lag (ARDL) cointegration methodology with bounds

testing of Pesaran, Shin, and Smith (2001) to estimate exchange rate and income elasticities with

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the use of the nine major categories of services trade quarterly data from 1999 to 2015.

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The contributions of this study will be two-fold: first, it advocates a new approach (a

model specification of nominal export revenue and import expenditure) to estimate exchange rate

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and income elasticities to capture the short- and long-run dynamics of the time-path of each
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individual trade flow to an exchange rate or income shock. This approach reduces the problem of

aggregation biases by using the traditional trade balance, elasticity, and inpayments and
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outpayments approaches.

Second, it advocates for the use of disaggregated services trade data to avoid aggregation
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biases. Empirical results confirm the hypothesis that the use of aggregate services trade data

may lead to aggregation biases and results in unreliable estimates of the elasticities. Aggregation
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biases could indeed be concealing the actual response of individual services trade to an exchange

rate or income shock. Estimations with disaggregated services trade data may reveal new
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evidence for the exchange rate and income impacts at individual services trade level.

Empirical results confirm that economic growth is an important determinant of most

imports and exports of services trade in the long-run; however, income exhibits different degrees

of impacts on individual services trade. The impact of dollar devaluation on individual services

18
trade are mixed and largely depend on the nature of services. The findings in this study show

that using dollar devaluation (deprecation) as a policy tool to raise export services trade and

reduce import services trade seems to be more effective in the long-run but not in the short-run.

However, the effectiveness of the policy tool depends on the nature of services. Currency policy

does not have any short- or long-run impact on some services trades, such as insurance services

and charges for the use of intellectual property. Policy makers may need to derive alternative

policy tools to achieve the goal of improving the trade balance, especially for those services

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trades that are not sensitive to exchange rate changes.

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19
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Table 1: Definitions of Data Variables

Variable Explanatory Notes

E Exchange Rate = The Reciprocal of Nominal Broad Dollar Index

(A rise in E denotes a depreciation of U.S. dollar)
Y Home Income = The US Nominal GDP
Y* Foreign Income = (G20’s GDP – US GDP) = The Rest of the World Nominal GDP
BS The Ratio of US Exports of Services to Imports of Services, i.e. BS = XS / MS
XS The US Exports of Services
XMRS The US Exports of Maintenance and repair services n.i.e.
XTP The US Exports of Transport
XT The US Exports of Travel (for all purposes including education)
XIS The US Exports of Insurance services

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XFS The US Exports of Financial services
XIP The US Exports of Charges for the use of intellectual property n.i.e.
XTCI The US Exports of Telecommunications, computer, and information services
XOBS The US Exports of Other business services

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XGGS The US Exports of Government goods and services n.i.e.
MS The US Imports of Services
MMRS The US Imports of Maintenance and repair services n.i.e.
MTP The US Imports of Transport

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MT The US Imports of Travel (for all purposes including education)
MIS The US Imports of Insurance services
MFS The US Imports of Financial services
MIP The US Imports of Charges for the use of intellectual property n.i.e.
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MTCI The US Imports of Telecommunications, computer, and information services
MOBS The US Imports of Other business services
MGGS The US Imports of Government goods and services n.i.e.
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Note: n.i.e. represents “not included elsewhere”.

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Table 2: Unit Root Test Results of Log Variables

Variable Specification ADFc KPSS

e Level -1.12 0.70***

First-difference -5.96*** 0.27
y Level -1.53 1.04***
First-difference -4.85*** 0.24
*
y Level -1.36 1.02***
First-difference -5.35*** 0.28
bs Level -0.82 0.60**

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First-difference -8.78*** 0.45
xs Level -0.45 1.03***
First-difference -6.32*** 0.12

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xmrs Level -0.39 1.06***
First-difference -12.00*** 0.06

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xtp Level -0.93 0.99***
First-difference -5.64*** 0.09
xt Level -0.19 0.97***
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First-difference -7.29*** 0.12
xis Level -1.53 1.01***
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First-difference -8.08*** 0.30

xfs Level -1.58 1.02***
First-difference -9.20*** 0.21
xip Level -1.17 1.03***
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First-difference -8.46*** 0.20

xtci Level 0.40 1.04***
First-difference -8.59*** 0.19
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xobs Level -0.09 1.05***

First-difference -8.93*** 0.16
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xggs Level -1.43 0.90***

First-difference -11.41*** 0.19
ms Level -1.62 1.03***
First-difference -7.67*** 0.26
mmrs Level -2.12 1.04***
First-difference -7.91*** 0.21
mtp Level -1.70 0.91***

25
 Difference -5.19*** 0.06
mt First-difference -0.49 0.98***
Difference -3.81*** 0.07
mis Level -4.04*** 0.89***
First-difference -6.12*** 0.75***
mfs Level -1.63 0.92***
First-difference -4.12*** 0.08
mip Level -1.81 1.05***
First-difference -10.17*** 0.36
mtci Level -0.22 1.00***

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First-difference -8.57*** 0.29
mobs Level -0.52 1.04***

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Difference -7.90*** 0.13
mgs Level -1.99 0.62**
First-difference -1.87 0.69**
Second-difference -7.98***

-p 0.25

Note: ** and *** indicate the null hypothesis is rejected at 5% and 1% level. The number of lags is chosen by the
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Schwarz Bayesian Criterion (SBC). ADFc refer to ADF-t statistics when an intercept is included. Asymptotic
critical values of ADF test are from MacKinnon (1996). The null hypothesis of KPSS test is that the variable in
question is stationary. Reject the null hypothesis implies a non-stationary data series. The critical values of KPSS
test are based on the response surfaces estimated by Sephton (1995).
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26
Table 3: Estimated Short-run Coefficients of Aggregated Services Trade

(Trade Balance, Import and Export Models)

Variable bs ms xs

bst mst xst

bst-1 -0.43*** (-2.91) --- ---

bst-2 -0.25* (-1.79) --- ---

mst-1 --- --- ---

xst-1 --- --- ---

et -1.63** (-2.14) 0.15 (1.64) -1.65*** (-3.15)

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et-1 0.05 (0.50) --- ---

et-2 -0.12 (-1.16) --- ---

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et-3 -0.16 (-1.50) --- ---

yt -0.78 (-1.65) --- ---

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yt-1 -0.63 (-1.43) --- ----

yt-2 0.80** (2.15) --- ---

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y*t 1.76** (2.42) --- 1.76*** (3.70)

et-1 -0.15 (-1.07) 0.40*** (6.16) 0.005 (0.08)

0.81*** (6.36)
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yt-1 -0.32 (-1.66) ---

y*t-1 0.24* (1.88) --- 0.21*** (3.23)

bst-1 -0.19** (-2.53) --- ---

mst-1 --- -0.58*** (-6.84) ---

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xst-1 --- --- -0.21*** (-3.44)

c 1.04 (1.04) -6.63*** (-5.80) -1.27** (-2.62)

AR(1) (LM) 0.28 0.006 1.40

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ECM 𝜀̂𝑡−1
-0.19*** (-5.22) -0.49*** (-5.62) -0.21*** (-4.81)

5.02** 22.37*** 5.51***

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Bounds test (F)

Critical values (k=3) 5% (k=2) 1% (k=2) 1%

[2.976, 3.896] [4.538, 5.475] [4.538, 5.475]

RESET test (F) 1.45 4.81** 0.58

CUSUM test stable stable stable

CUSUMSQ test unstable stable stable

Note: *, ** and *** represents the significance of the t-test or F-test at the 10%, 5% and 1% level respectively, and t statistic is given in parentheses.
The lag structure is selected based on the Akaike Information Criterion (AIC) and the Schwarz Bayesian Criterion (SBC). The asymptotic critical
values (CVs) of lower and upper bounds for the F-test Statistic are from Narayan (2005).

27
Table 4: Estimated Short-run Coefficients of Nine Major Categories of Services Trade (Import Models)

Variable mmrs mtp mt mis mfs mip mtci mobs mggs

mt mt mt mt mt mt mt mt mt

mt-1 0.002 --- -0.48*** --- --- --- -0.20* --- ---

(0.02) (-3.71) (-1.69)

mt-2 0.38*** --- -0.32*** ---- --- --- --- --- ---

(3.58) (-2.88)

e t --- -0.21 --- --- --- --- --- --- ---

(-1.42)

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y t --- 2.03*** 2.99*** --- 3.39*** --- --- --- ---

(3.43) (3.87) (3.26)

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y t-1 --- 3.32*** 2.80*** --- --- --- --- --- ---

(5.67) (3.29)

e t-1 0.49** 0.20*** 0.10 -0.04 0.15 0.16 0.31*** 0.18* -0.18**

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(2.27) (2.93) (1.07) (-0.35) (1.04) (1.18) (2.92) (1.90) (-2.20)

y t-1 0.56*** 0.23*** 0.22* -0.06 0.16 0.60*** 0.32*** 0.40*** -0.078**
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(2.84) (3.64) (1.95) (-0.67) (1.58) (3.08) (3.68) (3.47) (-2.15)

m t-1 -0.26*** -0.26*** -0.16* -0.02 -0.14** -0.39*** -0.19*** -0.17*** 0.04*

(-4.05) (-5.11) (-1.72) (-0.75) (-2.09) (-3.84) (-4.27) (-3.88) (1.79)

lP

c -7.33*** -1.23* -2.05* 1.16 -1.49 -6.46*** -3.52*** -4.90*** 0.90

(-2.55) (−1.83) (-1.89) (0.92) (-1.16) (-2.69) (-3.21) (-3.26) (1.61)

AR(1) (LM) 1.22 0.06 0.15 0.26 0.26 0.77 0.74 0.28 0.74
na

ECM 𝜀̂𝑡−1 -0.25*** -0.26*** -0.16*** -0.02*** -0.12** -0.39*** -0.18*** -0.17*** 0.04***

(-3.82) (-7.98) (-4.82) (-4.59) (-2.39) (-4.22) (-4.90) (-4.37) (4.9)

Bounds test (F) 5.02*** 15.16*** 5.53*** 8.46*** 2.02 5.87*** 7.01*** 9.66*** 7.41***
ur

Critical values (k=2) 1% [4.538, 5.475] 5% [3.285, 4.070] 10% [2.704, 3.455]

RESET test (F) 1.11 4.91** 2.19 1.74 1.36 2.31 0.50 0.12 0.28
Jo

CUSUM test stable stable stable stable stable stable stable unstable stable

CUSUMSQ test stable stable stable stable stable stable stable unstable unstable

Note: *, ** and *** represents the significance of the t-test or F-test at the 10%, 5% and 1% level respectively, and t statistic is given in parentheses.
The lag structure is selected based on the Akaike Information Criterion (AIC) and the Schwarz Bayesian Criterion (SBC). The asymptotic critical
values (CVs) of lower and upper bounds for the F-test Statistic are from Narayan (2005).

28
Table 5: Estimated Short-run Coefficients of Nine Major Categories of Services Trade (Export Models)

Variable xmrs xtp xt xis xfs xip xtci xobs xggs

xt xt xt xt xt xt xt xt xt

xt-1 -0.30** --- --- --- --- --- --- --- ----

(-2.42)

et --- -3.70*** -3.12*** --- --- --- --- --- ---

(-5.19) (-3.13)

y*t --- 3.46*** 3.11*** --- --- --- --- --- ---

of
(5.29) (3.46)

e t-1 -0.28 0.22*** 0.10 -0.12 -0.06 0.03 -0.19* -0.28** 0.73*

ro
(-0.73) (2.68) (0.81) (-0.71) (-0.32) (0.35) (-1.72) (-2.64) (1.79)

y* t-1 0.37* 0.12** 0.08 0.08 0.35** 0.70*** 0.23*** 0.43*** 0.32**

-p
(1.68) (2.48) (1.52) (0.69) (2.11) (4.80) (3.25) (4.78) (2.54)

x t-1 -0.21** -0.20*** -0.10* -0.05 -0.25** -0.72*** -0.17*** -0.32*** -0.45***

(-2.04) (-3.43) (-1.90) (-0.81) (-2.37) (-5.08) (-3.31) (-4.99) (-3.93)

re
c -4.73 -0.17 -0.28 -0.98 -3.77* -5.12*** -2.63*** -4.36*** -1.72

(-1.55) (-0.42) (-0.52) (-0.62) (-1.92) (-4.29) (-3.07) (-4.50) (-1.05)

lP

AR(1) (LM) 0.11 0.18 1.43 0.01 0.00 3.84 0.55 0.43 0.50

ECM 𝜀̂𝑡−1 -0.23** -0.20*** -0.10*** -0.09** -0.36*** -0.70*** -0.16*** -0.34*** -0.51***

(-2.39) (-7.76) (-4.19) (-2.25) (-3.70) (-6.10) (-3.58) (-4.84) (-4.49)

na

Bounds test (F) 5.52*** 14.33*** 4.19** 4.36** 4.61** 10.43*** 8.15*** 14.10*** 4.22**

Critical values (k=2) 1% [4.538, 5.475] 5% [3.285, 4.070] 10% [2.704, 3.455]

RESET test (F) 0.08 4.27** 1.50 0.90 0.86 2.93 0.60 0.73 4.22**
ur

CUSUM test stable unstable unstable stable stable stable stable stable stable

CUSUMSQ test stable unstable unstable unstable stable stable stable stable stable

Note: *, ** and *** represents the significance of the t-test or F-test at the 10%, 5% and 1% level respectively, and t statistic is given in parentheses.
Jo

The lag structure is selected based on the Akaike Information Criterion (AIC) and the Schwarz Bayesian Criterion (SBC). The asymptotic critical
values (CVs) of lower and upper bounds for the F-test Statistic are from Narayan (2005).

29
Table 6: Estimated Long-run Elasticities of Services Trade Models

Model Exchange Rate Home Income Foreign Income

bs -0.76 (-1.40) -1.66*** (-2.81) 1.25*** (3.44)

ms 0.72*** (7.92) 1.40*** (32.36) ---

xs 0.03 (0.08) --- 1.00*** (14.19)

mmrs 1.67** (2.13) 2.33*** (5.83) ---

mtp 0.78** (2.61) 0.88*** (6.57) ---

mt 0.38 (0.58) 1.51*** (4.16) ---

of
mis -2.83 (-0.30) -3.94 (-0.37) ---

ro
mfs 1.64* (1.86) 0.92** (2.35) ---

mip 0.37 (1.10) 1.60*** (9.65) ---

-p
mtci 1.87*** (4.40) 1.63*** (8.65) ---

mobs 1.03* (1.90) 2.42*** (9.62) ---

re
mggs 2.85* (1.70) 2.31* (1.79) ---

xmrs -2.23*** (-2.75) --- 1.89*** (9.98)

lP

xtp 1.12*** (2.10) --- 0.59*** (5.43)

xt 0.96 (0.71) --- 0.73** (2.63)

xis -0.33 (-0.18) --- 1.42*** (2.77)

na

xfs -0.10 (-0.26) --- 1.43*** (15.03)

xip -0.03 (-0.25) --- 1.00*** (37.80)

ur

xtci -0.76 (-1.35) --- 1.30*** (10.60)

xobs -1.05*** (-3.85) --- 1.38*** (21.53)

Jo

xggs 1.49*** (2.39) --- 0.76*** (5.03)

Note: *, ** and *** represents the significance of the t-test at the 10%, 5% and 1% level respectively, and t statistic is
given in parentheses.

30