Examining the Relationship Between Trade Balance and Exchange Rate: the Case of China's Trade with the Usa

Topics: Bretton Woods system, Inflation, Foreign exchange market Pages: 7 (2119 words) Published: September 23, 2010
This study addresses the question of whether exchange rate changes have any significant and direct impact on trade balance. By examining the trade balances between one of the Asians country which is china and US countries for the sample period from 1977 to 2008, this study found that the role of exchange rate changes in initiating changes in the trade balances has been exaggerated. As such, an alternative explanation to the observed behavior of China trade balances in the selected sample period has been postulated. In particular, we propose that trade balance is affected by real money, rather than nominal exchange rate. A mathematical framework that provides theoretical background to our proposition is presented. Our empirical data analysis suggests that the real money effect proposition could consistently explain the observed trade balances in China, Singapore, Thailand, malaysia and the Philippines during the period of study, with respect to Japan. Thus, in order to cope with trade deficits, the governments of china might resort to policy measures focusing on the variable of real money.

Theoretical Framework
Notionally, the predictable view of the stability of payments says that a small devaluation of currency improves trade balance. This vision is fixed in a static and limited equilibrium approach to the set of scales of payments that is well known as elasticity approach (Metzler, 1948). The view was the substitution impacts with in consumption and production induced by the relative price domestic versus foreign changes caused by devaluation. The model, which commonly known as BRM model, has been recognized in literature as providing a sufficient condition for an improvement of trade balance as exchange rates devalue.

The Marshall-Lerner condition states that for a positive outcome of devaluation on the trade balance, and unconditionally for a stable exchange market, the complete values of the sum of the demand elasticizes for exports and imports must exceed unity. Holding this Marshall-Lerner condition, when the exchange rate is above the equilibrium there is excess supply for foreign exchange and when the exchange rate is below the equilibrium there is excess demand of foreign exchange. The BRM and Marshall-Lerner conditions have become the fundamental assumptions for those who support devaluation as means to steady the foreign exchange market and/or to improve the trade balance.

A different approach to the balance of payments emerged at the beginning of 1950s when authors such as Meade (1951), and Alexander (1952, 1959) shifted the focus of economic analysis to the balance of payments. This approach is referred as absorption approach. The core of this approach is the proposition that any improvement in the trade balance requires an increase of income over total domestic expenditures. That is mean, it analyses the economy from the point of view of aggregate expenditures, in particular, the direct effects of exchange rate changes on relative prices, income and absorption, and eventually on the trade balance.

The monetary view of the balance of payments emerged. As regard to monetary or global monetarist approach (Mundell, 1968, 1971), the balance of payments is basically a monetary phenomenon. The balance of payments behavior is analyzed the supply and demand of money. In very simple terms, if people demand more money than is being supplied by the Central Bank then the excess demand for money would be satisfied by inflows of money from abroad. In this case, the trade balance will improve. On the other hand, if the Central Bank is supplying more money than is demanded, the excess supply of money is eliminated by outflows of money to other countries and this will worsen the trade balance.

This paper chose the celebrated monetary approach to the relationships between money supply, price level and exchange rate described in Krugman, 1996. The monetary approach assumes that the price level in...
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