INTRODUCTION
Background to the study and statement of problem
Vietnam, a young and open economy undergoing industrialization, relies heavily on exports for development Over the past decade, the country has seen an impressive average annual export growth of 20% However, this growth is outpaced by a 22% increase in imports, resulting in a persistent trade balance deficit This trade imbalance stems from low competitiveness, which can be addressed through two strategies: internal and external The internal approach focuses on supply-side policies to enhance labor productivity and wages, while the external approach involves adjusting exchange rate policies to devalue or appreciate the local currency This study adopts the external approach to analyze Vietnam's trade balance.
Numerous empirical studies in literature examine the relationship between exchange rates and trade balances, yielding varied conclusions While some research indicates strong long-run and short-run connections, others find no significant relationship at all Additionally, some studies suggest a long-term relationship exists, but not in the short term These discrepancies often arise from differences in countries studied, observation periods, and econometric methodologies used Nevertheless, research consistently shows that fluctuations in exchange rates significantly impact trade balances, with depreciation leading to increased exports, reduced imports, and an overall improvement in trade balance.
In Vietnam, the serious trade-balance deficit has prompted researchers to investigate the role of the exchange rate While most studies agree that exchange rate fluctuations significantly affect the trade balance in the long run, the short-run effects remain uncertain.
This thesis addresses the unexplored relationship between exchange rate and trade balance in Vietnam, utilizing methods not previously applied in the literature It critiques the traditional Ordinary Least Squares (OLS) approach, commonly used in Vietnamese studies, as inadequate due to the characteristics of time series data The objective is to establish a robust and reliable quantitative relationship between exchange rate fluctuations and trade balance, particularly in the context of Vietnam's persistent trade deficit Additionally, the thesis offers solutions to enhance the trade balance through effective exchange rate management.
Research question
The study tries to explore complete impact of exchange rate on trade balance in both short and long run Correspondingly, the study aims to answer the following questions:
1 Whether there is a stable long-run relationship between the exchange rate and the trade balance of Vietnam? If that stable long-run relationship does exist, whether a permanent depreciation of exchange rate would lead to improvement of the trade balance?
2 Whether depreciation of exchange rate causes negative short-run impact on trade balance? How long does it take for positive impact of that depreciation to occur? (Does J-curve effect exist in Vietnam’s exchange rate-trade balance relationship?)
3 What are the solutions to improve the trade balance of Vietnam by using exchange rate tool?
Research objectives
To answer research questions, the study proceeds
To assess the competitiveness of Vietnam's merchandise trade, it is essential to calculate the real effective exchange rate (REER) of the Vietnam Dong against the currencies of its main trading partners.
- To test the robust relationship between REER and trade balance and estimate the responsiveness of trade balance to REER fluctuation in the long-run
This study aims to investigate the short-run negative effects of Real Effective Exchange Rate (REER) depreciation on the trade balance It will also assess the duration of these adverse impacts and estimate the time required for the trade balance to reach a new equilibrium level.
Understanding the relationship between exchange rates and trade balance is crucial for policymakers By identifying the factors that influence how trade balance responds to exchange rate fluctuations, we can propose effective strategies to manage exchange rates This approach aims to enhance trade balance and promote economic stability.
Methodology
This study employs three econometric models to analyze the long-run and short-run relationships between exchange rates and trade balances, as these results can vary significantly based on the observation period and the economic techniques used.
Johansen’s cointegration analysis and the Autoregressive Distributed Lag (ARDL) approach, introduced by Hashem M Pesaran, Yongcheol Shin, and Richard J Smith in 2001, are utilized to investigate the long-term effects of exchange rates on trade balance.
Error-correction models (ECM) are utilized to analyze the long-run cointegration of trade balance equations, focusing on their short-run effects in relation to the J-curve pattern.
Limitation
This study examines the effects of exchange rate fluctuations on Vietnam's trade balance It suggests that appropriate timing and levels of exchange rate adjustments can enhance trade balance However, these fluctuations may also lead to negative consequences for the economy While the research demonstrates how changes in the exchange rate can benefit the trade balance, it does not address the potential adverse effects on the economy Consequently, the study is unable to weigh the benefits of an improved trade balance against the possible economic losses resulting from currency depreciation.
4 the solution to depreciation currency to improve trade balance seems to be less persuasive in the context of a whole economy.
Organization of the study
The study is organized into 5 chapters Chapter 1: Introduction
Chapter 2: Literature review Chapter 3: Performance of exchange rate and trade balance in Vietnam in 2000-2010 Chapter 4: Estimating the effect of exchange rate on trade balance in Vietnam
Chapter 5: Conclusion and policy recommendation tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
This chapter explores traditional theories regarding the relationship between exchange rates and trade balances It discusses the most widely used model for analyzing the impact of exchange rates on trade balances, highlighting its application in both developed and developing countries, including Vietnam The chapter aims to provide a comprehensive overview of the estimated effects of exchange rates on trade balances Additionally, it examines the experiences of several countries in managing exchange rate policies to enhance their trade balances, contributing to a broader understanding of this significant relationship.
2.1 General arguments about exchange rate 2.1.1 Exchange rate concepts
In general and popular acknowledgement, exchange rate (also known as foreign exchange rate) between two currencies specifies the price of one currency in term of another currency (Maurice D.Levi,1996)
The exchange rate between two currencies consists of the quote currency and the base currency The quote currency indicates the value of the base currency, which is expressed in terms of the quote currency and typically represents one unit in the quotation.
When quoting exchange rate, there are indirect quotation or direct quotation and
In currency quotation, the choice between US style and European style depends on the selected home currency Indirect quotations reflect the value of the home currency in terms of foreign currency, while direct quotations show the value of foreign currency in terms of the home currency The US dollar plays a pivotal role in these quotations, as it serves as the term currency in US style quotations.
In Europe style quotation, US dollar is base currency
According to the Foreign Exchange Ordinance (2005), the exchange rate of the Vietnam Dong (VND) is defined as the amount of VND required to purchase one unit of foreign currency.
6 currency unit This implies direct quotation is used in Vietnam Also, all mentioned exchange rate in this study is quoted directly
2.1.2 Nominal exchange rate and real exchange rate
2.1.2.1 Bilateral nominal and real exchange rate
The bilateral nominal exchange rate (NER) between two currencies is defined as the price of one unit foreign currency in domestic currency terms (Hinkle et al 1999)
NERs are popular because they are daily quoted by commercial banks for the purpose of serving customers who have demands for buying and selling currencies
The nominal exchange rates (NERs) of currency pairs are influenced by the supply and demand for currencies However, a significant limitation of NERs is that they do not indicate the purchasing power of a unit of foreign currency The bilateral real exchange rate (RER) addresses this issue by providing a clearer understanding of what can be bought with foreign currency.
The Real Exchange Rate (RER) is the ratio of the domestic prices of tradable goods to non-tradable goods within a country, as defined by Hinkle et al (1999) It quantifies how many units of non-tradable goods can be exchanged for one unit of tradable goods An increase in the RER, when measured in domestic currency, indicates enhanced competitiveness for the country due to a rise in relative prices Assuming that tradable goods prices are uniform globally, the RER can be mathematically expressed based on the distinction between tradable and non-tradable goods.
Where NER represents for nominal exchange rate between two currencies in index form; Pt and P * t represents domestic and international price of tradables respectively;
P n represents for price index in home country
The concept of Real Exchange Rate (RER) is defined in internal terms, while in external terms, it is represented as the Nominal Exchange Rate (NER) adjusted for price level differences between countries This adjustment reflects the ratio of the aggregate foreign price level to the home country's aggregate price level, measured in a common currency However, this study does not focus on the external aspects of RER.
The Real Exchange Rate (RER), as calculated in equation (2.1), indicates its value changes over time relative to a base year When the RER exceeds 1 (RER > 1), it signifies that the home currency is undervalued, resulting in lower average prices domestically compared to foreign markets, thereby enhancing the competitiveness of domestic goods Conversely, when the RER is below 1 (RER < 1), it indicates an overvalued home currency, with higher average prices in the home country than in foreign markets, leading to a decline in the competitiveness of domestic goods.
Researchers encounter significant challenges when calculating Real Exchange Rates (RERs), particularly in selecting appropriate empirical price and cost indices This issue is prevalent in both developed and developing nations, but it is often more pronounced in developing countries Edwards (1989) highlighted that factors such as parallel foreign exchange markets, extensive smuggling, unrecorded trade, and volatile terms-of-trade complicate the measurement of RERs in developing nations, unlike in industrialized countries Theoretically, RERs are calculated using the wholesale price index (WPI) or producer price index (PPI) alongside the consumer price index (CPI) as proxies, as noted in studies by Edwards (1988), Edwards (1989), Baffes et al (1999), and Elbadawi (1994).
This article discusses two key arguments regarding price measurement The Consumer Price Index (CPI) reflects changes in the prices of consumption goods for domestic consumers, making it significantly influenced by non-traded goods and serving as a measure of non-traded prices In contrast, the Wholesale Price Index (WPI) is based on the law of one price, which dictates that export and import prices are determined in the international market The WPI includes a larger proportion of traded goods sourced from main trading partners, and when multiplied by bilateral nominal exchange rates, it provides an accurate measure of traded goods prices in the home country Consequently, this study utilizes the WPI and CPI as proxies for tradables and non-tradables, respectively.
2.1.2.2 Real effective exchange rate tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
The real effective exchange rate (REER) is essential for assessing a country's competitiveness in relation to multiple foreign trading partners, rather than just one While nominal exchange rates can indicate competitiveness against a single country, the REER provides a comprehensive view of how domestic goods fare against all international competitors.
The Real Effective Exchange Rate (REER) represents a weighted average of the Real Exchange Rates (RERs) between a home country and its trading partners, with weights based on the trade shares of each partner As an average measure, a country's REER can fluctuate significantly.
A currency can maintain an "equilibrium" state, exhibiting no overall misalignment, when it is overvalued against certain trading partners while remaining undervalued against others (Luis A.V Catão, 2007).
Theoretically, there are Arithmetic Mean (AM) method and Geometric Mean (GM) method of averaging to calculate REER (Maxwell, 2004) defined respectively as follow:
Where RER i denotes real exchange rate of home currency against foreign currency i computed according to equation (2.1), wi denotes weights attached to currency i, t denotes time periods
When the Real Effective Exchange Rate (REER) is below 1 (REER1), the home currency is undervalued relative to the chosen base period, which enhances the competitiveness of domestic goods.
The two alternative methods for defining the Real Effective Exchange Rate (REER) index differ in their averaging techniques, which leads to variations in their computational strengths and weaknesses.
(2004) pointed out that the major strength of the AM is its ease of computation, which makes it more appealing to researchers and practitioners, including those in Vietnam
LITERATURE REVIEW 2.1 General arguments about exchange rate
Exchange rate concepts
In general and popular acknowledgement, exchange rate (also known as foreign exchange rate) between two currencies specifies the price of one currency in term of another currency (Maurice D.Levi,1996)
The exchange rate between two currencies consists of the base currency and the quote currency The quote currency indicates the value of the base currency, which is expressed in terms of the quote currency and typically represents one unit in the quotation.
When quoting exchange rate, there are indirect quotation or direct quotation and
In currency quotation, the choice between US style and European style depends on the selected home currency Indirect quotations reflect the value of the home currency in terms of foreign currency, while direct quotations show the value of foreign currency in terms of the home currency The US dollar plays a pivotal role in these quotations, as it serves as the term currency in US style quotations.
In Europe style quotation, US dollar is base currency
According to the Foreign Exchange Ordinance (2005), the exchange rate of the Vietnam Dong (VND) is defined as the amount of VND required to purchase one unit of foreign currency in Vietnam.
6 currency unit This implies direct quotation is used in Vietnam Also, all mentioned exchange rate in this study is quoted directly.
Nominal exchange rate and real exchange rate
2.1.2.1 Bilateral nominal and real exchange rate
The bilateral nominal exchange rate (NER) between two currencies is defined as the price of one unit foreign currency in domestic currency terms (Hinkle et al 1999)
NERs are popular because they are daily quoted by commercial banks for the purpose of serving customers who have demands for buying and selling currencies
The nominal exchange rates (NERs) of currency pairs are influenced by the supply and demand for currencies However, a significant limitation of NERs is that they do not indicate the purchasing power of a unit of foreign currency The bilateral real exchange rate (RER) addresses this issue by providing a clearer understanding of what can be bought with foreign currency.
The Real Exchange Rate (RER) is the ratio of domestic prices of tradable goods to non-tradable goods within a country, as defined by Hinkle et al (1999) It quantifies how many units of non-tradable goods can be exchanged for one unit of tradable goods An increase in the RER, when measured in domestic currency, indicates enhanced competitiveness for the country due to a rise in relative prices Assuming uniform prices for tradable goods globally, the RER can be mathematically expressed based on the distinction between tradable and non-tradable goods.
Where NER represents for nominal exchange rate between two currencies in index form; Pt and P * t represents domestic and international price of tradables respectively;
P n represents for price index in home country
The concept of Real Exchange Rate (RER) is defined in internal terms, while in external terms, it is represented as the Nominal Exchange Rate (NER) adjusted for price level differences between countries This adjustment reflects the ratio of the aggregate foreign price level to the home country's aggregate price level, measured in a common currency However, this study does not focus on the external aspects of RER.
The Real Exchange Rate (RER), as calculated in equation (2.1), indicates its value changes over time relative to a base year When the RER exceeds 1 (RER > 1), it signifies that the home currency is undervalued, resulting in lower average prices domestically compared to foreign markets, thereby enhancing the competitiveness of domestic goods Conversely, if the RER is below 1 (RER < 1), it indicates an overvalued home currency, with higher average prices in the home country than abroad, leading to a decline in the competitiveness of domestic products.
When calculating Real Exchange Rates (RERs), researchers often struggle with selecting appropriate empirical price and cost indices, a challenge that is particularly pronounced in developing countries Edwards (1989) highlighted that factors such as parallel foreign exchange markets, significant smuggling, unrecorded trade, and volatile terms-of-trade complicate RER measurement in these nations, unlike in industrialized countries Theoretically, RER is derived from tradables and non-tradables using the wholesale price index (WPI) or producer price index (PPI) alongside the consumer price index (CPI) as proxies, as noted in studies by Edwards (1988, 1989), Baffes et al (1999), and Elbadawi (1994).
This article discusses two key arguments regarding the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) The CPI reflects changes in the prices of consumption goods for domestic consumers and is significantly influenced by non-traded goods, making it a suitable measure for non-traded prices Conversely, the WPI, which includes a larger proportion of traded goods, is derived from the prices set in the international market based on the law of one price By multiplying the WPI with bilateral nominal exchange rates, we can accurately assess the price of traded goods in the home country Therefore, this study utilizes the WPI and CPI as proxies for tradables and non-tradables, respectively.
2.1.2.2 Real effective exchange rate tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
The real effective exchange rate (REER) is essential for assessing a country's competitiveness in relation to all its trading partners, rather than just a single foreign country While nominal exchange rates can indicate competitiveness against one nation, the REER provides a broader perspective by considering multiple foreign markets.
The Real Effective Exchange Rate (REER) represents a weighted average of the Real Exchange Rates (RERs) between a home country and its trading partners, with weights based on the trade shares of each partner As an average, the REER provides a comprehensive measure of a country's currency value relative to its trading partners.
A currency can achieve "equilibrium" by being overvalued against certain trading partners while remaining undervalued against others, as noted by Luis A.V Catão (2007).
Theoretically, there are Arithmetic Mean (AM) method and Geometric Mean (GM) method of averaging to calculate REER (Maxwell, 2004) defined respectively as follow:
Where RER i denotes real exchange rate of home currency against foreign currency i computed according to equation (2.1), wi denotes weights attached to currency i, t denotes time periods
When the Real Effective Exchange Rate (REER) is below 1 (REER1), the home currency is undervalued relative to the chosen base period, which enhances the competitiveness of domestic goods.
The two alternative methods for defining the Real Effective Exchange Rate (REER) index differ in their averaging techniques, which leads to variations in their computational strengths and weaknesses.
(2004) pointed out that the major strength of the AM is its ease of computation, which makes it more appealing to researchers and practitioners, including those in Vietnam
The geometric mean (GM), while more complex to calculate than the arithmetic mean (AM), offers valuable properties such as symmetry and consistency Unlike the AM, which is significantly affected by the chosen base year for index computation and requires rebasing for trend analysis, the GM remains unaffected by the base period This limitation of the AM can restrict the analysis of misalignment, as it is relative to the base year Additionally, while the AM assigns greater weights to currencies that have experienced significant appreciation or depreciation relative to the home currency, the GM treats these changes symmetrically.
This makes the GM more efficient in capturing trends in REER For all reasons above, this study uses the GM method of averaging to calculate REER of Vietnam Dong.
Main determinants of exchange rate movement
Exchange rates between two currencies are influenced by several key factors This section highlights five significant elements that are both theoretically and practically proven to cause fluctuations in exchange rates Generally, any increase in the supply of a currency tends to decrease its value, while an increase in demand for a currency typically enhances its value.
In the 1920s, Gustav Cassell introduced the Purchasing Power Parity (PPP) theory, which asserts that a country with a consistently lower inflation rate will see an appreciation in its currency value, as its purchasing power grows in comparison to other currencies.
If country A has a lower inflation rate than country B, the prices of goods in country B will be relatively higher This disparity in inflation rates influences trade dynamics, leading to increased exports from country A to country B.
As country B's economy grows, imports from country A will decline, leading to an increased demand for currency A and a decreased demand for currency B This shift in demand will impact the value of both currencies.
10 currency A will increases against value of currency B or exchange rate between the two currencies decreases in country A
The terms of trade of a country, defined as the ratio of export prices to import prices, play a crucial role in its economic health (Edwards, 1987) When export prices increase at a faster rate than import prices, the terms of trade improve, indicating higher demand for the country's exports This improvement leads to increased export revenues, which boosts demand for the national currency and enhances its value Conversely, if export prices rise more slowly than import prices, the value of the currency may decline relative to its trading partners.
The relationship between interest rates and exchange rates is intricate; however, a fundamental principle is that a currency with a higher real interest rate tends to appreciate against one with a lower real interest rate This occurs because higher real interest rates provide investors with greater returns compared to other economies, attracting foreign capital and leading to an increase in the exchange rate.
For example, real interest rate of currency A is higher than that of currency B
When capital movement is permitted between two countries, investors are likely to show interest in investing in currency A This increased demand for currency A leads to investors exchanging currency B for currency A, resulting in a rise in the value of currency A and a decrease in the exchange rate in country A.
2.1.3.4 Political stability and economic performance
Political stability and economic performance significantly influence how investors allocate their funds Foreign investors are drawn to countries with strong economic indicators and stable political environments, as these factors reduce perceived risks As a result, nations with favorable conditions attract more investment, leading to increased demand for their currency, which subsequently raises its value against others.
11 turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries
2.1.3.5 Condition of balance of payment
The balance of payment account is a comprehensive record of payment flows between a country's residents and the global economy over a specific period It indicates demand for the country's currency with a plus sign and supply with a minus sign, effectively illustrating the overall supply and demand dynamics for the currency.
The balance of payment consists of two primary components: the current account and the capital account The current account tracks a country's international trade performance, while the capital account measures the flow of capital in and out of the country This balance itemizes the factors influencing currency demand and supply, impacting its appreciation or depreciation Specifically, a balance of payment deficit indicates that the demand for foreign currency exceeds its supply, leading to a rise in exchange rates Conversely, a surplus suggests that the demand for foreign currency is lower than its supply, resulting in a decrease in exchange rates.
Trade balance concepts
The trade balance, a key element of the current account, reflects the difference between a country's exports and imports over a specific period, also known as net exports A trade surplus occurs when exports exceed imports, while a trade deficit arises when imports surpass exports Additionally, the current account encompasses other transactions, including income from international investments and unilateral transfers such as international aid.
12 sometimes divided into a goods and a services balance In this study, the trade balance is referred to merchandise trade
Where TB denotes the trade balance, X denotes the values of merchandise exports and M denotes the value of merchandise imports
The trade balance is a crucial component of a country's current account, significantly influencing its overall status A country's current account condition is vital as it indicates the extent to which it may need to borrow or lend to maintain balance in its payments A persistent current account deficit necessitates borrowing to cover the gap between imports and exports, leading to increased liabilities to the global economy Atish Ghosh and Uma Ramakrishnan (2006) warn that misusing borrowed foreign funds without generating long-term productive gains can jeopardize a country's solvency Lawren Summers (1996) emphasizes the importance of monitoring current account deficits exceeding 5% of GDP, especially if financed in a manner that risks rapid reversals Therefore, prudent management of the trade balance is essential for economic stability.
The trade balance of a country, which reflects the value of exports and imports, is influenced by six key factors identified by Maurice D Levi (1996) Generally, any factors that enhance exports will improve the trade balance, while those that diminish exports will worsen it Conversely, factors that increase imports will negatively impact the trade balance, whereas those that reduce imports will have a positive effect.
When inflation in the home country surpasses that of foreign countries, the cost of production domestically increases relative to international markets Consequently, this leads to a decrease in the competitiveness of home country goods, as they become more expensive compared to those produced abroad.
13 less competitive and thus the quantity of home country’s exports declines while imports rises As a result trade balance becomes deficit
Exchange rate fluctuations significantly impact trade balances Specifically, when the exchange rate decreases, it leads to a larger trade deficit, assuming other factors remain constant As the value of the domestic currency rises, the exchange rate falls, making locally traded goods more expensive while simultaneously reducing the cost of foreign goods.
The result is exports decrease, imports increase, net export decrease
Fluctuations in global prices significantly affect a country's trade balance When the prices of exported goods from the home country increase, the value of exports rises, leading to an improved trade balance, all else being equal Conversely, if the prices of imported goods rise, the value of imports also increases, which can negatively impact the trade balance.
Ceteris paribus, the trade balance deteriorates
An increase in real incomes among foreign buyers leads to a boost in the export market for both raw materials and manufactured goods from the home country This, in turn, enhances the home country's exports and improves its trade balance, assuming all other factors remain constant.
Higher import tariffs and lower import quotas, along with increased non-tariff trade barriers, can significantly reduce imports into a country If foreign nations implement these measures, it can lead to a decline in exports from the home country Conversely, when the home country enforces such restrictions, imports are likely to decrease.
Relationship between exchange rate and trade balance
The elasticities approach to the balance of payments is based on a static and partial equilibrium framework, influenced by economists such as Alfred Marshall, Abba Lerner, and Joan Robinson This approach emphasizes the importance of the Marshall-Lerner condition in understanding the dynamics of trade and currency adjustments.
The Marshall-Lerner condition, independently discovered by economists, addresses the critical question of when a real devaluation under a fixed exchange rate or a real depreciation under a floating exchange rate can enhance a country's current account balance.
This condition is based on two key assumptions: first, that trade in services, investment income flows, and unilateral transfers are zero, making the trade balance equivalent to the current account, which allows for an analysis of the relationship between trade balance and exchange rate Second, it assumes that supply elasticity is infinite.
The elasticity of demand for exports, denoted as \$\eta_x\$, measures the percentage change in exports resulting from a 1 percent change in the exchange rate Similarly, the elasticity of demand for imports, represented as \$\eta_m\$, indicates the percentage change in imports due to a 1 percent change in the exchange rate.
The Marshall-Lerner condition indicates that a real devaluation or depreciation of a currency can enhance the trade balance, provided that the absolute sum of the elasticities concerning the real exchange rate exceeds one, expressed as \$\eta_x + \eta_m > 1\$.
Numerous studies have examined the Marshall-Lerner condition, yielding varied results Most research indicates that the condition is satisfied in the long-run elasticity but not in the short-run elasticity, as noted by Hooper et al (2000) This suggests that real devaluation can enhance the trade balance over the long term, while its impact in the short term is negligible The underlying reason for this phenomenon is that elasticity tends to be higher in the long run and lower in the short run Recent findings highlight flaws in this theory, particularly emphasizing the critical distinction between short-run and long-run elasticities, which contributes to the J-curve effect.
2.3.1.2 The J-curve effect tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
The J-curve, introduced by Stephen P Magee in 1970, highlights a key aspect of the Marshall-Lerner condition, emphasizing that it takes time for consumers to adjust their preferences towards substitute goods This phenomenon explains why demand is more inelastic in the short run compared to the long run Following a depreciation and the resulting rise in import prices, residents may continue purchasing imports due to their unadjusted preferences for domestically produced alternatives and the lack of available domestic substitutes It is only after producers start supplying previously imported goods and consumers shift their purchasing decisions to these substitutes that the demand for imports can fully decline post-depreciation.
Depreciation initially worsens the trade balance as suppliers need time to increase production for exports and foreign consumers must adjust their preferences However, over time, this depreciation leads to an improvement in the trade balance as exports expand.
The time path of changes in the trade balance which has the pattern of letter J might look like that shown in Figure 2.1 (Maurice D.Levi, 1996)
Keynesian multiplier approach is a modified and extended version of the elasticities analysis in the sense that it take care of the limitation of the latter
Keynesians agree with elasticities approach that a devaluation of a country’s currency will improve the trade balance However, Keynesians argues that elasticities approach
Deficit (-) tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg
The analysis of exchange rate changes in Keynesian economics primarily emphasizes the automatic adjustments following shifts in a country's payment position, overlooking the impact on real output and monetary variables When a country faces a decrease in export demand, it experiences an initial deficit that leads to reduced domestic income and expenditure through the multiplier effect Consequently, with a positive marginal propensity to import and save, imports will decline, partially mitigating the initial adverse shift in the trade balance and helping to restore equilibrium.
The relationship between exchange rates and trade balance has garnered significant interest from researchers, leading to the development of various models tailored to specific country conditions Notably, the two-country imperfect substitutes model proposed by Goldstein and Kahn offers valuable insights into this complex dynamic.
The model developed by Tihomir Stucka in 2004 builds on the foundational work of Rose and Yellen (1989) and incorporates key aspects of both the elasticities and Keynesian approaches In this model, the trade balance is treated as an endogenous variable, influenced by the real exchange rate and the levels of domestic and foreign income, which are considered exogenous variables.
TB = f(Y, Y*, E), , , (2.5) Where TB represents trade balance, Y represents domestic income, Y* represents foreign income, E denotes real exchange rate in term of direct quotation
This model focuses on the merchandise component of trade, where imports and exports are analyzed alongside the trade balance Domestic income plays a crucial role in determining the demand for imports and the supply of exports.
Foreign income significantly influences export demand The models assume that imports and exports are not perfect substitutes for domestic products, allowing for the estimation of finite elasticities in demand and supply for most traded goods.
Besides, real foreign income and real exchange rate are expected to be positively related to the trade balance, while domestic income negatively related to the trade balance
Previous studies have examined the relationship between exchange rates and trade balance in developed countries, developing countries, and Vietnam While some research has incorporated additional exogenous variables, the majority of studies utilize the standard model (2.5) to estimate the trade balance equation.
2.3.4.1 Brief of empirical studies on developed countries
The United States and Japan have been the primary focus of research on the relationship between exchange rates and trade flows Rose and Yellen (1989) analyzed quarterly data from 1960 to 1985 and found no evidence of a J-curve pattern or a long-term relationship between bilateral exchange rates and trade In contrast, Marwah and Klein (1996) studied the US and Canada, revealing that after a depreciation, the trade balance initially worsens before following an S-curve pattern Bahmani-Oskooee and Brooks (1999) employed the Autoregressive Distributed Lag (ARDL) approach and found no J-curve effect but identified a significant long-term relationship, suggesting that a real depreciation of the US dollar positively impacts the trade balance.
The role of exchange rate policy to trade balance
Exchange rate policy is a crucial aspect of monetary policy, encompassing the government's (typically the central bank's) actions to influence the supply and demand for foreign exchange This is achieved through a selected exchange rate regime and a system of intervention instruments aimed at achieving specific objectives of the exchange rate policy, as well as broader monetary policy goals.
Exchange rate policy must align with monetary policy objectives to be effective Ohno (2003) identifies several key goals for macroeconomic authorities in developing countries, such as enhancing competitiveness, ensuring price stability, adjusting the current account, maintaining domestic financial stability, managing public debt, preventing currency crises, mitigating external shocks, and promoting growth, foreign direct investment (FDI), and industrialization.
Exchange rate policy in any nation typically consists of two key elements: the selection of an exchange rate regime and the establishment of instruments that enable the central bank to intervene in exchange rate fluctuations.
Every nation with its own currency must determine the appropriate exchange rate arrangement to adopt An exchange rate regime refers to the approach used by governments to manage their currencies in relation to other major global currencies.
Governments can adopt one of three primary exchange rate systems: the floating exchange rate, where currency values fluctuate based on market forces; the fixed or pegged exchange rate, which ties a currency's value to another major currency; and the managed floating exchange rate, a hybrid approach that allows for some market-driven fluctuations while also permitting government intervention.
In a floating exchange rate regime, a government permits its national currency to fluctuate based on market forces without intervention, meaning the central bank is not responsible for exchange rate variations The exchange rate is influenced by the supply and demand for currencies, leading to unpredictable movements that can impose a tax on trade and significantly affect investment in traded-goods industries However, purely floating exchange rates are rare today, as central banks often intervene to prevent excessive appreciation or depreciation of their currencies.
A government may choose to adopt a fixed exchange rate regime, aligning its national currency's value with that of a single foreign currency, a basket of currencies, or a standard of value like gold.
A fixed exchange rate regime is suitable for small open economies aiming to stabilize their currency against a pegged counterpart Due to constant fluctuations, central banks must actively intervene to uphold the official exchange rate in response to market dynamics.
A managed floating exchange rate regime allows a government to influence its currency's value without fully pegging it or letting the market set it freely According to Hu Xiaolian (2010), this regime encompasses three key elements: first, the exchange rate fluctuates based on market supply and demand, serving as a price signal; second, adjustments in the exchange rate are guided by trade and current account balances, highlighting its "managed" aspect; and third, the exchange rate is determined with reference to a basket of currencies.
Historically, both extremely floating and pegged exchange rate regimes, such as those during the interwar period and the Bretton Woods System, have faced significant challenges in open economies The pegged exchange rate under Bretton Woods was particularly susceptible to speculative attacks, while the floating exchange rate regime often overlooked the central bank's crucial role, leading to increased costs in international transactions Consequently, there is a growing consensus that central banks should actively monitor exchange rate performance and implement appropriate interventions.
The International Monetary Fund (IMF) oversees the functioning of the international monetary system by categorizing nine exchange rate regimes into three fundamental academic groups based on their flexibility.
Table 2.1 – Exchange rate regimes classification by IMF Fixed-rate regimes Intermediate regimes Flexible regimes
Currency unions involve multiple countries sharing a common currency, which can enhance trade and economic stability Horizontal bands refer to exchange rate systems where currencies are allowed to fluctuate within a specified range Managed floats are exchange rate regimes where a country's currency value is primarily determined by market forces, but the government intervenes occasionally to stabilize or influence the currency's value.
Dollarized regimes Currency board Conventional fixed pegs
The IMF recommends that countries select an exchange rate regime that aligns with their specific national policies and unique circumstances, as there is no universally optimal exchange rate system applicable to all nations at all times.
2.4.3 Instruments of exchange rate policy
Depending on the sensitivity of instruments on supplies of or demands for foreign exchange, instruments of exchange rate policy can be divided into two groups:
Direct instruments are employed by central banks to swiftly influence the supply and demand for foreign currency, allowing for immediate intervention in exchange rate fluctuations By utilizing foreign reserves, central banks can buy or sell currencies to align exchange rates with their expectations The effectiveness of such direct interventions is largely dependent on the size of these reserves, which is why the IMF advises central banks to maintain foreign reserves that are proportionate to their short-term liabilities and international settlements Additionally, direct intervention in the foreign exchange market can alter the currency base, impacting the overall money supply in the economy and potentially leading to inflation or deflation if neutralizing instruments are not utilized.
Administrative tools, such as mandates to resell foreign currencies and regulations limiting the buying and trading of foreign exchange, can significantly influence the supply and demand for foreign currencies However, central banks in market economies are generally discouraged from employing these direct and forceful measures due to their administrative nature.
2.4.4.2 Indirect instruments tot nghiep down load thyj uyi pl aluan van full moi nhat z z vbhtj mk gmail.com Luan van retey thac si cdeg jg hg