Dynamic Analysis of Trade Balance and Real Exchange Rate: A Stationary VAR Form of Error Correction Model Approach

Abstract

This paper analyzes the dynamics of trade balance and real exchange

rate based on the elasticity and purchasing power parity (PPP)

approaches. Here, a stationary vector autoregressive model with cointegration

error, transformed from the error correction model in Kim

(2012), is employed. Trade balance and PPP are jointly considered as

the two long-run cointegration relationships that represent external

economy equilibria. The model was applied to the dynamic analyses

of Koreas trade balance using monthly data from 1990, where model

variables from the elasticity and PPP approaches were selected. Based

on the estimation, we first confirmed the finding of Cheung et al.

(2004), whereas trade balance is additionally considered. The nominal

exchange rate adjustment, not the price adjustment, is the key engine

that governs the speed of PPP convergence, and the nominal exchange

rates were found to converge much more slowly than the prices. The

nominal exchange shock did not significantly affect trade balance,

whereas the price shocks did. Therefore, manipulation of the nominal

exchange rate through intervention to improve trade balance might

not be an effective policy tool.