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

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 Korea's 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.