Nonlinear Causality between Exchange Rate and Trade: Empirical Evidence from Korea

Nonlinear Causality between Exchange Rate and Trade: Empirical Evidence from Korea

Despite the strong theoretical foundations of trade models, the empirical evidence in favor ofcausality between exchange rate and trade is relatively limited. Previous studies that adopt alinear framework typically fail to find evidence in favor of a relationship among the exchangerate, export and import. Unlike previous studies on the relationship among them, this study didnot assume any specific functional form of linearity and extended the analysis by applyingboth linearity and nonlinearity to the specification of testing Granger causality. This studyempirically investigates the link between exchange rate and trade through a new approach forgeneral representation of causality relation without restricting a specific functional form tomonthly data for Korea from 1990 to 2015. The empirical results show that there is acointegration among exchange rate, exports and import, and the causality is not only linear butnonlinear as well. More importantly, they imply that allowing for nonlinearities increases thenumber of rejections of the null of no causality, which supports the presence of nonlinearitiesin the data generating process. The finding demonstrates agreement with theoretical predictionsand significant improvement over previous efforts by the literature.