An Analysis of Trade Patterns in East Asia and the Effects of the Real Exchange Rate Movements

Abstract

This paper investigates how patterns of vertical specialization in trade among the three major East Asian economies ― China, Japan and Korea ― are shaped, and what the effects of the real exchange rate fluctuations on trade volumes are. We develop a simple two-country model that focuses on the multistage production process, and apply TimeVarying Parameter (TVP) VAR to the countries’ bilateral trade data. From our theoretical model, we find two distinct features of vertical specialization where multistage production processes occur: one is that, when a multistage production process exists, an increase in final demand in one country causes both countries’ intermediate goods exports to expand; the other is that, if a multistage production process exists in the production of one country’s final goods, then real depreciation of the currency in the other country has an amplified effect through the circulating trade chain. In the following empirical analysis, we first find that a multistage production process is prominent in the production of China’s final consumption goods. Another finding is that the existence of a multistage production process across two countries, especially Korea and China, strengthens the effect of the real exchange rate on intermediate goods trades through the amplified effect that the theoretical model predicts.