Co-integrating relationship between terms of trade and current account deficit: the Australian evidence

Abstract

This paper examines the relationship between terms of trade and current account deficit (CAD) in Australia using the co-integration approach. The period covered is 1965:I to 1992:IV. Assuming that different exchange rate regimes will have different impacts on the relationship, the study considers three different exchange rate regimes for the period covered. The empirical results indicate that terms of trade along with domestic income and foreign income has a significant long-term relationship with the trade balance during the fixed exchange rate regime (1965:I to 1974:III), but not during the flexible exchange rate period. In other words, terms of trade did not have significant impact on Australia's current account deficit in the flexible exchange rate regime under study.