Real Exchange Rate Changes and the Trade Balance: The Evidence from Pakistan

Abstract

This study uses quarterly data from July 1980 to June 2006 to explore the relationship between changes in real exchange rate and the trade balance of Pakistan. Applying the Auto Regressive Distributed Lag (ARDL) approach to cointegration, we examine the existence of a possible long-run relationship. We find the following: (1) a long-run relationship between the series exists, and (2) the coefficient of elasticity is negative and statistically significant, which does not support for the J-relation. Given this, the policymakers should take a conservative approach in using currency devaluation to cure the fundamental disequilibrium in the balance of payments. It is likely that such policy may not produce the desired outcome—i.e., the trade balance may not improve.