The Short-Run Relationship Between Real Effective Exchange Rate and Balance of Trade in China

Abstract

This paper analyzes the short-run relationship between the real effective exchange rate and the balance of trade in China. We examined the causality between effective exchange rate and balance of trade with Granger-Causality test using the monthly data from January 1994 to August 2009. The test suggests that in the short run balance of trade causes a change in effective exchange rate but not vice versa. The uni-directional relationship between exchange rate and balance of trade compels the use of transfer function methodology. Transfer function estimation shows that a shock in balance of trade has a 3-4 month delayed effect on effective exchange rate in the short-run but this delayed effect dissipates in the long run.